LOOKING back thirty to forty years ago, the common stock, then in its pure but primitive state, was rather commonly regarded as the speculation of the enterprise; frequently representing no original investment at all, it was given as a bonus to the purchasers of the preferred stock, which thus represented the investment. If and as the company prospered, the common stock acquired a proportionate value. There was no element of intentional deception, but rather a commonly recognized practice. The common stock of no par value, a later evolutionary device, was then unknown, and therefore it was necessary to set up the common stock at its par value upon the balance sheet, which was forced into balance by entering as an asset an item entitled ‘goodwill,’ equal in amount to such common stock. Thus the idea gained currency that common stocks were essentially speculations for the future and not entitled to be regarded as sound investments.
Gradually conditions changed. The opening of the present century found the United States entering upon a period of unprecedented prosperity, which, with brief intermissions, has continued right up to date. Generally speaking, individual companies prospered. Most of them realized that the goodwill carried as an asset was nothing but ‘water/ and set about to write it off through profits as they accrued, instead of paying larger dividends.
In this manner common stocks became representative of actual value, both from the asset and from the earning-capacity point of view. They were justly entitled to be regarded as investments, representative of a proprietary interest in our growing country. But the investing public was slow to modify its earlier conception of common stocks as primarily a speculation. Bonds were the chief instrument of sound investment, and even good preferred stocks did not enjoy the full credit to which they were entitled.
Then came the Great War, with its natural but disastrous effects upon the bondholder. Interest rates advanced sharply, causing bond prices to decline. In response to economic laws, the purchasing power of the dollar fell off severely. The bondholder found both the market value of his investment declining and the goods he could purchase with his income decreasing. To add insult to injury, he saw common stocks profiting from war activity and increasing dividends.
Soon propaganda started to call this condition to the attention of the investing public. Bonds were old stuff a losing game. Common stocks were the thing — grow with the country! Everything fitted neatly into the picture and could be easily demonstrated by comparisons over the past twenty years. The bondholder was a fool. The public was captivated. All seemed so clear and simple now. Why had they not seen it before? Buy Common Slocks! Never mind the price! They were going up, and someone would pay you a profit. This new doctrine spread like wildfire, and the craze for common stocks was on. Is it any wonder that this condition, augmented by continued good business, has resulted in the most outstanding market phenomenon this country lias ever witnessed?
A common stock may very properly command a price which discounts the future. Chat is, its present income may not he sufficient to support ils current price, hul prospects of increased income may warrant the present price. If grow th of earnings fulfills this expectation within a reasonable number of years, the current price is sound; if not, it is too high.
The long-term bond of choice quality will never become obsolete. It may be less popular for a while, but it will always afford a definite income to its holder, and this with a ’high degree of assurance.’ It will also afford the ‘criterion of value of common stocks. To illustrate this comparative quality, good bonds and preferred stocks at present yield the investor 5 per cent and more, while common stocks yield an average of 4 per cent and less— in many instances very materially less, ft follows as a logical conclusion that the former are preferable to the latter for investment purposes, except upon the single hypothesis that earnings will so increase as to make possible, within the not too distant future, dividend increases sufficiently large to cause common stocks to yield more than bonds and preferred stocks yield now. While this is possible, it is extremely problematical, and certainly a liberal assumption.
The amount by which the market price of a common stock exceeds its tangible asset value per share represents a premium paid for earning capacity, and is quite similar to the item goodwill previously discussed. Such a. premium is quite sound and proper when supported by earning capacity, either present or prospective, provided it is within reasonable limits. Excessive premiums suggest such a high earning capacity of ‘tangible assets’ as to invite compelition and thus reduce earning capacity.
Analysis of a small group of prominent industrial stocks, exclusive of radio and aviation securities, at current price levels shows that, in spite of a substantial decline in market prices, the investor is paving four dollars for every dollar of tangible assets, which admittedly represents an enormous premium for goodwill and earning capacity. In the case of the stock showing the smallest premium, the investor is paying slightIv more than two dollars and a half for each dollar of tangible value, and even ibis is a very high premium. These facts afford some conception of the price now being paid for goodwill.
The effect of all this is quite parallel to the state of affairs in the early years of the epoch under review. In large measure we are returning to tactics of carly-day financing with common stocks, present market values resting largely upon goodwill and earning capacity, and, as such, representing essentially a speculation for the future — a reversion to type. History appears to be repealing itself. And so the pendulum swings, now this way, now that, and usually too far at its extremes.
In the field of exact science, given circumstances produce definite results which can be predicted with certainly. But economies is not an exact science, and, though its laws continually operate and eventually control, human volition may temporarily suspend their operation. This human equation renders the forecasting of security fluctuations hazardous at best and almost impossible of realization with sustained success. Export economists, experienced in financial affairs, can determine with reasonable assurance the course security prices ’should’ follow. This important step having been accomplished, the problem should then be submitted to the psychoanalyst, whose province it would be to determine how ’mass psychology’ will act under such given circumstances; and, if there be virtue in the claims of the psychoanalyst. here indeed lies an opportunity to prove his case.
A. M. CLIFFORD