Common Stocks and Common Sense

by ARTHUR W. JOYCE

THE past two years have witnessed wide extremes in common-stock prices — a very high peak and a very violent decline. These conditions have affected a vastly larger number of individuals owning stocks than was ever so affected previously. It is probably entirely conservative to state that there are now at least a million people owning common stocks whose acquaintance with this investment medium had its inception during the latter phase of the long bull market which paused quietly during the summer of 1929 and ended loudly the following November. It is probably equally conservative to say that these comparatively recent recruits to the army of stockholders were not inclined to be very analytical when they originally enlisted during those fast-moving days of 1928 and 1929. Speculation was rampant and the urge of rising prices and quick profits overshadowed everything else. In the time which has since passed, to stick to army vernacular, the fighting has been heavy and the losses tremendous, and it is more than likely that the greatly reduced numbers who are now reënlisting are doing so much more thoughtfully than before, irrespective of their previous length of service.

It may not be amiss, therefore, to suggest certain broad subjects to which they should give serious consideration.

BROADLY stated, there are only two distinctly separate types of securities — bonds, which are an evidence of debt, and stocks, which represent ownership. These definitions are elementary and smack of the schoolroom, but they are basic, nevertheless, and worth remembering. These two types are utterly dissimilar. They are designed for different purposes and they accomplish different results. Their very behavior, so to speak, is different. Now it is not intended in this paper to set forth the advantages and disadvantages of bonds and stocks, and certainly not to present a case for one over the other. The writer has previously been privileged to suggest in these columns that every investor should have a definite purpose in his investing, that ‘safety’ is less an evidence of purpose than it is of common sense, and that purpose is something which naturally varies among different individuals. Having in mind that more careful consideration is now being given to the subject of investments than ever before, it seems appropriate to carry these remarks one step further with the suggestion that the investor, in formulating his policy, should not stop with an analysis of the two types of securities and their respective adaptability to his needs, but should continue with a serious attempt to analyze himself, in order to determine his adaptability, as a human being, to them.

The fundamental differences between the two types of securities are no greater than the contrasts in temperaments and natural aptitudes of the investors who buy them. There are investors who are naturally lenders, whose temperaments are such that they can only contemplate their investments with complete peace of mind when their instinctive demand for safety, regularity of income, and relative stability of value is satisfied by the possession of high-grade bonds. There are also investors with a natural aptitude for the more active adventure of ownership and whose temperaments render them adaptable to its greater risks. Each of these types of individual doubtless obtains the greatest possible combined total of investment efficiency, plus peace of mind, when he sticks to the type of security for which he is best suited, because he understands it better and is thus apt to make fewer mistakes. Since it is not likely that any investor, be he naturally either lender or owner, will ever find his blood pressure raised very much by the possession of high-grade bonds, it follows logically that it is his approach to common stocks which presents the more serious problem.

THE logical reason for investing capital in common stocks is to obtain the advantages of longterm ownership in a successful enterprise. The primary advantage lies in the increase in the intrinsic value of the stock — a process which starts with the accumulation of undistributed profits and is greatly accelerated by the compounding of earnings thereon. Closely allied to this is the expectation that this increase will be accompanied by larger and still larger dividends. The priority assigned to this dual advantage must be correct, since it is the common stock alone among all securities which exemplifies it. The matter of current dividends is important, but it is secondary as a motive for investing in common stock. This also must be correct; for if it were otherwise, practically all investors would be lenders, preferring the superior advantages of the bond in regard to a fixed and well-secured income, and a principal which theoretically remains intact at maturity, to the greater risks along these lines which are inseparable from ownership.

There exists, however, a definite tendency among investors in common stocks to overrate the significance of current dividends. It is easy to understand why this occurs, because it is natural to associate income with capital; but the result throws the whole subject out of balance, is likely to destroy the investor’s perspective, and can readily lead to false conclusions. Since there is no such thing as a corporation which is uniformly successful year in and year out, it is not sensible to have any preconceived notion of the exact amount of dividends to be regularly obtained from common stock. The progress of a corporation in the right direction is not always indicated by the dividends it pays, nor is its lasting retrogression necessarily an established fact if dividends are reduced, because in the first instance regular dividend payments are quite likely to be continued a reasonable length of time beyond the point where they are justified by current earnings, and because in the second instance, especially under adverse business conditions, a dividend reduction, or even a temporary omission, may well occur at just about the time when current earnings are beginning to improve. Since it is a corporation’s earnings which justify its existence, and since these earnings are not always synchronized with dividend disbursements, the error of judging its progress by its dividend action alone is obvious. Reasonable stability of dividends may properly be expected, — this, indeed, is typical of the most conservative stocks, — but absolute stability of income simply is not a common-stock virtue.

There is also a tendency among investors to be unduly sensitive to the market action of common stocks. So far as market value indicates the price at which a stock is currently salable, it is definitely significant, but beyond this point the only certain thing about it is that it varies. Its variations naturally divide into two kinds — long-term variations (from year to year), or trends, and short-term variations (from day to day), which, for want of a better title, might be called spasms.

It is undoubtedly an ambitious act to touch so briefly upon such a complex subject as the significance of stock prices, but the justification for doing so here is to emphasize that an investor should be concerned chiefly with long-term trends, because they usually reflect basic conditions. Considering the great variety of conditions which influence long-term price trends, the investor will find that he has accepted a sufficient task in focusing his attention upon them alone without being distracted by day-to-day fluctuations. The latter are obviously too rapid to reflect changes in intrinsic values, and thus belong to the field of speculation, which, despite its lure of quick profits and notwithstanding its economic usefulness, is definitely outside the field of investment.

WHAT remains, then, for the investor in common stocks to turn to as the most reliable factor to assist him in determining, first, whether he is looking at them through the clear optical equipment of an investor or in a crystal ball; second, whether he is adaptable to them and whether he really wants to own them; and third, whether any given time is reasonably appropriate for their purchase, retention, or sale? He should ask himself if he recognizes that common stocks really represent partnerships, and if his attitude toward the stock of a given corporation is that of an investor who has decided that he wants to be u partner in it. The instant he grasps the full significance this aspect the entire subject clears up very rapidly.

There can be no doubt as to the character of the partnership. There need be no question as to the motive for entering into it. There should be no delusion as to risk, since ownership implies risk; and while there may still remain some qualms as to the investor’s aptitude for such risks, there is no law compelling him to accept them. Even the more complex question as to the most auspicious time for action is rendered easier to answer intelligently when the partnership aspect is recognized for what it really is, without in the least implying omniscience for the partnership attitude and not for an instant forgetting that good judgment is always essential. The conclusion is unmistakable that the proper approach by an investor to common stocks is from the point of view of partnership.