Chapter 6 of 10 · 3941 words · ~20 min read

Part 6

There is one point about dividends which is widely misunderstood by ordinary traders. It appears impossible to make a great many individuals understand that short sales may be as intelligently made the day before a stock sells “ex-dividend” as at any other time. Even when good reasons for a decline exist, traders fight shy of “swallowing the dividend,” or retire commitments just before dividend payment for no other reason than that such distribution is to be made, which is, in fact, no reason at all.

The disadvantage to the seller of stocks through the earning capacity or increment is the same on the day or the week preceding a disbursement as at any other time. The earnings of the company are a steady day to day affair, and are, as they accrue, constantly considered in the price of the stock. In other words, the prices of listed shares are at all times “flat.” At a point midway between two dividend days, the stock reflects in its current price half the amount of the undistributed dividend, or other increment. For example, if a certain stock sells normally at par and pays 6% per annum (3 per cent. in January and 3 per cent. in July) the price of the stock in March, eliminating speculative influences, would be 101½ and in July 103. When on July 1st, the 3 per cent. is distributed, the amount is simply taken away from the company and from the price of the stock also. It now returns to its normal price, 100, and whether it will go up or down from that point is a question for speculation. The factor which made the price 103 has been eliminated and it remains for the corporation in question to again earn 3% available for distribution before the next dividend day.

Perhaps this point may be made clearer by assuming that a certain stock is not handled on the “flat” basis, but is dealt in “and interest” after the method sometimes employed in bond transactions. Let us again eliminate speculation and take for example a stock selling at 100 and paying 6%. Assuming that a dividend had been paid on this stock on January 1st, the purchaser of the stock on February 1st would pay 100 for his shares, and would also pay to the seller the accrued dividend for one month, or ½ of 1% which is exactly the same proposition as if the stock had been quoted flat on the Stock Exchange at 100½. On March 1st, the purchaser would pay 100 for his shares and 1% accrued dividend or 101, etc.

It appears, therefore, that the widespread idea that it is dangerous to sell a stock just before a dividend day is not sound. In fact, the whole matter may be dismissed by saying that if there was any good or logical reason for expecting a premature recovery of the price of dividend-paying shares, or an advance founded on any reason in connection with dividends other than the gradual accumulation from one date of disbursement to the next, the whole problem of making profits in Wall Street would be solved. The rule must necessarily work both ways, and if it is dangerous to sell at certain periods, it must be, in inverse ratio, safe to purchase. All we would need to do therefore, would be to await the dates on which shares sold “ex-dividend” and make purchases. Here then, is exploited a patent way of getting the best of the market without study or effort. In truth, there is nothing whatever in the theory any more than there would be in buying Government bonds for a rise just after the interest had been paid on them. If good reasons exist for sales, they may be made as confidently at one time as another. The disadvantage of being short of dividend-paying stocks is always present, and it cannot be escaped, but the operation is a day to day affair not a matter of certain dates.

_Basing Railroad Values._

“The problem of railway valuation is comparatively simple, and beyond the reach of but few. A railway is primarily a carrier, a carter, a drayman. Obviously then, in considering an investment, we shall ask, What sort of a road has it? What sort of vans, and what sort of horses? What sort of trade? A teamster doing business on a fine level macadamized road, with big, heavy vans, and heavy draft horse, can work at a profit and underbid a carrier with old vans and poor horses, working on roads of heavy grade. So, for example, a railroad, other things being equal, with a water grade like the New York Central, has a tremendous advantage over an up and down grade like that of the Erie. The Illinois Central can do business much more cheaply than the Missouri Pacific. A road with a magnificent equipment like the Lake Shore can undercut a poorly equipped road like the Nickel Plate.

“The initial facts that we wish to know of a railway then are, What sort of a road has it, what is its traffic, does it get good rates? When we know what business it does, what its earnings are, then we shall ask, how is it capitalized, what are the fixed charges these earnings have to bear, what is there left, and what is the amount of stock which has to share the surplus? We shall ask if its earnings are stable, if the maintenance is adequate, if the policy of the road is conservative, if its management is good or bad. When we have done all this, then we shall go into the market, ask the prevalent rate of money, and by a simple rule of thumb, we shall know, in a broad way, whether the stock is cheap or dear.”--From “American Railways as Investments,” by Carl Snyder.

_The Effects of Business Depression on Rails and Industrials._

“There is apparently a popular belief that the general market always moves together in a considerable swing, and that any advance in one set of stocks would be accompanied by a corresponding advance in others. So far as the general tone of a day’s market is concerned this is true; but, nevertheless, individual stocks or groups of stocks can easily and gradually change their selling basis in a brief period of time. In 1901, for example, the industrial stocks reached their high levels, and suffered a considerable decline in 1902. Meanwhile the rails were advancing. To illustrate and confirm this statement the highest prices of both Rails and Industrials in July, 1901, and July, 1902, are set forth in the following tables. There can be no unfairness in choosing this particular period. What is to be demonstrated is that it is possible for the groups to cross each other in price in a given time. The ten most active stocks have been chosen in each group as fairly representative of the entire market:

RAILROAD STOCKS.

High in High in Stock July, 1901 July, 1902 Atchison 89⅜ 95¾ B. & O. 108¾ 112⅛ Can. Pac. 108¼ 139¾ St. Paul 177¼ 189⅜ Erie 43⅝ 39½ L. & N. 111 145⅞ Mo. Pac. 121⅞ 119½ Penna 151¾ 161¾ Reading 47 69⅞ Union Pacific 110⅞ 110⅝ ------- ------- Average price 102.97 118.41

INDUSTRIAL STOCKS.

High in High in Stock July, 1901 July, 1902 Amalgamated 124¼ 68¾ American Smelting 58 47½ American Sugar 145⅝ 134½ Anaconda 48⅞ 27 Col. Fuel & Iron. 116⅛ 102¼ National Lead 23 22¼ Tenn. Coal & Iron 72½ 69½ Rubber 21¼ 17 U. S. Steel 48⅞ 41 U. S. Steel, Pfd. 99½ 92⅛ ------- ------- Average price 75.80 62.18

“These tables show that during the fiscal year used, railroad stocks advanced an average of over 15 points, while industrials declined almost 14 points. In other words, the spread was 29 points. The man who bought rails and sold industrials would have made on the average 29 points. This exhibit entirely overthrows any argument that the market moves one way or the other homogeneously.

“There was a reason for the spread illustrated above. There always is a reason. We had big crops in 1902, which helped the railroads. The industrials, on the other hand, were busily discounting the business depression of 1903.

“Precedent shows that in a period of general depression Industrial stocks suffer about 33% more than rails. That is to say, in the high and low prices covering a long period, industrial securities should show a distinctly greater pro-rata of decline. Let me illustrate, using the stocks employed in the former table and covering the period of our last great cycle, 1901-02-03. As most of the high prices in rails were made in 1902, the highest prices of both 1901 and 1902 will be used, and the lowest of 1903:

RAILROAD STOCKS

High in Low in 1901-1902 1903 Atchison 96⅝ 54 B. & O. 118½ 71⅝ Can. Pac. 145¼ 115⅝ St. Paul 198¾ 133¼ Erie 45½ 23 L. & N. 159½ 95 Mo. Pac. 125½ 85¾ Penna 170 110¾ Reading 78½ 37½ Union Pac. 133 65¾ ------- ------- Average price 127.11 79.22

INDUSTRIAL STOCKS.

High in Low in 1901-1902 1903 Amalgamated 130 33⅝ Am. Smelter 69 36¾ Am. Sugar 153 107⅛ Anaconda 54¼ 25½ Col. F. & I. 136½ 24 Nat’l Lead 32 10½ Tenn. Coal & I. 76⅝ 25⅞ U. S. Rubber 34 7 U. S. Steel 55 10 U. S. Steel, Pfd. 101⅞ 49¾ ------- ------- Average price 84.22 33.01

“It will be observed from the above table that Industrials declined about 51 points while rails declined about 48 points. But the decline cannot be figured in points. The higher range of railroad shares must be considered. A decline of two points in a stock selling at 100 is only equivalent to a decline of one point in a stock selling at 50. Therefore, in order to get a correct view of the matter, we must reduce the decline to percentages. On this basis, railroad stocks lost about 38% of their value, and industrial stocks lost about 60% of their value.”--From Thomas Gibson’s Market Letter, May 4th, 1907.

_Undigested Securities._

“The new methods and the new projects are going through the test of fire today, and some of them are being consumed. The tests which weeded out the badly organized and incompetent of the early stock companies, which drove to the wall the “wildcat” banks of ante-bellum days, and which wiped out dividends and stock rights in badly managed railways, are now being applied to the new forms of organization which have been the growth of the past decade. But the stronger and better organized of these new corporations are likely to meet these trials without disaster, or to modify their methods to conform to the teachings of experience, until there remains to the financial world a valuable residuum of new methods for giving flexibility to capital and promoting its transfer promptly and efficiently from the industries where it is not needed to those where it will render its highest service.”--From “Wall Street and the Country,” by Chas. A. Conant.

_How to Compute the Value of Rights._

“Inasmuch as the method of computing the value of rights is slightly complicated, an illustration may be given. Let us take the instance of St. Paul again, where the stockholders were allowed to subscribe to 23% of their holdings to new stock at par. The common stock was at that time selling a little below $200 per share. Let us take the round figure, and the operation is as follows:

One hundred shares at $200 per share equals $20,000 Twenty-three shares at $100 equals 2,300 ------- Total cost of 123 shares $22,300

“Average cost, $181 per share.

“Deducting $181 from the market quotation leaves $19, the value of the rights on each share of St. Paul stock. As a matter of fact, the selling price was a little below $200, and the highest price of the rights fell a little below $19 per share.

“In other words the process is simply to take the number of new shares per hundred shares of the original holding to be subscribed for, and add the value of these new shares at the subscription price to the cost of one hundred shares at the market price; then divide the total cost of both old and new shares by the total number of shares, and deduct the average price from the market quotations. This gives the selling value of the rights.”--From “American Railways as Investments,” by Carl Snyder.

_Barometer of Averages._

“In order to facilitate the examination of properties and their comparative condition, the following table has been prepared. The figures were arrived at by averaging the operating expenses, fixed charges, margin of safety, and dividends of principal properties for the last fiscal year. The stock prices are based upon the closing figures of June 6, 1907. The margin of safety shown, is the margin over common dividends. Results were as follows:

Average operating expenses 69.01% Average fixed charges 54.70% Average margin of safety 5.28% Average dividend common 6.03% Average price of stock 1.09⅝

“As in all computations of this kind the figures are comparative and not basic. The fact that one stock is in a much better position than others does not necessarily mark that stock as a purchase, for _all_stocks may be too high, and underlying conditions may not warrant purchases in any quarter. Again, we must always consider the fact that important elements which cannot be tabulated in figures may be present. However, the table possesses value as a rough barometer, and after it has been broadly applied, specific influences may be given due consideration. If, for example, we find a common stock selling well below 109⅝, with operating expenses below 69.01; fixed charges below 54.70; margin of safety above 5.28 and the dividend rate above 6%, we have a remarkable combination of facts favoring the shares and investigation will be stimulated. The figures vary widely at times in different corporations and cannot always be considered either bullish or bearish, as the good or bad features may be already discounted in the current price of the shares. It may also be found that one property is going backward gradually while another is improving its position.--From Thomas Gibson’s Market Letter, June 8th, 1907.

_The Best Method of Trading._

“It may appear that if the market is to sway back and forth, sales on advances, and purchases on declines would offer the maximum of opportunity to the shrewd trader. But not so. To illustrate this, a market movement from high to low prices as shown by a chart is presented on the following page.

“As simple as this illustration may appear, it is worthy of most earnest consideration. True, the upward and downward movements show opportunities on both sides, but if the _purchaser_ makes a mistake, as all speculators will, he is hopelessly involved. If he buys at the wrong point he will never see daylight during the progress of the movement. Look at the other side of the matter. The _seller_ cannot make a mistake. No matter at what point he sells a profit lies before him. A little reflection will show what a tremendous difference exists here.”--From Thomas Gibson’s Market Letter, Feb. 2nd, 1907.

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_Indications of Crises._

“Preceding Indications.--This preceding period is characterized by well-defined indications, some of which develop contemporaneously, but which, so far as they are distinct in time, occur in approximately the following order:

“1--An increase in prices, first, of special commodities, then, in a less degree, of commodities generally, and later of real estate, both improved and unimproved.

“2--Increased activity of established enterprises, and the formation of many new ones, especially those which provide for increased production or improved methods, such as factories and furnaces, railways and ships, all requiring the change of circulating to fixed capital.

“3--An active demand for loans at slightly higher rates of interest.

“4--The general employment of labor at increasing or well-sustained wages.

“5--Increasing extravagance in private and public expenditure.

“6--The development of a mania for speculation, attended by dishonest methods in business and the gullibility of many investors.

“7--Lastly, a great expansion of discounts and loans, and a resulting rise in the rate of interest; also a material increase in wages, attended by frequent strikes and by difficulty in obtaining a sufficient number of laborers to meet the demand.”--From “Crises and Depression,” by Theodore Burton.

_The Ordinary Swing of Prices During a Cycle of Speculation._

_The Factor of Safety._

“There remains but one point to which, in view of the conditions roughly sketched above, the writer would call especial attention. That is, that the investor should look well, always, to the factor of safety. Before he puts his money into any road, no matter if it be on the recommendation of the greatest banker in the United States, let him consider how far that company is prepared to weather a storm. Few roads ever prospered under receivership, no matter how honest or how able. The receivership itself is a handicap. No matter how high the yield, no investor whose primary regard should be the safety of his money will put it into a road whose fixed charges, after ample charges for maintenance, consume much more than 50% of the total net income available for interest, dividends and improvements--that is, save in exceptional cases like the New York Central--and until he has satisfied himself thoroughly that the property is sound.

“For the convenience of those not well acquainted, the following list of the principal roads is given, with the percentage of total net income consumed by fixed charges in the highly prosperous fiscal year of 1905:

TABLE OF FIXED CHARGES.

Atch., Top. & S. Fe 42% Chi. & East. Illinois 68% Atlantic Coast Line 57% Chi. & N’western 39% Baltimore & Ohio 39% Chi., Bur. & Quincy 45% Boston & Maine 78% Chicago Gt. Western 67% Canadian Pacific 33% Chi., Mil. & St. Paul 32% Central of Georgia 47% C., St. P., M. & O. 42% Cen. R. R. of N. J. 50% C., C., C. & St. Louis 69% Chesapeake & Ohio 53% Col. & Southern 55% Chicago & Alton 73% Delaware & Hudson 40% Del., Lack. & West 38% N. Y., Chi. & St. L. 41% Denver & Rio Grande 52% N. Y., N. H. & H. 48% Det., Tol. & Ironton 87% N. Y., O. & Western 53% Du., S. S. & Atlantic 115% Norfolk & Western 37% Erie 66% Northern Central 28% Gr. Rap. & Indiana 76% Northern Pacific 29% Grand Trunk 65% Pennsylvania 38% Great Northern 26% Pitts. & Lake Erie 11% Hocking Valley 31% P., C., C. & St. L. 54% Illinois Central 47% Reading 45% Iowa Central 79% Rock Island 83% Kansas City South’n 54% Rutland 69% L. Erie & Western 69% St. L. & S. Fran. 82% Lehigh Valley 46% St. L. & S’western 76% Long Island 101% Seaboard Air Line 78% L. S. & M. S. 38% Sou. Pacific 49% Louis. & Nash. 54% Southern 69% Maine Central 46% Texas & Pacific 40% Michigan Central 57% Tol., St. L. & S’w’n 61% Minn. & St. Louis 77% Union Pacific 31% M., St. P. & S. S. M. 44% Vandalia 54% M., K. & T. 75% Wabash 80% Missouri Pacific 60% Wheel. & Lake Erie 90% N. Y. C. & H. R. 64% Wisconsin Central 69%

_Importance of Fixed Charges to the Investor._

“The high degree of stability imparted to interest payments and dividends by a low percentage of fixed charges, and the high degree of instability imparted by a large percentage, is so elementary that it would seem to need no emphasis. And yet this item is habitually disregarded by perhaps 90% of bond and stock buyers. On this account it may be worth while to illustrate by simple comparison the effect of a 20% decline in gross or net earnings. We will compare the conditions of two roads whose fixed charges are respectively 75% and 25% of the total net income. The operation would be as follows:

Suppose a 20% Decline Say Earnings $1,000,000 $800,000 Exp. (70%) 700,000 560,000 ---------- -------- Net $300,000 $240,000 If F. C. 75% = 225,000 225,000 ---------- -------- Surplus for div. $75,000 $15,000 (Case I) Decrease 80% If F. C. 25% = 75,000 75,000 ---------- -------- Surplus $225,000 $165,000 Decrease 26% (Case II)

“It will be seen from the above that a 20% decline in the net earnings would, in the first instance, mean a decrease of 80% in the surplus; while in the second case, the same decline would mean a decrease of only 26% in the surplus--figures which sufficiently indicate what a high percentage of fixed charges means.

“In this connection it may be further noted that in the large holding companies, like the Pennsylvania, the New York Central, the Union Pacific, and others, the factor of safety and the surplus shown tends to be relatively more stable than in companies largely or exclusively dependent upon the earnings of their own roads. This is due to the general custom of American Railways of paying out in dividends only a part of the actual surplus earned. From this it results that dividends are much more stable than earnings, and that the income of the holding companies from this source will correspondingly show smaller fluctuations than earnings. When, therefore, as in the case of some of the large holding companies named, the income from investments represents a considerable portion of the total net income shown, the surplus, other things being equal, will be much more stable than in other companies.

“It is needless to add that this stability is still further heightened when, as in the case of the Pennsylvania, Union Pacific and some other roads, the percentage of fixed charges is at the same time low.”--From “American Railways as Investments,” by Carl Snyder.

_Borrowing and Lending Stocks._

“When a speculator sells stock which he does not possess (when he sells it short) he (or what is the same thing, the broker who acts for him) has to borrow the stock to make delivery to the purchaser. The one who possesses stock (who is long of it) is, in ordinary circumstances, as anxious to lend it as the one who has sold it short is anxious to borrow it.