Common Stock Investment

Buy what thou hast no need of and ere long thou wilt sell thy necessaries,    —poor richard

INTRODUCTION

As we have already seen, the ownership of common stock presents certain advantages and also certain disadvantages. Among the former are ownership in the business, the opportunity to share in the profits, the receipt of dividends, and also a hedge against inflation. Chief among the latter are the fluctuation in price (value), fluctuation in dividends, and the total risks which must be assumed. Nevertheless, as we have made clear, a well-planned series of in­vestments should include some common stock representation. Quite obviously, whatever com­mitments are made must be undertaken with extreme care; one cannot evaluate a particular stock, for example, without knowing the place it occupies in the industry within which it oper­ates, so that familiarity with the promise held by each segment is both desirable and necessary.

The main distinguishing characteristic here is the degree of sensitivity to variations in business conditions. With this in mind, we may draw up a table in which we will attempt to classify various industries according to their degree of sensitivity so that we may be in a position to know what to expect when investing in a certain type of industry.

The lesson to be derived from the table below is quite simple: utility issues may offer far more stability in revenues, earnings, and dividends than many a railroad or industrial so-called "blue-chip" stock. This has been abundantly shown in times of historic business breaks, such as 1929-32 and 1937-38 and also in any period during which the general economy feels some strain. During a depression the loss of patronage to a utility is in the low-rate and low-profit crude oil textiles commercial portion of the business. During a spurt of prosperity, the utilities show a slow and steady advance in earnings because of the pres­sure to provide additional facilities to meet additional demand. Our concept here of utilities includes natural gas company shares as well as those of electric power, water, and telephone companies.

Sensitivity
Low                                  Average                                     High
telephone                    railroads                                automobiles
electricity                    chemicals                              electrical equipment
water                          paper                                    machinery
gas (residential)           retail trade                            manufacturing
food                           motion pictures                     mining
insurance                    gas (commercial)                   coal
banking                      petroleum                             rubber

Three important matters deserve investiga­tion as a safeguard before a stock is chosen for investment: (a) what proportion of total capi­talization is in bonds and/or preferred stock (optimum no greater than 70 per cent); (b) how many times are such fixed charges earned (optimum three or better); (c) what percentage of total revenues is actually brought down to the common stock after allowing for all prior obligations? This last is to make certain that fixed charges will not eat up the available revenue and leave little or nothing for the com­mon; a minimum figure in the neighborhood of 10 to 12 per cent is desirable. Should the in­vestor be unable to determine these important factors, then he should appeal to his broker or investment counsel for such information; to overlook them would be to court future disaster.

The regular and rather dependable earnings of the public utilities will allow for regular dividends, which, on an over-all basis, may amount to a considerable percentage of earn­ings. Naturally, generous dividends will be very acceptable to the stockholder and these, cou­pled with the promise of continued steady earnings, have placed such utility shares in con­stant demand. While prices are by no means excessive, they usually reflect the high esteem in which such shares are held by investors. Price fluctuations tend to be restricted because of the relative stability in earnings, particularly in comparison with industrial stocks, which mirror the impact of general business conditions because they are so dependent upon them for their success.

In addition to inquiring into the satisfactori-ness of the capital structure of the company, there are a few other matters deserving of seri­ous consideration. Is the territory served stable and prosperous? Is there danger from com­petition with public power facilities? Are rates satisfactory, and are the rate-making commissions reasonable in their attitude? Are operating costs well controlled? Is there adequate provi­sion for depreciation and maintenance (about 15 per cent of gross sales) ? How large and how dependable are the hydroelectric facilities? Is there a majority of residential load? In making any comparisons, all these items deserve atten­tion.

In conclusion, it may be said without serious challenge that the securities of many public utilities are usually of good quality and deserve consideration as investment media especially suitable for the investor of modest means. They represent, at least in most cases, good values and provide a relatively steady income with some possibilities of further growth. Information con­cerning them is readily obtainable, and their an­nual reports are usually available for the asking. Appendix D suggests a number of likely candi­dates; the current price and dividends are tabulated; careful study of this table may bring its rewards.

THE INDUSTRY APPROACH

Let us now suppose that the investor is in­terested in some other category than the public utilities and wonders just how to decide upon some particular common stock which he may feel is worth purchasing. How should he go about it? Certainly not by listening to "tips" or other misinformation. Certainly not by taking the "advice" of someone who is really not quali­fied to give it. Certainly not by paying any at­tention to "scare" headlines in the current papers. How, then, should he proceed?

All investment in common stocks requires both proper timing and proper choice. If one knows what to buy, there is also the problem of when to buy. We will all agree that hind­sight is much easier to come by than fore­sight; anyone could easily have made that first million by being amply supplied with both. It is equally plain that certain industries have come a long way in the last decade or so; for example, the drugs, cements, electronics, and air conditioning. Many of these cannot be con­sidered any longer as bargain-counter items, because of strong demand.

The aim of most investors is to buy under the general market, so that the purchase of items within those groups which are now at their peaks would, most certainly, be open to question unless one thinks that they may go even higher! Perhaps the really smart thing might be deliberately to pick a certain industry which seems to have lagged behind the general parade and shows evidence of having been neglected because it lacks current "glamour" in the eyes of the investors, although lowered price does not always indicate a bargain price. Supposing such an industry has been spotted, then the next step might be to find a particular stock within that segment which seems to offer interesting possibilities and to compare it with others in the same field with regard to the immediate and the long-term outlook.

Too many people are willing to buy a certain stock without regard to its position in the in­dustry which it represents and, more often than not, without making any sort of comparison with others in the field. Such an analysis as here indicated cannot be made in a few minutes. Some industries may be behind the general market action, but this does not necessarily in­dicate that they are reasonably priced; much depends upon the value which the current mar­ket attaches to possible future earnings; the catch here is to find some which have been ig­nored by the current market, and a certain amount of statistical digging will often make this apparent. A general knowledge of all seg­ments of the economy is part of the appraisal considered above, but coupled with this must go a certain sense of timing, since what to buy must always be accompanied by when to buy. Should present indications point toward a main­tenance of present business conditions for some considerable period of time in the future, then careful investigation is required to make a satis­factory choice. In this connection the broker may be able to offer considerable assistance.

In picking out an appropriate industry for investment considerations, we must keep in mind the fact that each industry differs from the rest in certain particulars and that each involves certain factors which have a direct bear­ing upon the soundness of their securities. The features noted in the paragraphs which follow will make this clear.

How permanent is the industry? Is it one which will shortly go the way of the carriage-makers and the traction companies? It is cer­tainly true that all kinds of industry do not continue indefinitely. The fact that our mode of living is in a state of continuous change is seldom recognized except, perhaps, by those older inhabitants who still talk about the "good old days." There are children today who have never seen a streetcar or ridden in a horse-drawn vehicle. Advances in technology, change in public living habits, change in law, change in foods and clothing—all these and many others simply draw attention to the fact that change is a basic feature of economic life. Pro­tection for the investor lies in the careful selec­tion of industries that are growing and not de­clining, dynamic and not static, coupled with the realization that a trend which will make certain products and services obsolete must be continually born in mind.

A growing industry has numerous advantages because the very newness of it means that op­portunities to develop new products and proc­esses are large, that the opportunities for future gains are large, that the time of destructive competition has not yet arrived. Such examples as chemicals (including plastics and petro­chemicals) , aviation, rubber, glass, and elec­tronics are well known. In some instances, the discussion of such growth industries has resulted in an unusual demand for these securities, with accompanying higher prices; caution is indi­cated and implies that such purchases should be made with both present and future develop­ments carefully weighed.

The stability of an industry is of considerable importance, since wide fluctuations in earnings and dividends will not make for a genial invest­ment atmosphere. This is particularly true of the so-called "heavy industries," sometimes called "feast and famine" industries, whose sales and profits may at times be spectacular and at other times shrink to zero. Great care is needed here since the investor may well be blinded by current successes and become over-optimistic; studies of past behavior may prove instructive.

Geography plays a large part in selection; for example, it is important to realize that a single plant in one location will bring heavy shipping charges, while a number of plants, strategically located, will permit considerable savings in such charges. The chain food stores are a good ex­ample of this, since they serve a national mar­ket. Another important aspect o£ geography is the determination of population shifts, since the actual growth in population of one section of the country at a faster rate than elsewhere indicates a new and expanding market.

Government intervention is an important item. Certain food items, such as sugar and milk, are enveloped in government regulations; in some cases, as with some of the power com­panies, stiff competition has been met from nearby government or cooperative power proj­ects. Any change in government attitude, with an accompanying change in government action, could be quite important to certain industries.

The attitude of labor toward certain indus­tries deserves mention. Those industries should be sought where labor costs and the total amount of labor participation is small; in those cases where labor is involved to a greater extent, the general attitude of the union involved should be carefully appraised. In some cases, mechanization and automation are reducing the labor problems which certain industries must meet.

Finally, the subject of diversification becomes important. A business management which seri­ously undertakes diversification is protecting itself, since experience has shown that depend­ence upon a single product or service is open to very severe reverses. This means, for ex­ample, that a petroleum refiner may find it ad­vantageous to go into the field of petrochemicals and that a rubber firm will become interested in the field of rubber chemistry and processes. We must emphasize, however, that diversifica­tion achieved by merely buying a heterogeneous collection of other firms is not the real thing; it may prove profitable, but it does not provide the foundation upon which to build for years to come, because it often does not permit true integration. For example, it would be better for a machine-tool company to acquire a builder of road-making machinery than, let us say, to merge with a food processor. Similarity of "know how" is very essential to success in such a case, and there have been numerous instances in which attempted diversification by acquisi­tion has proven a great disappointment. The management of a fully integrated company is a big job in itself; the management of a firm with distributed branches is a still larger task; but where a series of far-flung enterprises are thrown together that call for very different know-how or are even in unrelated fields, it is doubtful if one can consider it a master stroke; to the contrary, it will rightly cause many an investor to shy away from such a situation. Let us be reminded here, as always, that there is a strong distinction to be made between invest­ment and speculation.

Last of all: what is the outlook, both for the immediate and the long term? Are prospects really bright? Does the industry represent some­thing basically sound? Is it really "here to stay"? In case of doubt, do not invest; too often you may be speculating without knowing it.

The above remarks are largely made as a mat­ter of caution; there is no hurry to buy any stock; the time should be taken to investigate thoroughly any industry before considering the choice of a stock within that segment.
Our next question is how to make the selec­tion of the stock itself, assuming that the indus­try has been decided upon; the ways in which this may be accomplished in a fairly objective and unemotional manner appear in the section which follows.

Most stock analysts are agreed that if we are to obtain a true picture of the worth of any stock, we must project its earnings and dividends into the future; this is because it is being bought for its future performance. For the average in­vestor to attempt to do this would be impos­sible, for he usually has no background and no training in this type of analysis; perhaps one investor out of ten thousand even has the time, much less the means at his command. As a re­sult, it would seem best for the prospective in­vestor to attempt a simple evaluation based upon present data, largely with the idea in mind of making a tentative selection; he may then obtain the outlook relative to future performance from his broker or by means of one of the various investment advisory services to which his broker will no doubt subscribe. We will adopt this as our best and most expedient compromise and will now set forth the various data which will have a bearing on the solution of the problem of selection.

Pertinent data concerning any particular stock will include a number of things which are rela­tively easily obtained, some from the most recent annual report, some from current liter­ature, and some from the quotations to be found in the current newspaper financial page. Let us first present a fictitious annual report and show how it is read.

GREATER GADGETTE MANUFACTURING COMPANY

Consolidated Balance Sheet—December 31, 1960
ASSETS                                                                LIABILITIES

CURRENT ASSETS:                                               CURRENT LIABILITIES:

1. Cash................... $1,000,000  Accounts payable............................... $ 300,000
2. Securities.............       500,000. Accrued taxes....................................... 700,000
3. Accounts receivable                  1,500,000                  . Accrued wages and other expenses....550,000
4. Inventories (cost or market)            1,000,000

TOTAL CURRENT ASSETS................................................................ $4,000,000       TOTAL CURRENT
LIABILITIES……1,550,000

5. Other investments (cost)......................................................................      200,000     Contingency Reserves…. 250,000
6. Property, plant and                      Capital Stock: 4% preferred $10 par, equipment at cost—. . . $7,500,000             authorized and issued100,000 shares                                                             $1,000,000
7. Reserve for depreciation… $5,500,000

1. Net Property.... .$2,000,000        Common, authorized and
2. Deferred charges      600,000          issued 400,000 shares,
3. Patents, good will                                 200,000.............. no par value    $1,000,000

total assets........ $7,000,000                                                             

1. Surplus:                                        $2,000,000
2. Earned                                         $2,400,000
3. Capital                                             800,000     3,200,000
4. TOTAL LIABILITIES                 $7,000,000

Consolidated Income and Earned Surplus Tear Ending December 31, 1960
28. Net                                                                                                    Sales$4,280,000
29. Cost of goods and operating charges:
30.Cost of goods and selling expenses................................... $2,900,000

1. Depreciation...................................................................       150,000
2. Maintainance, repairs......................................................      100,000
3. Taxes, other than Federal Income Tax.............................         50,000      3,200,000
4. Net Profit from Operations $1,080,000
5. Other income (royalties and dividends) 220,000
6. Total income $1,300,000
7. Provision for Federal Income Tax     676,000

41.net income    $   624,000
42.   Less dividends:
Preferred Stock $0.40 per share$     40,000
Common Stock $1.00 per share      400,000

1. Balance carried to Earned Surplus$   184,000
2. Earned Surplus January 1, 1959  2,216,000
3. Earned Surplus December 31, 1960 $2,400,000

KEY TO NUMBERED ITEMS

1. Current Assets. These are often called "quick assets," since they represent cash and things which may be turned into cash when necessary.
2. Cash is just exactly that: money in the bank.
3. Securities represent such things as U. S. Government Bonds which are readily marketable; values are usually given at cost or market, whichever is the lower figure.
4. Accounts receivable represents all money owed to the company by its customers; usually these are debts which have been incurred by taking merchandise on credit. Such accounts are deemed payable within the next year.
5. Inventories: the value the company places upon the finished goods and raw materials which it has on hand; usually cost or present market value, whichever is lower.
6. Total current assets: very important; represents the total of the above separate items.
7. Other investments usually means good marketable securities other than the governments listed above.
8. Property, plant and equipment could be labeled "fixed assets"; includes land, buildings, machinery, furniture, trucks, office equipment, etc. Commonly these are listed at cost, although some items may be "written up" if, for example, the company real estate has advanced in value; other items may be "written own" if they become out of date.
9. Depreciation shows provision has been made to set aside funds which will take care of that sort of equipment which wears out with the passage of time. Adequate depreciation reserves are quite important in the proper conduct of any business.
10. Subtraction of Item 9 from Item 8 gives the net property valuation.
11. Deferred charges represent an expenditure similar to a prepayment which is not yet refunded. Suppose a new product has been introduced and that a considerable expense has been undertaken to advertise it, distribute samples, and then await the results. Since the returns will not come in for some time, the charges have been "deferred" and will be written off gradually.
12. Patents and good will refers to the fact that a new process or product is jealously guarded and the patents issued are of great worth to the company itself; these are sometimes called "intangibles" because it is so difficult to assign proper values to them. A good example is a brand name which has, in time, become a household word.
13. Total assets represent the sum of the current assets (Item 6) and the fixed assets (Items 7 through 12). They are often considered a measure of the relative size of a company, by comparison with others in the same field. Our company, which we will suppose to be relatively new, is small compared with the leader in the field, whose total assets are $44 million.
14. Current Liabilities include all debts which are considered as falling due during the ensuing year.
15. Accounts payable represent money which the company owes to its creditors, such as unpaid bills for raw material.
16. Accrued taxes refer to unpaid taxes such as real-estate and perhaps the state corporation tax.
17. Accrued wages are those sums due at the time this report was made out and still unpaid to the employees.
18. Total current liabilities is the sum of the previous three items.
19. Contingency reserves is a tricky item; it is set up so as to provide for unforeseen events and is also designed as to prevent the surplus (later described) from being too large. It is basically a sort of insurance against some probable loss which cannot be easily evaluated. When the contingency reserve figure is unduly large, or when it shows a very sharp increase, careful examination should be made; it is listed as a liability, though it seems more like an asset.
20. Capital Stock refers to the form of corporate structure. A company may have only one form of outstanding security, common stock, which is the simplest form of capitalization. Others may also resort to the use of bonds and/or preferred stock. At any rate, this section will list all bond and stock ownership. Our company has two stock issues: a 4% preferred, so called because its rights take precedence over the   'common"; usually such rights are "cumulative," which means that the past dividends must be paid in full before any further payments are made on the common; the common stock represents the ownership of the company by common stockholders. Today "no-par" stock is issued because the assignment of a value is found to be fictitious and misleading, since it does not represent the original sale price or the market value.
21. The preferred stock has a $10 par value and bears 4% as its stated rate of return, which means that each share will earn 40 cents annually; there are 100,000 shares.
22. There are 400,000 authorized and issued common shares.
23. Surplus represents "what is left" and is of two kinds:
24. Earned surplus is the net income which has been earned, but not paid out to the stockholders; it is income which has been plowed back into the business with the expectancy of producing still greater returns. It is really a part of the value belonging to the common stock.
25. Capital surplus has arisen from the original sale of the common stock for more than its stated value. If 400,000 common shares are carried at $1,000,000 this is $2.50 per share; but the shares were actually sold for $4.50 originally, so the difference is entered as capital surplus.
26. Total liabilities is the sum of items 19 (current liabilities) and 20-26.

The balance sheet of the Greater Gadgette Manufacturing Company represents its finan­cial state of affairs on a particular day, Decem­ber 31, 1960; it is not a record of the year's operations, which is to be found on the "consoli­dated income" statement which follows. The balance sheet is broken into two parts: at the left is assets and on the right are liabilities. Under the first of these headings will be found a list of all the things which the company owns or the things that are owed to it, plus any re­serves which have been set aside for deprecia­tion. On the other hand, the liabilities section lists the things the company owes to others, along with the surplus which has been accu­mulated through the operations of the company and also the stockholders' interests in the com­pany itself.

The comment is often made that there is no use looking at the balance sheet because it al­ways balances! This is a requirement of account­ing practice, but we shall see very shortly that the balance sheet can tell us a good deal about the company and its prospects, which is just what any investor will wish to find out.

What may the prospective investor expect to learn from such a balance sheet as the fore­going? Before we give an answer to this ques­tion, let us make an important point. There was a day, several decades ago, when the prepara­tion of a balance sheet was an operation often modified by trickery. Assets were overstated, and liabilities were often hidden or reduced. Today we have no real ground for serious doubt. Accounting practices are standardized; the cer­tified public accountant has assumed a promi­nent place in the financial world; the Securities and Exchange Commission, for most practical purposes, has placed stringent rules for such re­ports for at least those corporations with listed securities. Nevertheless, the investor is still faced with the job of translating the figures into items of real significance. This is not an impossible task, as there exist certain yardsticks which are very useful in giving the investor some measures of the true worth of the corporation whose bal­ance sheet is being scrutinized. These we will now discuss.

The first is the "current ratio" or "net quick assets"; it is obtained by dividing the current assets by the current liabilities; in our own example this will be item 6 divided by item 19, which yields a value of nearly 2.6 and is a measure of the ability of the company to meet its current obligations. A well-organized com­pany will show a sufficient excess of cash and re­ceivables over current liabilities; in our case the cash and securities almost equal the current liabilities. For the current ratio the agreed mini­mum is 2:1, although some youthful companies, which have not yet really gotten under way, may show as little as 12:1. A few industries, such as public utilities and railroads, have the great pro­portion of their assets tied up in fixed assets and therefore can get along with less than the magic 2:1 figure.

Should we now subtract the current liabilities from the current assets we will have the "net working capital," which in our case is $2.45 mil­lion. If you are an investor, this item must al­ways be carefully checked, since it indicates the comfortable margin beyond which the company can meet its obligations and still be able to ex­pand its business should there be the necessity for further development. By all means, the mini­mum margin of safety in net working capital should be enough to equal the current liabili­ties; but of course, we would feel more com­fortable if this net working capital exceeds the current liabilities by a good margin. The amount of net working capital considered satisfactory depends upon the type of business. Heavy industries require more, while certain types of industries can get along with much less. A good means of comparison is to calculate the value for a number of other firms in the same industry and then take the average. An enter­prise with inadequate working capital is always open to financial strain, since it may rely too much upon its creditors to provide its assets. Adequate capital, on the other hand, precludes this, since any loss falls upon the proprietorship rather than upon the creditors.
Still another item of some importance is the requirement that there shall be as much work­ing capital as the total book value of bonds plus preferred stock; this is considered a pre­cautionary measure.

Before anyone would invest in any corpora­tion, he would seek to know something of its capital structure; this simply means the relative proportions of bonds, preferred stocks, and com­mon stock. Too heavy amounts of senior securi­ties reduce the attractiveness of the common for investment purposes. In our example above, we have $1 million of preferred, $1 million com­mon, $3.2 million surplus, and $0.25 million reserves—total $5.45 million. Of this total less than 20 per cent is represented in the preferred; the other 80 per cent belongs to the common stock and illustrates the rough rule that an industrial company should ideally not have more than about a quarter of their capitaliza­tion in preferred and/or bonds. If it does, the company may find it difficult to obtain further capital, because its debt is already large; further common stock would prove difficult to sell be­cause of the dilution of the interests of the original common stockholders.

Another important matter in this connection is the existence and judgment of extent of "leverage." Suppose a firm has an outstanding bonded indebtedness of $5 million of 4 per cent bonds, thus requiring an annual interest charge of $200,000. If the earnings of the company were, say, $250,000, this could be met and still leave $50,000 for the common; an increase of earnings by 10 per cent, to $275,000, would in­crease the amount left over for the common to $75,000. Now suppose that business takes a turn for the worse and only $200,000 is cleared; this will all be used for the bond-interest charges, leaving nothing for the common; any further decline in earnings will mean that the company will be unable to meet its bond interest charges without dipping into its surplus. This is the danger of high-leverage stocks, and investors are warned to avoid them like a plague.

Another item is the "net asset value per share," which represents the "book value" of the common stock and is a measure of the assets which the corporation has available to work in behalf of each common share; it is not in itself too significant, but is often valuable in making comparisons with the book values of the shares of other corporations in the same field. The net book value is obtained by adding the net value of tangible assets (less reserves for deprecia­tion) , subtracting all creditor's claims, and di­viding by the total number of outstanding com­mon shares. In our example, this will be $7 million, less $1 million preferred and $1.55 mil­lion liabilities, divided by 400,000 gives $11.12 per share. This figure indicates the "backing" in assets for each share. In almost all cases the corporate book values are based upon original costs, not current valuation, less proper allow­ances for depreciation. Certain intangibles are not included, so that the value presented is somewhat on the conservative side. While the investor should not become obsessed with book value figures, they are sometimes intriguing. A stock with a book value of $3.35 coupled with a market price of $15 would indicate caution; another with a book value of $27, but priced at $18.75, would indicate a situation worth in­vestigating. Net assets per share should not be overemphasized, but at the same time should not be ignored.

COMPANY EARNINGS AND PROFITS

So far our investigations have been largely concerned with what the company or corpora­tion looks like. As a stockholder or prospective investor, we are also concerned with the success of the business; in other words, the net income; so we will now interest ourselves in the portion of the balance sheet which relates to income. We want to know whether the firm made money and how much. This portion of the balance sheet goes under different names; some call it "record of earnings," some call it "statement of profit and loss," and some call it "income ac­count"; these all mean the same thing, because in all cases they show whether the business made or lost money, what it did with the money earned, and how this affected the securities themselves. Turning to our example, we have the following.

Item 31 is "net sales" and represents the money paid into the company by the customers who utilized its goods and/or services. It is the money actually received after any allowance for discounts. Item 32 is the total cost of all outlays having a bearing upon the sales which were made; we might call them sales expenses, al­though there is little uniformity in the treat­ment of these items among various companies. Item 34 (depreciation) is the amount trans­ferred from income to the depreciation reserve during the year. After deducting all expenses from the total income, we have the net profit before Federal Income Taxes; to this we will add a small amount of other income, such as royalty payments, special fees for special serv­ices, refunds, etc. We then have the total income, and after subtracting the allowance for Federal Income Tax we have the net income (item 41). This is, naturally, very interesting in itself, but it should be immediately compared with the figure for previous years in order to see how well this company is maintaining its position in its markets. Next is what was done with this net income. We find that a portion was used to pay the preferred stock dividends (item 42) and also a dividend of $1.00 per share for the year on each share of the common stock; this divi­dend item in itself is not constant, but depends upon the wisdom and generosity of the board of directors, who set the dividend policy each year in their annual meeting. If they are reasonably conservative, the payout may be low (up to 50 per cent); if they are more generous, they may pay out even more; but beware the com­pany which distributes too large a percentage of its income as dividends, especially if it has not been entirely earned. The remainder of the earnings are returned to the business (item 43) ; there the directors hope they will aid fur­ther in building up the business in future years. When this remainder is carried to previous earned surplus (item 44), it is there added and will then give a new figure for earned surplus (item 45).

An analysis of the income statement yields a few additional useful data for the purposes of the investor. We may obtain the profit margin after taxes by dividing item 41 (net income) by net sales; this yields 0.15 or 15 per cent after taxes, which is truly very exceptional. Such figures are not nearly so useful as they might be when compared with similar figures of other companies engaged in the same or in a similar business. Should the margin of profit of our company prove to be outstanding, then we have reason for optimism in considering the purchase of its common stock; should the opposite be true, then we would do well to hesitate or even turn our attention to some other and better candidate.

The buyer of common stocks is usually very much concerned with the earnings per common share, for it is this which may be compared over a considerable period of time, and it is from this that dividends come. There is no doubt that the earnings per common share exert a powerful influence upon the market price of the stock. All we need do here is to subtract the preferred stock dividends from the net in­come ($624,000 less $40,000) and divide by the total number of common shares; if we do this, we obtain $1.46 which again becomes far more significant when compared with previous years.

We have spent quite some little time in out­lining the reading of a balance sheet, but there are a few more things involved here than meet the eye. One of them is the necessity of always making comparisons. Where any sharp or un­usual changes are to be found, they must be carefully weighed. Should cash rise or fall, should inventories rise or fall markedly, should sales be very much higher or lower, should dividends be cut because income has fallen decidedly—all these, and many more similar signs, must be considered. Many companies today realize that the stockholder will wish to make such comparisons, so that they often provide five-year or even ten-year records of cer­tain pertinent data in the annual report; they almost always make a comparison with the previous year.

Be prepared to find the President's Report a very optimistic document and be willing to take issue with his statements if you have reasonable grounds for so doing. On the other hand, re­member that his judgment as a businessman is probably far better than yours. This brings us to another topic which does not appear in the balance sheet, but may appear from a careful reading of the annual report. That topic is management itself. Naturally it is of para­mount importance that any firm should have top grade management; the quality of manage­ment is usually very difficult, though not im­possible,  to appraise.  Here are several bases upon which to form some opinion: the position of the firm in the industry, its ability to meet competition, the amount allocated to research, its advertising expenditures, its financial sound­ness, its willingness to develop new products and processes and thus not fall into a state of complacency or decay, its awareness of the need for diversification, its relationships with the public, its labor relations, its ability to show continuous profits and to pay regular and consistent dividends throughout the years. One-product firms and one-man organizations are usually at a disadvantage; bickering within the organization may result in loss of trade and decreasing profits; wide swings in earnings and dividends suggest lack of good and efficient management. There is no substitute for good management, and it is no accident that all those companies that have achieved leadership in the current economy have done so to a large degree because of the quality of their manage­ment.

THE PRICE-EARNINGS RATIO

About stock prices: another common crite­rion used in making common-stock selections is the price-earnings ratio, which may be defined as the current market price divided by the cur­rent annual earnings per share. For example, if a certain stock is priced at $30 and its current earnings are $2, then its price-earnings ratio is 30:2 or 15. In turn, if a stock is selling at $24 with earnings of $2.40, it has a P:E ratio of 10. What is the real importance of this figure to the investor?

Earnings are the very life blood of free enter­prise, because it is only from earnings that dividends, which are the return to the investor, can be paid out. The P: E ratio relates the price of a stock to the earnings which the capital in­vestment is currently generating. It becomes immediately evident that this yardstick may be very useful, but what limits may be set? What is a good average P:E figure? Statistical studies indicate that the P:E ratio may vary from time to time as a reflection of both investor confidence (pride) and current earnings. In general, a high market may be accompanied by a some­what higher average ratio and a low market by the reverse. If we restrict ourselves to good-grade common stocks we may find that a ratio of 18 or 20 times earnings is a fair figure, with, perhaps, 12 to 15 as a general average. These figures apply to "stable" stocks, whose earnings and dividends are reasonably stable. Lesser-grade stocks, whose earnings and dividends are quite erratic, cannot boast a P:E ratio of real significance.

If the P:E ratio is unusually high in a given case it may mean that the stock is actually over­priced, because a stock which has never earned more than $1.50 and is priced in the neighbor­hood of $30 has a ratio which is obtained largely from the price, rather than its earnings; how­ever, there may be some unusual feature or recent developments which will explain this behavior, such as the "glamour" attached to uranium or electronics.

Continued growth has become a very impor­tant market factor in determining present day prices of common stocks, since investors are constantly searching for what is called a "growth situation" and are willing to pay a somewhat higher price for it. Accordingly, the price of a particular stock may have been driven up to dizzy heights and the resulting P:E ratio be considerably above prevailing normal values. For example, International Busi­ness Machines has recently sold as high as 47 times earnings, Minnesota Mining at 32 times, Dow Chemical at 30 times, and National Lead at 27 times; at the same time, such well-known giants as General Motors, Socony Mobil, and Texas Company have sold at no more than 14 times earnings. What is the explanation? It is very simple: investors are searching for those companies that are growing at a very rapid rate in both sales and profits; they are, therefore, willing to pay more for them now with the ex­pectation of large gains in the future and as a result the price has been bid up to a considera­ble height above what would seem "normal" and the price-earnings ratio reaches a fabulous figure.

GROWTH STOCKS

Growth   stocks,   are,   as   already   indicated, much in demand and are especially attractive to the investor who is more interested in capital gains than income. What is a growth company? As the term is used by most analysts, it applies to a company that is expected to show sales and earnings continuously increasing at a much faster rate than the advance in the economy as a whole. Many growth trends are volatile, so that it is not always apparent just which stock is in a true growth situation and which is merely a flash in the pan. There is some argument as to whether growth is based upon research alone, since a number of growth examples show a steady increase in earnings and also in the equity per share, without extensive research programs. It is true that many of the present-day growth companies, as exemplified by the chemicals, have far-reaching research programs; but it is equally true that some other growth companies have lacked well-organized research. Neverthe­less, we may recognize a growth situation by sev­eral of the following characteristics: (a) con­tinuous increase in earnings; (b) continuous increase in net worth per share; (c) develop­mental advances in a product or process; (d) the plowing back of a considerable portion of earn­ings into the business, with correspondingly few or even no dividends; (e) an industry with ex­cellent sales and earnings prospects; (f) a dy­namic research program; (g) an outstanding management, with much technical know-how in the development of new products and proc­esses, coupled with the ability to attract younger men who possess energy, ability, and resource­fulness.

Before selecting a growth situation the in­vestor must realize that he may be assuming considerable risk. For every Minnesota Mining and Manufacturing, there are perhaps a hun­dred others which fail to make the grade and become mediocre; for every Food Machinery and Chemical or Dow Chemical, there will be a hundred others that drift into the class of un­successful or even failure enterprises. The best plan might be to follow the leaders in financial circles and purchase only those whose growth characteristics are already recognized; otherwise a high degree of speculative risk will attach to the choice of the small company which has a "new process" or "unusual product" as yet un­tried. Very often stock in such companies is attractive because it is cheap; but even cheapness is no recommendation for extreme speculation. A list of some of the currently recognized "growth situations" may be obtained from a broker.

Still another reason for a high price-earnings ratio is to be found in those companies which do the exploration work for mineral wealth, such as petroleum, copper, rare metals, etc. In­vestors are willing to pay more for them, because mineral reserves will probably prove more valu­able in the future and are considered to be quite conservatively valued today; indeed, the costs of prospecting and extraction of mineral wealth have steadily increased with time.

Perhaps we may include some word of warn­ing at this point and suggest that an exceedingly low price-earnings ratio will convey a caution signal to the investor. Why should a P: E as low as 8 occur? Such a low figure may indicate sev­eral things: (a) the stock is very underpriced; (b) the industry group represented is at the moment in disfavor; (c) prospects for the stock are mediocre because of continued poor or er­ratic earnings; (d) the industry represented is a segment of the economy which is neglected because of more "glamour" attached to other segments; (e) the industry or stock is enjoying only temporary prosperity; (f) the industry is subject to wide swings in earnings. At any rate, be careful!

The investor of modest means will perhaps find the greatest use of the P:E ratio in making comparisons between several companies in the same field. If he finds that four out of five have a ratio of about 12 and that the fifth one shows a ratio of 18, then this latter becomes a candi­date for further study; the reason must be sought out, and it may be significant.

The current general price-earnings ratio for better-grade stocks has remained in the vicinity of 12 to 14 for some time; it may be considered a figure which represents the over-all appraisal of common stocks, which is a mixture of opti­mism tempered by caution; but it is a signpost for the investor which is never to be ignored.

The use of the price-earnings ratio as a means of deciding the reasonableness of the current quoted price of a certain stock may be illus­trated by reference to the fictitious balance sheet used for purposes of illustration. Our cal­culations showed that the stock was earning $1.46 per share on the basis of the most recently obtainable data. If we assume a P:E ratio of 12 as a reasonable figure, this means that the stock might well be priced in the neighborhood of $17.50 per share. A P:E ratio of 14 would indicate $20 as a satisfactory figure. It is difficult to set an exact ratio value, but it may be ob­tained by checking the current price and earn­ings per share of other stocks in the same in­dustry. If this indicates that a ratio of 12 is a reasonable assumption, then we would compute a price in the neighborhood of $18 as a satis­factory quotation for the stock. If the current quotation is less than that, then such a price may be considered attractive, provided that there are no new developments which would account for a lesser valuation. The market places some premium upon the future as well as the current earnings and dividends, so that the price itself reflects all of these factors; at the same time, it may happen that this particular stock is under-priced by all reasonable standards; it may also be overpriced and the prospective purchaser must make his decision.

Successful investment may be shown in the case of Professor X, who was for years a pro­fessor of mathematics in a small Midwestern college. His salary never exceeded $4500 per year during his teaching career of over thirty years. He lived modestly, but was also known to be generous. His one weakness was his library, which contained thousands of choice works in the finest bindings. Ordinarily, there would have been little attention paid to the passing of this kindly, hard-working, and modest man, yet considerable publicity was given when it was discovered that he left an estate of over a million dollars in high-grade securities! It is quite obvious that he must have been a student of investment to have been so successful. What was his secret? Why do 82 out of every 100 men leave no estate at their death? The brokerage firm which handled the account of Professor X furnished the answer: he always investigated thoroughly before making any investment, and he always bought undervalued and basically sound securities of considerable promise. It is true that he occasionally made a mistake, but he followed the principle of diversification so well that his losses were far overbalanced by his gains. Overcaution avails us little; outright speculation is going to the opposite extreme-successful investment requires background, pa­tience, foresight, skill, a sense of values, and successful timing. It is only after some experi­ence that results may become apparent and success may be had in some measure.

The above discussion will make one thing clear: the beginner should seek plenty of advice! In so doing he should beware of those persons who prey upon the uninitiated and should select an investment adviser whom he can trust; if necessary, refer to the Better Business Bureau. He need not be afraid to ask questions, espe­cially if they relate to the soundness and backing of the person or house with which he may now do business for years. He should make sure the financial adviser is acceptable; if he is not, he should be dismissed courteously and another obtained. Many of the progressive present-day brokerage houses welcome the small investor, so he need not feel at all reluctant to seek them out. Investigate—it's your money!

Professional investors know that not all com­mon stocks are listed on one or more of the various stock exchanges. There is considerable trading in securities which are "unlisted"; for convenience, they are often termed "over-the-counter" securities, since many of the stocks of new and untried companies have been sold di­rectly to the investor or speculator in that man­ner in the past. It is estimated that the number of important unlisted stocks in which there is a public interest will total at least three times the total of listed securities. Many are quoted daily, and the quotations plus a basic "average" are published by NQB (National Quotation Bu­reau) . It is true that one may expect numerous "penny" stocks among the broad list of some 15,000, but the list also encompasses such well-known names as Anheuser-Busch, Bullock's, Dun & Bradstreet, International Cellucotton, Kellogg Company, Plymouth Cordage, Taylor Instrument, Time Incorporated, Veeder-Root, Weyerhaeuser Timber, plus many banks, in­surance companies, and mutual funds. Quota­tions are usually stated as a double number, such as 152-16, meaning that the "bid" price was $15.50 per share and that market offerings were at the "ask" price of $16 per share. Many firms purposely avoid listing on an exchange, because they feel that this would compel them to disclose information which could be o£ con­siderable value to their competitors. It is inter­esting to note that many present-day listed companies did their apprenticeship as O-C stocks and afterward "graduated" to a listed status on one of the recognized exchanges. While the uninitiated investor should choose his in­vestments with extreme care, particularly with regard to the available information regarding them, it is still possible to obtain analyses re­garding some o£ the O-C stocks from brokers; such patient investigation may pay well in the future, since O-C listings often include many youthful companies which well may assume leadership in the future.

STOCK SELECTION

If Mr. John Q. Citizen is to make an objec­tive and intelligent selection of a particular stock (on the assumption that a particular in­dustry has already been selected) he will be wise i£ he pays close attention to a number of things which may serve as a foundation. Among other things he will determine if a certain com­pany has a satisfactory set of conditions as com­pared with at least two others in the same field. For example, he must compare such things as relative size (from total assets), current ratio (current assets to current liabilities), cash posi­tion (including accounts receivable), working capital (the ability of the company to make its necessary expenditures without financial em­barrassment) , and assets per share; management is not so easily appraised, although such matters as dividend record, labor relations, expenditures for expansion, and advertising expenditures may be of some assistance.

Assuming that the foregoing have all been found to be reasonably satisfactory, we will now show the application of a rough guide which we will call the Seven Point Score, which is merely an attempt to digest certain data at hand and, in addition, to test whether the stock is a "good buy" at current prices. The items are here summarized with appropriate explanations:
 (1)   Capital Structure, or the proportion of senior capital (bonds and/or preferred stock) to common stock. The former should not be ex­cessive, since heavy fixed charges may well pre­clude payments on the common in all but very prosperous times. A small amount of senior capital need not prove burdensome and is some­times necessary in order to borrow without is­sue of additional common shares. Naturally, a situation with common stock alone is highly de­sirable, but an established position in a given industry may well support the issue of some senior capital (but never in excessive amount).

1. Financial Position, which simply means the lack of excessive liabilities, the presence of sufficient cash and equivalent, and an absence of heavy inventories on hand; the business may suffer if too much capital is tied up in inventories, resulting in a financial difficulty.
2. Earnings per Share over the last five years, from which an average is taken.
3. Dividends per Share over the last five years, from which an average is taken.
4. Dividend Payout: obtained as a percentage by dividing  (4) by  (3) ; this will indicate whether the stock is paying a large, medium, or small amount of earnings back to the stockholders.
5. Profit Margin (per cent): obtained by dividing net sales after taxes by net sales before deductions; an indication of successful management: to translate sales into profits.
6. Price Determinant; this is obtained by taking 80 per cent of the most recent earnings per share (on the conservative supposition that business may not prove quite so good in the next following year) and projecting this into the future by multiplying by the current price-earnings ratio, this last being obtained again as an average  of several  within  the  industry.  The purpose is to see whether the current price is justified and whether the stock to be bought may even  be  undervalued.  For  example:   average earnings per share over the last five years were $2.00; current P:E ratio in the industry is 12; therefore the projected price on the basis of 80 per cent o£ present earnings would be 0.80 × $2 × 12, or about $19; if the present price were say $16, the stock might be quite attractive for purchase; if at $20, it is fairly priced; if at $25, it may well be overpriced. Caution: the market price often takes into account future prospects as well as past performance, so that one must use good judgment here; on the other hand, there are often undervalued and "sleeper" situations to be found and that is what makes common-stock investment so fascinating.

The Seven Point Score merely tabulates the above seven items for each of three companies in parallel columns and, after making the neces­sary simple computations, each item for each company is scored on the basis of some arbitrary figure, such as five points. To be successful, any rating system of comparison must determine ab­solute standards, which are difficult to obtain; even experts disagree. One school of thought maintains that the chief concern of the investor in common stocks is with earnings and divi­dends; another considers capital structure and financial status as the most important, rightfully pointing out that without a healthy financial position a stock cannot show satisfactory earn­ings and dividends. Since there seems to be a lack of complete agreement, we will adopt the attitude that all such matters are of equal con­cern to the investor, but insist on restricting comparisons to several candidates within a par­ticular industry. The tabulations follow.

SEVEN-POINT METHOD OF COMPARING COMPANIES FOR STOCK SELECTION
Company X                                             Company T   Company Z
(1)   Capital Structure:
funded debt (million $)                             none          none      $1.5 (3%)
preferred stock (million $)                        $2              none           none
common stock (shares at stated value)      0.50           0.35           0.45
earned surplus (million $)                          2.02           3.60           6.60
(2)                                                           Financial Position ($ millions):
cash and equivalent                                  0.3              1.7             0.9
current assets                                           4.0              3.3            10.0
current liabilities                                       2.2              1.3             1.5
(3)                                                         Earnings per Share       $1.05         $1.60   $2.70
                                                               0.55            .90            1.75
                                                               1.30           1.50           2.60
                                                               0.70            .85            1.45
                                                               0.90           1.25           1.50
average $1.12                                          $1.22        $2.00
(4)                                                         Dividends per Share     $0.80         $0.80   $1.25
                                                               0.25           0.50           1.00
                                                               0.60           0.80           1.25
                                                               0.25           0.50           0.80
                                                               0.25           0.60           0.80
average   $0.43                                        $0.64        $1.02

1. Dividend Payout (%)                                                      38%                  52½%            51%
2. Profit Margin:

net sales (millions)                                    $ 6.0          $5.2          $17.0
profit after taxes                                       0.15           .26            0.68
% profit of sales                                                     2½%              5%           4%
(7)   Price Determinant:
Current Price                                                       $12.50             $15           $32
Projected Price (P:E 14)                                      $  9 $14            $28
Historic Range (10 yrs.)                                   ($7-$l3)                     ($10-$I6)      ($22-$33)
Scores                                                                         (1)       2    5 4

1. 2                                                         4            5
2. 2                                                         3            4
3. 3                                                         4            4
4. 3                                                         4            4
5. 2                                                         4            3

(7)                                                               _3          _3_            _2_
Total       17             27                 26

Note 1. Company X has a score which indi­cates that it is quite unattractive for present purchase. It seems to be priced upon the basis of present earnings, but its financial status leaves much to be desired. It is a good example of a leverage situation, since the $2 million of 5 per cent preferred will mean an annual charge of $100,000 in dividends alone; besides, the cash and equivalent figure is much too low for rea­sonable comfort. Even if we had been somewhat more generous in our scoring of certain items, we would still find this situation very doubtful.

Note 2. Company Z is by all odds the best of the three. Its finances and capital structure are good, and it has turned in an impressive per­formance in both earnings and dividends. At the same time, it is somewhat overpriced; per­haps because current market appraisal considers it a leader in the field and therefore able to show even further gains; the price is based squarely on current earnings, as examination will show.

Note 3. Company Y presents an intriguing possibility in a number of ways. While its total score, being lower than Company Z's, does not suggest superiority, there are a number of items which indicate some promise. Chief among them are the good profit margin, excellent finances, simple capital structure, and attrac­tive price. It is a small company and has only a small portion of the total market, but at the same time shows evidence of outstanding man­agement, since the portion of profits from earn­ings is actually better than average; this may indicate an outstanding ability to control costs; further examination may indicate a possible growth situation.

STOCK PRICE AVERAGES

We have become accustomed to index num­bers in our daily lives. They are used for all phases of human activity, one of the best known being the Cost of Living Index. It is only natural that we should employ some sort of index to show the behavior of stock prices. There are a number of such indexes, although some of the most well known are really averages and not true indexes, since an index must have a base of reference; but the averages are so well known and so commonly talked about that some explanation of them is in order.

The Dow-Jones averages were first published as far back as 1884 and were originally the simple arithmetic averages of 11 active stocks, later increased to 12. In time other stocks were added, some dropped and others substituted. By 1896 one average was made for the railroad stocks and another for industrial issues. The long history of such changes is of little impor­tance to us here, nor is the recital of the changes made in the method of computation. As now published, the Dow-Jones consists of four averages: 30 industrials, 20 rails, 15 utili­ties, and the combination of these into a 65-stock average, all being stocks listed upon the New York Stock Exchange. They are published regu­larly and are well known in financial circles throughout the nation. A certain theory of stock-market forecasting, known as the Dow Theory, is based upon their behavior.

Other well known averages are those of the New York Herald Tribune and The New York Times; the Standard & Poor is really an index. For the purposes of the investor of modest means, the important thing is that nobody buys or sells the stock "averages"; people buy indi­vidual stocks.

The averages (and you may take your choice) are of value in that they may indi­cate a trend, but unfortunately they are some­times too insensitive to do so positively. On a week to week or even a month to month basis, the three most popular averages (Dow-Jones, Standard & Poor, New York Times) may quite well agree as to the market trend; on a day-to­day basis, they may fail to confirm one another, so that the investor may well be puzzled. For our purposes, we may say that the gyrations of a certain average are only of interest over a considerable period of time and they are to be accepted with caution. In this connection we may note that experts have indicated that the Standard & Poor has an increasing group of ad­herents, since it utilizes 500 stock issues which normally account for close to 80 per cent of the common-stock trading on the New York Stock Exchange; and, what is very important, S & P computes averages for particular industries as well.

What is the best index? That is difficult to answer in the form o£ a flat statement, as some­thing depends upon how it may be used. At any rate, there is much in print dealing with this interesting and even fascinating aspect o£ the stock market; the investor of modest means need not become unduly disturbed, for if he buys for investment, the minor fluctuations of the stock market need not be of great concern to him.

Now for an object lesson in following the averages. If we were to plot the behavior of various industries between January 2 and No­vember 10, 1956, we would find that the com­posite average of such stocks (over 500 in num­ber) had gained very slightly; yet at the same time, oil stocks increased 57 per cent, office-equipment and construction-machinery stocks advanced by about 44 per cent, and aluminum, heavy-machinery, and natural-gas stocks by about 19 per cent; at the same time, rayon stocks de­clined 30 per cent and motion picture, radio, and television stocks declined by about 19 per cent! The conclusion to be drawn is obvious: do not be satisfied that following the averages is fol­lowing stocks; business conditions may favor cer­tain industries and be quite unfavorable to others; so keep track of industry behavior and even of individual stock performances within an industry classification. In addition, the use of the averages as a means of prediction of future performance of the national economy is subject to serious doubt and some experts, especially economists, claim that it is of no value whatso­ever. The averages are no magic "open sesame"; the careful investor will look at every indication he can find and not cling blindly to one alone.

The careful analysis of any market situation and the proper timing of market action cannot be achieved in a short time; indeed, one analyst of more than twenty years experience remarked that "the most predictable factor in the stock market is its complete unpredictability." An understanding of the national economy and the psychology of the investor public is certainly a good part of the background needed, so that continued study is a must!

DOLLAR COST AVERAGING

As mentioned before, the purchase of com­mon stocks is very different from the purchase of bonds or preferred stocks, since the two last represent an attempt to produce a steady in­come with a considerable margin of safety. The plan of investment diversification, previously discussed in another chapter, provided for some investment in common stocks because these are best for long term growth. It is true that some common stocks have paid dividends for decades; it is equally true that some have averaged rela­tively low returns, while others have paid nothing at all. Common stocks are rated as least attractive in regard to income safety, which means the investor's expectation of receiving ex­actly the same number of dollars as he invested if he eventually sells his common stock. How­ever, that is but one side of the story; the other refers to the fact that common stocks as a whole have advanced surely and steadily over the years simply because the business of the country has grown steadily and has continued to be more productive and more profitable; this basic trend shows no signs of abatement, although there may, from time to time, be occasional dips in the prices, earnings, and dividends of common stocks, which usually follow the temporary fluctuations in general business conditions.

The average investor of modest means would like to share in this; at the same time, he wishes to receive some income; consequently, he may decide to buy what are good "defensive" equi­ties, such as the public utilities; on the other hand, he may wish to participate in the con­tinued growth of the nation's business and so may be willing to forgo some of his return in the expectation of having gains in his invested capital. We will suppose that he has made up his mind to buy the stock of the XYZ Company, but hesitates because he does not want to be in the position of buying at too high a price; he is also aware that if he buys at a low enough price and holds the stock for some time, he may eventually be able to show a satisfactory profit. Some do this by use of an investment formula which they follow religiously, but all such for­mulae are not foolproof. Mr. Citizen must make a cautious approach; he cannot be "in and out of the market," because he cannot afford it. The device known as "dollar cost averaging" is em­ployed by many, especially those who make use of the Monthly Investment Plan (MIP)  sponsored by the member firms of the New York Stock Exchange. As shown previously, it is very simple. A certain fixed dollar amount is speci­fied, with which regular purchases are made, buying as many full shares as this amount will obtain. This is done over a period of time. Its best feature is the fact that if the investor has spotted a good sound stock, he will find that the fluctuations of the market are of little concern to him, because he buys more shares when the price is low and fewer shares when it is high; consequently, the average cost is brought down to a point lower than the average price.

1960 vs. 1929. Having come this far, the in­vestor may be haunted by the serious doubts created by investors of 1929. Indeed, he may know of some whose world collapsed about them on October 29, 1929, and may then wonder whether or not such a debacle could be repeated.

No one knows how many "little fellows" took part in the 1929 "bust" by losing their shirts and being left financially flat; but it is certain that thousands and perhaps millions did so be­cause they risked speculation with strong odds against them! At that time it was common to buy heavily "on margin"; which meant paying only 10 per cent of the purchase price in cash and then expecting the stock to continue to rise indefinitely. This meant that many people were actually gambling. Many had heard "tips" and rumors and used pitifully small, hard-earned savings to "take a plunge"; still others mort­gaged houses, borrowed on life insurance, and cashed in jewelry. Practically all those people lost all they had. They made no distinction be­tween investment, speculation, and gambling and all found to their sorrow that they had not correctly appraised the risks involved. Now, for our purposes here, why should we suppose that this state of affairs may not be repeated? Here are some of the ways in which 1960 is not 1929:

1. The present investor is a middle-income person, who has the extra money to invest.
2. He buys for cash, since margin accounts are frowned upon except for qualified persons, and even  then  the cash-down percentage required is much higher.
3. Strict regulation is now in effect, which has put an end to many dishonest and questionable practices of 1929.
4. The present investor invests, and mainly in high-grade stocks—such favorites as American Tel.  and Tel.,  General Motors,  General Electric, Standard Oil of New Jersey, Monsanto Chemical, etc.
5. A large number of company employees in the low-income brackets are able to buy stock in the corporation for which they work, on a monthly savings plan.

Stock prices will always fluctuate, as J. P. Mor­gan once remarked; but there has been a change in the type of investor in thirty years. Todays investor invests; he is not a gambler!

DEFENSIVE STOCKS

The writer is of the firm opinion that the in­vestor of modest means will do well if he con­fines himself at the beginning to the so-called "defensive" stocks (utilities, food, etc.). In them the element of timing is not so important and price fluctuations are less violent. Let us show how this operates in the case of the utilities.

Here we have corporations of fair size which sell an essential for use which may be one or more of the following: water, telephone, natural gas or manufactured gas, electric power. All are regulated, usually through state or Federal agencies. Their financial structure and rates (whether at wholesale or retail) are carefully scrutinized; at the same time, a realistic ap­proach is made to rate making, since it is real­ized that a utility cannot operate without a fair profit.

Since the utility usually has a very stable load and sells its product at a fixed price, it follows that it does not participate in any violent mar­ket fluctuations to any large degree. In less prosperous times it may suffer loss of some of its commercial (wholesale) business, but this is low-profit business anyway, so that the loss is not usually serious. The bulk of the dollar volume of practically all utilities is the residential or householder type of customer and these tend to increase with the increase of population. For example, most of the "war babies" of World War II have now arrived at maturity and are founding homes of their own, which means fur­ther expansion for the public utilities; and since their business is so steady, they find little or no difficulty in raising any needed additional capi­tal for expansion; indeed, they often grant their present stockholders the first right to any addi­tional stock issues (usually at a stated ratio). For example, the XYZ Power Company needs $5,000,000 for expansion: $4,000,000 of this is raised by sale of bonds through underwriters; the remaining $1,000,000 is obtained by the sale of 50,000 shares of common stock at $20 per share, the shares being allotted to the existing stockholders at a ratio of, say, 1 share by subscrip­tion for each 10 shares owned; so that Mr. John Q. Public, if he already owns 20 shares, may subscribe for 2 additional. This is usually called "subscription by stockholder's rights," although not all utilities employ it.

As previously remarked, severe business set­backs are least felt by public utilities; this means that their quoted prices remain within a nar­row range and their current dividend rate usu­ally is maintained. Further expansion with more and more customers means an increase in gross receipts and that in turn promises an in­crease in dividend payout. The continued growth of the nation, coupled with a series of prosperous years, has meant a steady increase in the quoted prices of utilities securities; in­deed, Mr. John Q. Public can find no better medium for a beginning in common stocks. (See Appendix D.)

CONCLUSION

The purchase of a common stock is no simple matter. The selection of an industry and of a stock within that industry requires the serious weighing of many things. Diversification, it is true, is always a watchword, but with this must be coupled an analysis of the over-all status of the business cycle. It is extremely doubtful whether a rush to buy at a time when stock prices have been driven to dizzy heights by over-optimism is at all wise; the purchase made at an all-time high may actually insure a loss at some future time when it may become necessary to sell. Income is not the sole feature of invest­ment; capital gain is also to be borne in mind; the means of obtaining such gains certainly cannot be found in listening to the siren call of high prices. In this connection, the current price earnings ratio is often an approximate guide.

It is well known that variations in economic conditions have occurred in the past, and, in spite of all our efforts to control them, will occur again in the future. Some of these variations are seasonal and of short duration; still others are lengthy and the analysis of secular trends in the past has shown a rather definite pattern of prosperity, recession, and eventual recovery; during recent years serious thought has been given by economic experts to the means of sta­bilizing the over-all economy, and various at­tempts have been made to enact certain control measures, some by government action and others self-imposed by business itself. Attempts have also been made to forecast future business con­ditions, and some have been at least reasonably successful. The entire matter constitutes one of the most intriguing portions of the field of economics. Generally speaking, the investor must keep his eyes and ears open and, at the same time, realize that a price-earnings ratio which is very high will signal high speculative activity, while the reverse will be true in times of a depressed market. A P:E ratio of about 12 to 14 may be considered as acceptable for average conditions during which there seems to be no definite indicator in either direction.

The assumption made here is that Mr. John Q. Citizen is not a trader or speculator; he is an investor and, consequently, is interested in investment over the long term; it will be to his interest to seek out undervalued stocks of sound characteristics; these will bring him benefits over the years, such that capital gains as well as current income may be his reward. It is true that he should place greater emphasis upon se­lection than timing, but the latter must always be considered in order to avoid buying at a peak. When market stability is to be discerned, the greater emphasis is upon selection; but both in­flated and depressed markets exhibit conditions which must be taken into account so as to avoid poor price judgments.

The following are intended to trace the pur­chase of common stocks by a relatively simple and realistic approach; at the same time, it must be remembered that hasty action without ap­propriate care will most certainly court future danger.

Determine a financial plan; there is no sense to an indiscriminate and hodgepodge ap-proach; the building of an estate is serious business and any action must be carefully planned.  The financial plan must include a necessary backlog for future emergencies; no investments should be made without such an emergency fund.

1. Be certain that you place a portion of your funds in fixed-income securities before attempting the purchase of equities. This is to minimize risk and is not to be considered lightly; always play safe, remembering that "a stitch in time saves nine" times as much worry!
2. Carefully pick the industry into which your funds are to be invested, having investigated (a) its past performance; (b) its future prospects; (c) its geographical aspects; (d) its labor relations; (e) its competitive position; (f) government relationships, both direct and indirect; (g) its relationships to the public by means of goods and/or services; (h) its over-all stability as to both sales and profits; (i) its past and immediate future as to earnings and divi­dends.

(D)   Make the selection of a stock within the industry. If it is a public utility, do not overlook the several important criteria noted in a previous section; if it is an industrial equity, then consider sales  trends,  consistent earnings, diversification in both products and location, aggressive and successful management, finances and financial structure, leadership in the field, and a record of steady growth and dividends policy; perhaps, in addition, it should be listed upon a recognized exchange in order to permit continuous check upon its progress. The foregoing factual material is usually available to the serious investor; in fact, most brokers will furnish such information upon request. By all means make a comparison of the candidate's stock with others in the field, so that you may reaffirm your judgment or perhaps raise some doubts as to its soundness and reconsider your decision.
(E)   After making a selection and being satisfied that the current price is fair, your broker being in a position to assist in this regard, buy the number of shares you can afford outright for cash, or else make the purchase through the Monthly Investment Plan. Have the certificates issued, remembering that in those states where joint tenancy is recognized, the certificate may be made out in that manner. Should you so desire, your shares may be left with your broker and  all dividends be collected by him and credited to your account;  otherwise dividend checks are mailed to you directly, along with the progress and annual reports of the corporation.
(F)   Make other selections gradually, but do not rush the purchase of any security and do not yield to any obvious sales pressures. A stock should sell upon its merits and does not require strong sales techniques. Be sure you are investing and not speculating!
(G)   Keep an accurate record of what you buy and sell, with the dividends received, and do not forget to include all dates. Such records will prove useful for tax purposes.
The foregoing constitute a directive as to procedure; the following constitute a series of acceptable guides to conduct while undertaking investment.

Some Rules for Successful Stock Purchase

1. Devise a complete investment plan before buying securities of any kind; objectively determine your limit of "stake in stocks."
2. Consider all possibilities when buying; appraise the industry and the stock itself; be aware of what you are buying, along with the measure of both the risks and the rewards which go with the purchase.
3. Invest only after thorough investigation of all pertinent data; buy only for cash!
4. Be patient; hold basically sound stocks through weak market conditions; be aware of the long-term pos-sibilities; disregard minor market changes.
5. Beware of an unusually high dividend rate; there is often an explanation!
6. Have enough courage to buy sound stocks after a prolonged market decline when stocks are available at bargain prices; at the same time beware of purchases at prices which are obviously historically high.
7. Be willing to take a loss when circumstances indicate an error in judgment; remember that capital losses offset capital gains for tax purposes.
8. Don't be a "hog"; buy or sell "at the market" if you want action; striving for that extra quarter or half point may mean complete loss of opportunity.
9. Beware of "get-rich-quick" situations; buy listed securities through a firm which you can trust, and then only after adequate investigation.
10. Assume a positive policy regarding valuable subscription rights; either sell or exercise them, but never follow a do-nothing policy, since this means an actual loss in money.
11. Always have in mind the Golden Rule of Investment—adequate diversification, which offers the best insurance against severe losses.
12. Supervise your portfolio! Keep your records up to date! Never expect to put away certificates in a safe-deposit box and forget about them. Part of the responsibility of investment is supervision. Be as careful in buying stocks as you would be in buying other valuable property.
    

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