Policies | Performance | Research | Investment Management Problems | The Investor's Alternatives

POLICIES

When you compare mutual funds, the wise investor will make sufficient allowance for differences in objectives (noted on the previous page) when measuring the results or, as they are generally called, the "performance" of investment companies. The most obvious need is recognizing the distinction between common stock funds and balanced funds. The latter maintain a substan­tial part (at least 35 per cent) of their assets in bonds and preferred stocks of investment quality. In consequence, when common stock prices rise rapidly, balanced funds are not able to improve their net asset value in the same degree as common stock funds, other things being equal. Conversely, when com­mon stock prices fall substantially, a balanced fund should be able to show a greater measure of stability.

When you compare mutual funds, a clear line of distinction must also be drawn between investment companies with a one-class-of-stock capitalization and those employing bonds and preferred stocks in their capital struc­tures. As the purpose of leverage is to accelerate the gains accruing to common stocks by the use of senior funds, common stocks of leverage-type investment companies may be expected to advance more rapidly in a rising stock market than stocks of investment companies with only common stock outstanding. In a falling stock market, the net asset value of common stock of a leverage-type investment company will decline more rapidly.

There are other distinctions of less fundamental importance when you compare mutual funds. Companies that concentrate heavily are likely to show greater changes in asset value than those which distribute their resources more evenly over a wider range. This is the land of distinction that separates diversified from non-diversified com­panies. There are also the specialized types of investment com­panies—such as those investing in bonds alone or only in the common stocks of a single industry, such as air transport or farm machinery. The characteristics of these investment companies are altogether different from the types considered in Chapter Six, even those that have concentrated their holdings to a con­siderable degree.

The following illustration emphasizes the importance of not shifting policy lightly. An investment company charter con­tained a provision that no more than 35 per cent of the port­folio would go into the stocks of any one industry. Presumably, this provision was the outcome of careful consideration and was of some significance to investors. The underlying principle was clear: if one industry constituted too large a part of the value of the portfolio, the investments would be more concentrated than might be desirable. In this instance, the investment com­pany had a large position in oil stocks, bought at low prices in terms of later quotations. The prices of the oil stocks had risen under the impetus of improved earnings and fears of inflation, and also because of concern about possible shortages of petro­leum products. When the market value of the oil stocks owned rose to substantially over 35 per cent of the value of the invest­ment company's assets, the company did not liquidate enough of this group to cut the total below the percentage stated in the charter. Instead, stockholders were asked to eliminate the restriction, and the change was approved. Some years later, oil stocks lost favor, and their prices declined materially.

This market change, however, is not the point at issue. Rather, when the provision limiting investment in any one area of the economy came to the point of genuine test, when—for the first time in twenty years—the provision had real meaning, it was abandoned. *

* When this step was first undertaken, I voiced objection. The foregoing is not based on hindsight (see "Investment Companies: A Reappraisal," Com­mercial and Financial Chronicle, December 4, 1952, text of an address before the New York Society of Security Analysts, November 28, 1952).

The framers of the Investment Company Act regarded a change in general policy as a matter of great importance. Al­though a registered investment company's charter powers are sufficiently broad to permit radical changes in its policies with­out notice to, or consent of, its shareholders, the act requires that the consent of the majority of its outstanding voting secu­rities be obtained before changing any of the fundamental poli­cies of an investment company as given in its registration statement. One may quote a judicious comment on this section of the act: "Of course, in practice, many companies reserve some freedom in their policy statement so as to avoid the neces­sity for formal change, but those that hold themselves out as specialized investment media may find it difficult to achieve this flexibility. Since even broad language in the registration state­ment requires thoughtful evaluation of investments in the light of the declarations, there is a heightened consciousness of 'policy' on the part of investment companies, with less likeli­hood of gradual, unconscious changes due to momentary pressures." **

** Warren Motley, Charles Jackson, Jr., and John Barnhard, Jr., "Federal Regulation of Investment Companies Since 1940,' Harvard Law Review, May 1950, p. 1134.

PERFORMANCE

"Not by the company they keep nor by their promises, but by their performances, shall ye know them" so say all the analysts and experts when you compare mutual funds. And what they say is true enough. What, however, is the proper guage or test of performance? I shall not try to answer the question directly, for reasons that will become ap­parent in the course of the discussion.

Crude errors or misleading methods are easily disposed of in a few words. In the calculation of the return to the investor, "yield" should not be represented by the combined distributions from net income, profits on the sale of portfolio securities, and distributions made from capital surplus.

Investment company sales literature used comparisons of the performance of the stock of a particular company with an index of security prices, commonly called a market average. The Se­curities and Exchange Commission's Statement of Policy of August 1,1950, declared it to be misleading to use any compari­son of an investment company security with any other security or medium of investment or any security index or average with­out pointing out: (1) that the particular security or index or average was selected by the person making the comparison; (2) that the results should be considered in the light of the com­pany's investment policy and objectives, the characteristics and quality of the company's investments, and the period selected; (3) any other factor necessary to make the comparison a fair one from the standpoint of the investor.

Another point in the Statement of Policy emphasizes a serious danger to be guarded against. For comparisons to be either fair or worthwhile, similar companies have to be com­pared or adjustments must be made for the differences. For example, in a rising stock market, a balanced fund, with 40 per cent in common stocks and 30 per cent each in investment quality bonds and preferred stocks, is obviously likely to show less increase in net asset value than a 100 per cent common stock fund. On the other hand, a common stock fund has not necessarily made a poorer performance because its asset value declined by a larger percentage in a declining stock market than that of a balanced fund with the characteristics mentioned above. As already indicated, the asset value of stocks of leverage companies will tend to rise and fall more precipitously than those of a non-leverage company, other things being equal. Nor is it fair to compare the results of a diversified investment company with one concentrating on special situtions. The first depends largely on general market changes; the second is largely independent of the course of stock prices generally.

Investment Trusts and Investment Companies, Report of the Securities and Exchange Commission, 1940, Part 3, Chapters I and II, p. 36.
Open-end companies are properly required not to caption charts or tables as the record of a fund if the data reflect either the acceptance of capital gains distribution in additional shares or the reinvestment of dividends from investment income unless the caption includes these facts.

The Securities and Exchange Commission, in its report, dealt extensively with the performance of investment companies for when you compare mutual funds. The Commission undertook to test claims of investment companies and their sponsors that these organizations provided the in­vestor with a kind of specialized and expert management, which he was not, qualified to undertake himself or could not afford to get for himself. The procedure followed was to compare invest­ment company results with the performance of a common stock index over the years 1927-1937. This period included years of rising and declining prices and active and inactive security markets.

The Commission concluded that, over this period as a whole, no significant difference existed between the performance of investment companies and that of the common stock index. The performance of investment companies was slightly poorer than the index during years of rising security prices and better than the index during periods of declining stock prices. The study goes on to say: "As the performance of these investment com­panies was substantially that of a common stock index—which may be regarded essentially as an unmanaged portfolio—it appears that the typical investment company over the past decade failed to meet the sometimes avowed objective of a performance surpassing such an index."

The Commission also noted that in the period 1930-1935 an investor would have been better off if he had kept his funds on deposit in a savings bank, or in government or other high-grade bonds, than in a typical or average investment company. This statement was qualified by the admission that there was no indi­cation of the extent to which the average individual investor in securities actually achieved a performance as good as the com­mon stock index or typical investment company.

Various studies tend strongly to support the view that most investors would be happy if their results approximated the stock market average. I am sure that an extensive study would con­firm this view, especially for smaller investors and those who attempt to make the most of intermediary market movements. If this be true, many investors would be better off purchasing investment company stocks than buying and selling securities on their own. Experience of investors is a more practical, signifi­cant test than statistical comparisons and can be applied by the investor to his own experience. It must be applied honestly and rigorously, i.e., in appraising his experience the investor too often will omit a purchase which has become worthless or which has fallen in price to a small fraction of its cost.

The fact is that, with notable exceptions, investment com­panies (common stock funds measured against indices of com­mon stock prices) tend to follow the course of the broad stock market averages. It is difficult to prepare a true index of invest­ment company stocks. The index of Standard and Poor's in­cludes leverage and non-leverage issues, companies with broadly diversified portfolios and companies with the characteristics of specialty funds; moreover, all the issuing companies are closed-end companies. The index, charted below, shows the parallel movement of investment company stocks and a broad average of common stocks.

Net asset comparisons, covering a number of important closed-end companies, are shown in Table 7. Standard and Poor's stated: Net asset comparisons show that (1) some com­panies have achieved much better than average results, and (2) the deviation from the average in recent years has been relatively moderate among the straight management companies with diversified holdings, indicating the growth of a technique of investment company management. Some companies may continue to better the performance of others, but the prospects are that there will also be considerable general uniformity of results in the future.

This is guarded language, and study of the statistical data demonstrates that a purely statistical approach has serious shortcomings. One can say only that with years and added experience an investment company gains or loses character, and the record, written once and forever, must serve as a rough and ready index of probable success. But to scan the record and draw too precise conclusions from the variations is a mistake.

TABLE 7
Net Asset Comparisons of Selected Closed-End Companies, 1950-1960
	Gain in 1951	Gain in 1952	Gain in 1953	Gain in 1954	Gain in 1955	Gain in 1956	Gain in 1957	Gain in 1958	Gain in 1959	Gain in 1960	Gain 10-Years 1951-60
Adams Express	20.4	6.8	4.7	47.2	23.8	15.6	16.4	39.5	5.2	0.3	174.0
American Iternational	24.7	7.7	5.7	48.1	22.0	14.8	16.8	40.1	5.7	1.6	165.9
Atlas	22.1	8.8	4.3	28.7	6.9	-1.0	+2.0	2.9	-13.6	20.9	8.5
Carriers and General	14.7	15.0	+1.4	40.4	22.8	5.9	7.1	33.7	7.4	+3.2	173.2
Consolidated Investors Trust	21.7	11.5	1.5	52.9	26.7	7.5	10.5	39.7	8.3	3.0	217.2
Dominick Fund	19.3	9.4	+0.9	43.2	19.9	20.4	14.4	41.9	8.2	+5.1	234.2
General American Investors	23.0	9.9	3.5	34.5	12.3	15.8	9.1	31.1	-5.9	3.2	113.6
Lehman	30.1	11.0	0.8	38.5	20.4	8.7	10.6	43.0	8.5	+2.5	223.8
Madison Fund	5.5	13.4	+3.0	49.1	14.5	10.0	8.8	39.8	10.2	+7.7	180.7
Niagara Shares	16.5	2.5	+2.0	39.4	18.5	13.0	8.8	43.1	16.4	+2.8	212.4
Tri-Continental	*	13.2	*	36.9	18.6	8.3	3.3	32.5	7.1	+2.2	*
U.S. and foreign securities	35.4	8.5	5.5	42.4	28.5	15.2	12.0	25.9	2.2	6.0	173.3
Average	23.3	9.8	1.7	41.8	19.6	11.2	9.7	34.4	5.0	1.0	170.6
500-stock index	16.5	11.8	6.6	45.0	26.4	2.6	14.3	38.1	8.5	3.0	184.7
500-stock index (adj.)**	23.4	17.8	1.2	51.3	31.6	6.9	10.3	42.5	11.9	+0.2	268.7

Source: Industry Surveys, Standard & poor, New York, November 3, 1960. Percentage changes in net assets were adjusted for common dividends declared and for capital changes.
* The substantial change resulting from absorption of Selected Industries in 1951 and of Capital Administration in 1953 disorts comparisons in those two years.
** Adjusted for dividends.

When you compare mutual funds, leverage company changes in net asset value of common stock may be more influenced by the degree of leverage than by investment results, and repurchase of stock at a discount is also a possible important factor in the changes in net asset value of closed-end companies (A description of the chain index used in these comparisons is contained in Arthur Wiesenberger, Investment Companies (New York, 1960), p. 71; and Moody's Bank and Finance Manual (New York, 1961), p. a. 44.). Other adjustments may be made, but the main problem is not to obscure the meaning of the adjust­ments. One financial publication discontinued the use of a "gauge," issued quarterly, and has contented itself with periodic long-term statistics covering dividends and net asset value per share, the former divided clearly between dividend payments from capital and those from income (P. A. Johnston, Bartons (New York), October 16, 1950, p. 18.; John A. Loftus, Investment Management (Baltimore: Johns Hopkins Press, 1941), p. 128.). The use of comparisons in short-run periods is to be discouraged. An investment com­pany may do better than the average of its contemporaries for a three or six-month period, but no serious investor should pay attention to results in absolute or comparative terms, except for a time period measured in terms of years rather than weeks or months. Even the results at the beginning or end of a five-or ten-year period are unsatisfactory in themselves. The ideal period for comparison is one in which the average used is ap­proximately the same at the beginning and terminal dates. Standard and Poor's ninety-stock index was in this position on December 31, 1936, and on December 31, 1945.

In the words of an earlier writer: "That the benefits of com­mon stock investment can be maximized by periodic with­drawals from the common stock market ist at best, a quixotic proposition. If it is valid at all, it must presuppose that invest­ment management can know when to withdraw from the com­mon stock market. The general development of business cycle theory and stock price cycle theory being what it is, such a prescription seems bold."6 This is another way of stating that timing is a policy in respect to which little success is recorded.

Experience leads to the conclusion that in a substantial number of instances where withdrawal from, and re-entry into, the market was successful, the reasons, if set forth contemporane­ously with each change in policy, would have been the wrong ones.

The doctrines of remedial error or reversible error spring from diversification. Except for special-type funds, the investment company's task is to combine income and possibilities of capital gain with a minimum of risk. As we have seen, extreme diversi­fication may lead to mediocrity. The most successful investment companies achieve a good degree of diversification with enough concentration to benefit materially from their analysis and yet avoid catastrophic results if either their analysis has been faulty or the market stubbornly refuses to reflect the soundness of their judgment. Leaving generalities, it will be found that the investment companies with distinguished records often have the following type of distribution of their funds among various industries:

	EXAMPLE I	EXAMPLE   II
	(percent)
Industry A	25	18
Industry B	18	14
Industry C	7	12
Remainder	50	56
	100	100

On the other hand, if the largest holdings in any one industry do not exceed 6 to 8 per cent, the management will have great difficulty in proving the advantages of supervision and manage­ment. Early studies of "management" investment companies, to distinguish them from holding company issues, indicated that in the roaring twenties electric and gas utilities were the most popular, and railroad stocks were much more popular than in recent years. No hard-and-fast line can be drawn between reme­dial error and what, in practice, would be irretrievable error. The area appears to lie between 25 per cent and 33.3 per cent; hence, the amount committed to a single industry should not exceed one-third of the fund.

The conclusion is that an investment management, which, for example, is convinced that a rise in the price of gold is likely, should not allow its enthusiasm to reach the point where 60 per cent of its assets consist of gold-mining stocks. The test is to be applied currently. Beginning with the assumption of a generally diversified portfolio, a severe loss in two important groups could be made up by exceptional results in other securi­ties provided that the suggested limits are not exceeded. To be sure, an extremely large concentration might turn out singularly well, but the ostensible reason for buying an investment com­pany stock is the desire to obtain diversification—unless one accepts the special-type fund. In that event, the investor could obtain a 100 per cent investment in gold mining, air transporta­tion, or farm equipment. In other words, the investor seeks diversification, yet not over diversification, i.e., application of judgment so that the fund will have a sizable interest in the best-situated industry groups (in the management's opinion) yet without over concentration.

The investor is entitled to have evidence of selectivity, i.e., skillful choice of individual securities and reduction or elimina­tion of inferior securities. This is diversification carried down to specific securities. Everyone acquainted with security prices knows that different groups of stocks do better or poorer than the stock market as a whole and that individual securities within a group ordinarily do not move up and down in unison. As a rule, it is only for very brief periods of extreme optimism or heavy Liquidation that stocks rise or fall together. As a matter of fact, variations in price movements among different stock groups seem to be greater now than in the past.

A list of the stocks most popular with investment companies appeared in Table 2, page 5. Large holdings are concentrated in so-called blue chips. A number of stocks are to be found year after year among the important holdings in dollar value. Invest­ment companies in the aggregate now own 10 per cent or more of the common stock of a growing number of companies. To some extent, the changes in the portfolios of investment com­panies involve sales and purchases among themselves.
The time may come when opportunities will be more attrac­tive among the stocks of companies outside the favorite 50 or favorite 100. Smaller investment companies especially should constantly survey individual stocks for unusual opportunities, for the field of their purchases is not limited to the same extent as is that of the biggest companies by considerations relating to the amount of stock that may be purchased in the market. As investment companies rarely move to cash and its equivalent to the point where these items represent 50 per cent of the assets of a fund, it seems that the best proof of superior ability lies in the choice of individual stocks. To mention but two ex­amples in the same industry, the advantages of a purchase of the common stock of Minneapolis-Honeywell Regulator Com­pany vs. American Radiator and Standard Santitary Corporation in the building group and International Business Machines Corporation vs. Underwood Corporation in the office machinery industry illustrate the point.

A list of the most popular stocks in the order of the number of shares owned by investment companies at the close of 1929 shows some of the differences in investment policy that have developed over the years, reflecting also changes in the eco­nomic and financial environment:

Central States Electric	Electric Bond & Share	North American
General Electric	New York Central	Chase National Bank
Consolidated Edison (N.Y.)	American Gas & Electric	Detroit Edison
American Telephone & Telegraph	International Harvester	Chesapeake & Ohio
Commercial Investment Trust	United States Steel	American Can
	Kraft Cheese	Bank of Manhattan
	Warner Bros. Pictures	Deere

The prominence of holding company stocks is evident. A com­plete list would also show a heavier investment in bank and railroad stocks than is common today. The "big names," never­theless, appear quite as frequently today. The constant appear­ance of the stocks of great companies has been called by one financial writer "blue chip-itis." (A. Wilfred May, Commercial and Financial Chronicle (Convention Num­ber), October 19,1950, p. 15.)

A comparison of the 1929 favorites with the present "favorite fifty" is interesting. International Business Machines, the recent leader, did not appear in the early group. American Telephone & Telegraph Co. moved up to a high rank only a short time ago. Oil stocks are currently less popular than they were. Neverthe­less, taking the entire fifty stocks, the persistence of oil and gas equities as the top group, despite their reduction in value since the end of 1956 (partly owing to sales by investment com­panies), is noteworthy. The constant relatively large invest­ment in public utilities and chemicals and rugs also stands out.

The selections of experts and of small investors make an interesting comparison. The New York Stock Exchange has promoted the Monthly Investment Plan (MIP), a plan for the purchase of common stocks monthly or quarterly in amounts between $40 and $1,000. The twenty most popular stocks, as listed in a pamphlet dated October 1960, were as follows (data as of September):

General Motors	Radio Corporation of America
General Electric	Pfizer (Chas.)
Dow Chemical	Phillips Petroleum
American Telephone & Telegraph	Monsanto Chemical
Standard Oil (N. J.)	Safeway Stores
Tri-Continental	Eastman Kodak
International Business Machines	Sears, Roebuck
General Telephone	Standard Oil (California)
Sperry Rand	American Cyanamid
Minnesota Mining & Manufacturing	Lehman Corp.

Two investment company shares were among the most popu­lar. The absence of public utility issues, except for the two largest telephone systems, seems to reflect the small investor's belief that stocks of regulated industries are less likely to rise in price and also are less satisfactory as a hedge against inflation than the stocks of industrial companies. Several electric and gas utility stocks, however, are included in the fifty stocks most popular with monthly investment plan buyers.

The preponderance of the stocks of giant corporations stands out in all the lists, as it does in the portfolios of individual in­vestment companies. Almost inevitably, investment company managements tend to favor the stocks of big companies. Besides the factor of marketability, big business has great advantages in production and marketing as well as in its research and financial capabilities. In some cases, natural resources are of tremendous value; in other cases, good will is of inestimable value. This is indeed an age of huge enterprise.

When you compare mutual funds note that many of the larger corporations not only have unusual finan­cial strength, but are also diversified in their activities. A port­folio studded with the names of blue chip companies evokes a feeling of security in investors and exudes an atmosphere of "quality." The ability to spend large sums on research, to re­cover from mistakes that might cripple small enterprises, to obtain funds easily, and the partial protection from competi­tion provided by high tax rates—all these factors contribute to the attraction of the blue chips. Nor can investment company managers ignore the fact that investors are likely to be far more critical of losses in the securities of smaller corporations than in the stocks of major enterprises.

There is, therefore, some validity in the criticism of invest­ment companies for "taking in each others' washing" and prob­ably causing blue chips to sell at prices unjustified by earnings, dividends, or the other tests used to measure the value of com­mon stocks. Nevertheless, a sizable investment company must keep a very great part of its assets in stocks that can be acquired in relatively large amounts. In recent years, more effort seems to have been given to finding "blue chips in the making" among companies that are not among the two hundred largest in the country but whose assets, sales, and profits are too great to al­low their being designated as "small."

RESEARCH

When you compare mutual funds you will note that research and research methods are controversial topics be­cause of their very nature - after all, research is priceless, but it comes at a price. It is difficult to tell to what extent an investment company has made a superior or an inferior showing because of its research activities. In practice, research may mean anything from reliance on the information provided by investment services and statistical manuals to thorough studies of the economics of an industry or of the operations of a particu­lar company. Over the years, I believe that progress has been made toward recognizing the value of genuine research and in improving research methods. In this respect, the Federation of Financial Analysts, which grew out of the activities of local groups like the New York Society of Security Analysts, Incorpo­rated, has played a noteworthy role. In some cases, it is still probably true that analysts submit valuable reports based on careful study, yet the decisions of the executive committee or board of directors of the investment company may be influ­enced largely by other considerations.

A representative research department generally consists of a group of senior security analysts, assisted by juniors, statistical aides, and a librarian. An economist may be a member of the staff or available for consultation. In certain specialized scien­tific or natural resource fields, technical specialists are also consulted at times. The adequate research department should center about a library that contains annual reports of leading companies, listing applications, prospectuses, and government publications, as well as the financial manuals. Staff members read and mark for filing the leading financial dailies and trade papers. Subscriptions to advisory services may be entered. The heads of research departments sometimes allege that if they must read all the leading services, they will have little time left for anything else. Occasionally, the department head receives the reports of advisory services and digests them, along with comment for the members of the investment committee or board of directors.

Depending on the size of the research staff, the analysts cover a number of industries: One may specialize in capital goods; another in consumer goods; others, in electric and gas utilities, transportation, and financial institutions. Other methods of classifying the members of the department also are employed. If a large investment is maintained in oil stocks, a member of the staff probably will specialize in the oil industry. It may be considered advisable to have more than one person follow a particular industry. Specialization may, of course, be carried to absurd lengths: in the twenties, some investment companies proudly displayed portraits of staff members who were special­ists in German securities, or South American issues, or southern railroads. It is the duty of an analyst to be familiar with the leading companies in his field and to keep abreast of financial reports and trade developments affecting the industry.

Investment companies supplement the usual sources of in­formation by having the members of the research staff visit companies periodically to make field reports and call on gov­ernment agencies (in the case of regulated industries).

From the foregoing, it can be seen that maintaining a re­search department can be expensive. Nevertheless, the depart­ment should not be regarded as "embroidery" or an expense item to be held down to a minimum, but as one of the most prolific sources of valuable suggestions and ideas. True, the work of analysts must be coordinated and placed in perspective in the light of general investment policy, but the analyst often is objective in his approach and able to resist the waves of en­thusiasm and pessimism that influence even the management of investment companies.

The following description gives an idea of the kind of work done in industrial analysis by a prominent investment com­pany. To follow the steel industry, the staff has developed a special technique over a period of years: (1) it estimates from various sources the annual rates of steel requirements in the major consuming industries (which account for two-thirds of total steel consumption)—automobiles, construction, canning and packing, farm implements, highways, railroads, machinery, oil, exports, and miscellaneous variable demands; (2) the staff converts this total of finished steel demand into the ingot pro­duction requisite and into the average annual percentage of capacity requisite; (3) the staff distributes the resultant de­mand in accordance with seasonal factors; (4) the staff checks periodically the course of the composite monthly output against total and constituent demands, to determine the inventory po­sition of the industry and its effect upon the degree of sub­sequent required expansion or contraction of activity, in accordance with the industry's habit of balancing out inven­tories over the course of the year. These methods have produced forecasts close to the realized figures, except in disturbed and unusual periods.

The steel industry includes a number of large competitive companies, each vying with the others in plant capacity and plant efficiency, each producing a distinct line of products, and each trying to entrench itself among one or more important groups of consumers. To reinforce research forecasts and to determine the outlook for specific steel securities, research ana­lysts must keep in touch with (1) technological developments in processes, products, and uses; (2) trends in capacity and equipment related to those developments and to consequent obsolescence; (3) competitive positions and prospects of indi­vidual producers; (4) trends of earnings and earning power for individual companies in relation to existing and prospective business demand; (5) the quality of the management of the individual companies. This appraisal may be the outcome of conferences with the managers of the corporations being stud­ied.

To illustrate the methods used by research specialists, let us consider the approach used by the analyst for an investment company that has traditionally invested substantially in the public utility industry. The analyst is engaged in a steady in­quiry into comparative values. Consequently, he continually attempts to appraise the securities of particular companies and to judge the outlook for the industry as a whole.

Electric utility companies constitute the most important group among public utilities. With the help of an assistant and library facilities, the analyst begins his research in the office. Annual reports of companies and supplemental data, govern­ment reports, and the available statistical manuals serve as his jumping-off point.

The analyst also stresses these factors for you to note when you compare mutual funds:

1. The economic characteristics of the area served by the company. What is the record of population gain? What are the estimates of responsible government agencies as to future pop­ulation growth? Is the area basically urban or rural? What is the ratio between residential and industrial sales of energy? What is the average income per family? What is the average use of electricity? What are the sources of the company's en­ergy? How vulnerable is the rate structure?



2. Financial information. This includes trends of operating revenues, capital expenditures, earnings and dividends per share, and the price history of the stock.



3. The company's capital structure (the percentage of total investment represented by bonds, preferred stock, common stock, and surplus). Costs of capital and the dividend pay-out will be surveyed to discover whether a policy has been estab­lished. The analyst will also examine operating costs, provision for depreciation, and the return on investment.

As a result of his familiarity with the industry and its finan­cial and economic characteristics and development, the analyst can compare the record of the company being considered with that of the industry as a whole and of other companies operat­ing under similar conditions.

At this point, office research exhausts its possibilities. The analyst now visits the company itself and talks with top execu­tives and their associates. Company officials often arrange to visit the office of the investment company to bring the analyst and officers up to date. A tour of the plants may be arranged. Discussion with the utility company heads generally revolves around questions raised by the analyst. From the answers, the analyst can draw conclusions on problems such as plans for ex­pansion, the orientation of management thinking (its concern for the common stockholders), efforts being made to attract new industries into its area, operating methods, customer and labor relations, provision for executive replacement through training programs for young and middle management.

Finally, the analyst dealing with public utility companies must consider the regulatory climate, for that is vitally important in the appraisal of regulated industries. Regulation may vary considerably from state to state. Is the regulatory agency inclined to allow its views to be influenced by partisan political considerations? Is it "hostile" on principle? What important rulings or steps indicate its attitude toward the rate of return a public utility may earn? Is the area one in which public power has been or is likely to become an important issue? Is there any pending legislation that might affect operating results?

Sometimes, it may be advisable to visit the state public util­ities commission and discuss its views and attitude with the staff or to secure opinions of the commission on rate proceed­ings. During the period when reorganizations of holding com­pany systems were being formulated under the Public Utility Holding Company Act, analysts visited the SEC to obtain a more intimate knowledge of the proceedings and ideas of the members of the staff of the commission's public utilities division.

From his studies and experience in the field, the analyst draws the information used in the report which presents his recom­mendations. The length and form of the report depends on the practice of the particular investment company.

In addition to special reports, the research department may provide management with various useful tools. Thus, one group of open-end fund managers uses research recommendations as the basis on which it sets up an approved list each month for its own use. The list includes all classes of securities. The com­mon stock section takes that portion of the total portfolio in­vested in common stock as 100 per cent. A percentage is then allocated to each important industry group. The groups are then broken down, again by percentages, into individual com­panies, which might be chosen for future investment. This ap­proved list is regarded as a theoretical ideal portfolio. It does not correspond to the company's actual portfolio, perhaps, but it can serve as a guide both for general management thinking and for future security transactions. (Joseph H. Humphrey, Jr., "Investment Company Portfolio Management," Commercial and Financial Chronicle, September 17, 1953).

When you compare mutual funds, note that the best results are obtained if the research staff is encouraged to make suggestions to officials and superiors in an infor­mal atmosphere without the latter's first indicating their own beliefs or inclinations. A wise administrative policy will guard itself against developing yes-men. There is another danger that investment company officials are more likely to recognize. Spe­cialists, after acquiring familiarity with an industry, develop a fondness for the securities of the leading companies that is hard to counter. This is among the reasons why the conclusions of analysts are sometimes discounted. Another is that an analyst who knows an industry especially well often loses perspective and, although invaluable as a source of factual knowledge, may not be able to formulate a sound judgment.

Companies use a number of different ways to cut the costs of research. One group of investment companies uses the services of a company that serves all the funds in the group. Another investment company has, for some years, employed an advisory council to make recommendations. The council consists of lead­ing security analysts of brokerage firms, who are expected to receive their compensation from orders that the firms with whom they are associated may execute. The council only has advisory functions. Decisions are made by the board of di­rectors.

In recent years, greater attention has been given to economic research. An economist is more frequently employed as a mem­ber of the research staff or, in other instances, may be named as a member of the board of directors. A perceptive economist can undoubtedly be useful in the management of investment funds. His function is not to judge individual securities. Rather, he considers the broad influences on the economy, such as Federal Reserve credit policy, the role of imports, changes in commodity price levels, trends in population, productivity, anti­trust policy, and the like.

The research staff and the board of directors may also be periodically furnished with data on gross national product, pro­duction and profit trends, and similar information. This pro­vides a survey of the general economic environment rather than a judgment on the wisdom of a particular investment. For example, the outlook for construction may appear to be dubious to the economist, but the analyst may conclude that the stock of a building materials company has declined to a point where it merits consideration as an investment.

It has taken some time for investment company managers and security analysts to realize that economists are not "too theoretical" in their approach. During the early thirties, econ­omists lost favor because so many both in the academic and the financial world had completely failed to recognize the finan­cial abuses of the late twenties or to appreciate the severity of the Great Depression.

The ultimate decision on portfolio changes, i.e., on purchases and sales, is outside the scope of the research department. Some investment companies are devoted to the committee method of decision; they believe that no single person is competent to weigh all the factors that enter into a decision and that com­mittee participation reduces the likelihood of error. Other com­panies allow individuals to assume primary responsibility for such decisions.

Whether one man or a group decides, an investment com­pany official who makes or participates in making the final decision on investment policy should be trained in the inter­pretation of financial statements, and be something of an econ­omist, sociologist, constitutional lawyer, student of industrial developments, and judge of comparative values.

No one individual possesses all of these qualifications. Yet, the most difficult task in investment company management is optimum use of the specialist coupled with awareness of the limitations imposed by the very nature of the specialist's work. This calls for wisdom in applying the results of specialization by putting the segments into their proper places in the general scheme. Judgment cannot be gained from books. It is the result of more than factual knowledge or experience alone. Judgment involves knowing what to reject as well as what to accept. It is an intricate process, often involving courage to go contrary to general opinion even in well-informed circles. The ability to discard preconceived notions, to weigh facts and forces objectively and to be flexible enough to admit even tacitly the error of previous judgments is a rare quality, yet vital in achieving more than run-of-the-mill success.

INVESTMENT MANAGEMENT PROBLEMS

The inherent difficulties of investment management are more formidable than the Monday morning quarterback may imag­ine. Enthusiastic salesmen also are inclined to minimize the difficulties, and in the last decade they were aided by the course of the stock market. The rise in the stock market has in itself led investors often to expect too much too quickly. A few references will illuminate the problem in the light of long-term experience.

The Cowles report (Alfred Cowles and Associates, Common Stock Indexes, 1871-1937 (Bloomington, Ind.: Principia Press, 1938), pp. 40-44.), which was a most comprehensive study of common stock investment experience, dealt with the record of almost all listed common stocks during the period 1871-1937. The study showed that the average annual rate of increase in market value of all common stocks for this period was 1.8 per cent. For industrial stocks, the average annual gain was 3 per cent; for public utilities, 6 per cent; for railroads, none what­ever. The ratio of cash dividends to stock prices averaged 5 per cent annually for all common stocks. The average for in­dustrials was 5.3 per cent; for public utilities, 5.5 per cent; for railroads, 4.8 per cent. The total investment return therefore was as follows:

	ANNUAL RETURN (Percent)
All stocks	6.8
Industrial	8.3
Public utility	6.1
Railroad	4.8

This study was intended to show what would have happened to an investor's funds if at the beginning of 1871 he had bought all the stocks quoted on the New York Stock Exchange. The purchases were allocated among individual issues in proportion to their total monetary value and the calculations assumed that each month up to 1937 the investor's holdings were redistrib­uted according to the same criterion among all quoted stocks. Brokerage commissions and taxes were ignored.

Recent studies that include a longer period than the Cowles examination suggest that the total investment return or gain, including increased market value, would be more than 10 per cent for a broad average of industrial common stocks. A study made in the United Kingdom is also interesting. An investment in thirty equities, all industrial, made in January 1919, would (as of January 1, 1960) show an average annual gain from in­come and capital appreciation of 10.6 per cent (de Zoete and Gorton, Equity and Fixed Interest Investment: A Study, 1919-1960 (London: 1960).).

Finally, for you, in antipation of evaulating mutual funds effectively, a word about the forecasters. An investment com­pany lives in a glass house; it makes a record for all to see. The practice of emphasizing an unusually successful forecast and allowing a bad one to rest in undisturbed silence is transpar­ently unsound. More importantly, an investment company must act. Giving advice and actually buying and selling securities are different matters indeed. Stock market forecasters do not necessarily lack ability. Certainly, they have no lack of assur­ance. Nevertheless, stock market forecasters claim too much. Observation and careful analysis prove that stock market fore­casting is only insignificantly superior to chance assertion: the records of eleven leading stock market forecasting services, involving 6,904 separate forecasts, were studied for a period of more than fifteen years, to July 1943. The forecasters averaged only 0.2 per cent better than they would have if they had tossed a coin (Alfred Cowles, "Stock Market Forecasting," Econometrica, July-October 1944, p. 206.).

In an earlier study, it was found that the dean of Dow the­orists over a period of years made ninety predictions, forty-five of which were right and forty-five wrong (Cowles Commission for Research in Economics, Can Stock Market Fore~casters Forecast? Econometrica, Vol. 1 and No. 1, (New Haven, Connecticut: Econometric Society), December 1930.). Stock market forecasting is for the professional. The whole approach was bril­liantly summarized by the late Lord Keynes: "We have reached the third degree where we devote our intelligences to anticipat­ing what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees (John M.  Keynes, The General Theory of Employment, Interest and Money (New York: Harcourt, Brace and Company, 1936), p. 156.)." Critics of investment company manage­ment results often have shown little regard for the responsibility resting on those who use other people's money. They would have applauded the investment companies who plunged into holding company stocks and new offerings in the twenties merely because the general Alice-in-Wonderland environment enabled them to show large gains in 1928-1929.

Although the advances in the study of business cycles, which have been made by such organizations as the National Bureau of Economic Research, are noteworthy, stock market prices are not the result of economic forces or logical thought alone. The imponderables are likely to elude the power of the mathemat­ical and other tools that are devised to forecast stock prices. Unfortunately, too much stress is placed on the results of in­vestment companies that, from time to time, succeed in out­performing the average.

Open-end investment companies have been commended and criticized, with a case being made for both attitudes toward their performance. In terms of the popular Dow-Jones indus­trial average, one writer has contended that leading common stock funds have shown better long-term results (John B. Armstrong, "The Case of Mutual Fund Management," The Financial Analysts Journal, May-June 1960, p. 33.).The writer then undermines his case somewhat by analyzing the weak­nesses in the Dow-Jones averages because of their construction. He notes that a small investor would have to pay relatively high commissions to "buy the averages," and that the perform­ance of an unmanaged fund would be reduced by brokerage costs involved in making the changes called for by alterations in the market average.

A less favorable study earlier concluded that it was ques­tionable whether the two basic axioms of investment company policy, professional advice (management) and continued su­pervision (management), are worth the price paid by the in­vestor (Edward R. Renshaw and Paul J. Feldstein, "The Case for an Unmanaged Investment Co.," ibid., January-February 1960, p. 43.). According to this writer, the evidence indicates that the average return from professional advice and continued supervision is very low.

A sponsor of open-end investment companies has published the results of a study that shows both the difficulties of invest­ment management and the reasons why investors who are influenced by the result of a year seem destined for disappoint­ment. A tabulation of the results of 102 investment companies was made. These were compared with each other during the four years 1955-1958 on a mechanical basis: for each calendar year, the performance (adjusted for dividends paid) was com­puted and the five funds which registered the best result for the year in question were placed in numerical order. Opposite each fund was given its performance result in the next calendar year. The results are summarized as follows:

First five funds		Range of position of these Five funds for the next following year
1955		16-56
1956		29-99
1957		86-102
1958		2-45

This should prove conclusively the inadvisability of project­ing next year's results from the performance of the last year. The investor must not believe that investment management can perform miracles.

Proceeding from the general to the specific, an examination of portfolio changes is revealing (Henry Ansbacher Long has for many years published a quarterly survey of investment company portfolio changes, which now appears in Barroris. A.Wilfred May publishes a similar analysis quarterly in the Commercial and Financial Chronicle. Several other surveys of this type are also published.).

In a review of portfolio changes in the final quarter of 1955, Henry Ansbacher Long pointed out that Westinghouse Electric bore the heaviest brunt of the selling of stocks in the electrical equipment group. The stock had been declining ever since the beginning of the year, and the decline from the average level in the closing months of 1955 to the low point in 1956 was com­paratively small. A. Wilfred May, in the Commercial and Finan­cial Chronicle of March 31, 1960, took fund managers to task for having sold Ford Motors heavily in the second quarter of 1958 when its market price ranged between 38 and 43. Ford apparently became a buying favorite in the first three quarters of 1959, when its range was 57-93.

In the Long review of portfolio changes between June 30 and September 30,1960, a period in which the Dow-Jones industrial average fell from 641 to 580, it was noted that "caution re­mained the watchword." Greatest activity was noted in the electrical utility group. Eight funds were buyers, whereas three funds apparently took profits. Large commitments were made in Central Hudson Gas and Electric and in Ohio Edison. Houston Lighting and Power, Consumers Power, and Public Service Electric and Gas were acquired by four managements. Oil and chemical stocks were second and third in popularity. Notable during the period was a growing interest in gold-min­ing stocks.

Among the groups sold on balance were such cyclical indus­tries as automobiles and parts, railroads, and paper issues, the only equities sold in the preceding quarter. To show that group shifts do not tell the entire story, one might note that there was net acquisition of more than 50,000 shares of Republic Steel, whereas net sales of Bethlehem Steel amounted to approxi­mately 80,000 shares. There was some criticism of investment company sales of oil shares in a declining market for such shares with repurchases at rising prices later on.

Before criticism is levied, however, policies of specific invest­ment companies must be examined and the use of the proceeds known. Shifts from group to group need to be studied more intensively than the present data permit before valid judgment can be made. Stocks in one group may be sold at prices that are not as high as these stocks sell at in the succeeding quarter. If the stocks purchased have advanced even more, however, there is no reason for adverse comment. Further, if sufficient reasons exist for the sale at the time made, that is the all-important consideration.

Despite a generally defensive posture, open-end-fund pur­chases of common stocks during the September quarter of 1960 amounted to $419 million compared with sales of $311 million. On the other hand, closed-end companies sold $41 million of common stocks and bought $34 million. In the previous quar­ter, open-end-company purchases of common stocks exceeded sales by approximately $140 million. Common stock funds gen­erally increased their liquid position (percentage in cash and equivalent), but only a few had as much as 15 per cent of their assets in this form. Closed-end companies also tended to raise their liquidity ratio in moderate amounts. One of the interesting sidelights is that in almost every period, some investment com­panies buy and other investment companies sell about the same amounts of a stock. In the quarter reviewed, purchases of United Aircraft amounted to 20,400 shares, with sales totaling 21,000 shares.

In the third quarter of 1958, the Dow-Jones industrial aver­age advanced more than 10 per cent to an all-time high. A. Wilfred May noted that for the first time in a long interval, investment company policy during this quarter pursued the course of the stock market and business. In the quarters im­mediately preceding, it was contended the funds had main­tained "judicious defensiveness (A. Wilfred May, Commercial and Financial Chronicle, November 17, 1958, p. 1.)." Favored industry groups included airlines, motors, coal, drugs, electronics, electrical equipment, paper, steels, and rails. A divergence occurred be­tween open-end funds, which were large buyers on balance, and closed-end funds, which were sellers, in the main. A num­ber of investment companies now publish a brief discussion about the stocks that have been purchased or a brief explanation of the reasons for purchases or sales. This may be consid­ered a wholesome practice.

The difference in opinion that may exist among presumed experts is illustrated in the statements of managers accompany­ing the September 30, 1958, investment company reports. One management noted that "because market conditions are good, prices are good." But another observed, ". . . the recent near-panic buying of so-called growth stocks is a top-of-the-market sign/'

Investment companies often receive letters from stockholders when the portfolio shows the retention of a stock that has had a sharp decline from previous levels. Sometimes, although to only a minor extent, shareholders' opinion seems to set policy. For example, many funds do not invest in liquor or tobacco stocks because of the antagonism toward the product of these industries, particularly in the Middle West and the South. Investors who follow the quarterly reviews of portfolio changes with the hope of finding clues to the management of their own money should always remember that, because of broad diversification, a large fund can make mistakes with far less danger than the individual investor.    

Unfortunately, we have no precise key to the appraisal of in­vestment company results. On the negative side, the investor is urged not to be guided by a single quarter's results, or even the results of a single year. The avowed objective of a fund, of course, cannot be ignored. No one can reasonably expect a bal­anced fund to rise as sharply in net asset value as a common stock fund. Beyond this, the investor should examine the com­position of the portfolio. An exceptionally good performance may be attributable to the rise of one or two stocks. The inves­tor should ask himself: "Are these the kind of holdings I would buy if I were responsible for the money of other people?'*

The investment company management is doing its job if it follows a consistent policy in accordance with its objectives, if it does not churn the fund, if it avoids fads in investment think­ing, if it has integrity, and if it keeps the long run consistently in view. A sound management will not try to lend the certainty of science to a field, which is not scientific; it will not take credit for exceptionally favorable results that are the outcome of gen­eral conditions and then excuse a poor performance by citing conditions beyond its control. In investment management as in other activities, character will usually come to the surface in time.

INVESTOR ALTERNATIVES WHEN YOU COMPARE MUTUAL FUNDS

Type of Investment	Main Attribute	Drawbacks
Bonds (high-grade)	Certainty of steady income; moderate price fluctuations; current return around 4.25 percent	No growth in income   or   substantial growth in market value
Preferred stocks (high-grade)	Certainty of steady income; relatively moderate price fluctuations, particular short term; current return about 4.6 per cent	No growth in income or substantial growth in market value except in the event of extremely low interest rates
Common stocks (representative)	Possibility of increase in price and income over a period of years: evidence of ownership, participation in country's economic growth: current return, based on present dividend Payments, about 2.9 per cent	Rapid fluctuations in market price merely because of shifts from optimism to pessimism; many factors (economic, financial, political, psychological) affect prices; investors now expect "too much too soon"; exaggerated ideas of average rate of increase in market value
Savings account (mutual savings bank, time de­posit of commer­cial bank, or sav­ings and loan as­sociation)	Certainty of steady income; availabil­ity of original cap­ital; current re­turn about 3.5 to 4.5 per cent de­pending on area	No growth in income or increase in capital
Real estate (for in­vestment, not as home)	Reasonable income; possible increase in value of prop­erty	Fluctuations in income and price that can be obtained; difficulty of valuation because each unit is different
Life insurance	Protection of family in case of bread­winner's or head's death a primary reason	Various forms of insurance should be investigated with attention to investor's purpose, ratio of pure insurance to saving, etc.; fixed dollar payments except for variable annuities
Variable annuity	Annuitant receives lifetime income payments, the amount depending on the market value of an accumulated fund at time each payment is made	Funds contributed under contract to be invested in common stocks; sale variable annuities by life insurance companies largely based on long-term inflationary contracts; life insurance companies may sell variable annuities in only a few states at present
Monthly Investment Plan (MIP)	Systematic Investment through monthly or quarterly purchases of common stock in amounts of $40 to $1,000; involves dollar averaging in individual stocks without any contractual obligation	Usual drawbacks of purchases or ownership of common stocks; relatively heavy costs when purchases are made in very small amounts: problem of wise selection of stocks
Investment Company Shares	Diversification; professional management: possibility for systematic investment (either contractual or voluntary basis) at regular intervals in small payments; attributes of bonds, preferred and common stocks in varying degrees.	Drawbacks in varying degrees of bonds, preferred, and common stocks, depending on nature of the fund.