Chapter 11. "Investment Advice & Growth Prospects "

Almost always, after we have discussed a problem with a friend about investment advice, we think back and say to ourselves: "Why didn't I add this, and this? How could I have overlooked that?" This chapter is the result of such questioning, as it were. We began with a "fireside chat." Let us see what an equally informal chat with the reader-investor would cover after he has read this book.

Actually, we have gone over the essentials, but shading and emphasis need touching up. These are the essential points:

1. Investment companies serve a real purpose.



2. Most investors may properly put part of their funds in investment company shares.



3. By and large, the record of investment companies has been favorable.



4. How much the investor should buy; what type of invest­ment company share and which investment company issues are most suitable — these are matters for the investor himself to decide.



5. The chief word of caution: Do not, as an investor, expect too much, too fast. In the recent past, the investor has come to expect just that. High expectations sometimes are disappointed.

In considering what investment company or companies to buy into, the investor should analyze his position candidly. What are his objectives? What are his plans for future invest­ing? What relation do investment company and all other stockholdings have to net worth, income, and holdings of othersecurities and to protection in the form of insurance of the in­dividual or family.

THE PROBLEM OF NET ASSET VALUE

Almost all investors pay attention to the record of invest­ment companies. The past record is sometimes called a guide to the future. This is questionable when stated baldly and without qualification. The record, at least, does show changes in net asset value from one period to another and dividend payments out of investment income and out of capital gains that have been realized. Investment services and commentators have de­vised methods for comparing the "performance" of investment companies with unmanaged indexes or averages of relevant se­curity prices.

In one important respect, the net asset value as it is invariably stated leaves something to be desired. All the prospectuses, an­nual reports, and interim reports show the net asset value as of a specific date; in other words, as of December 31 or March 31 of any year. This follows accepted practice in accounting.

This mode of presentation could be improved. It might be desirable for investment advice companies to publish, along with this information, data on the average net asset value in the aggregate and on a per share basis. The form best serving the purpose would be a ninety-day moving average. This proposal may seem theoretical and somewhat radical. Yet, presenting the information in the form of a ninety-day moving average would give the investor a more nearly accurate measure of perform­ance than the present practice. In fact, the present method is in a large degree merely theoretical.

An example will illustrate the defects in the method now used and the advantage of the supplemental information proposed. As of December 31,1959 (or any other year), investment com­pany X had net assets of $10 million, based on closing prices of the securities in its portfolio on that date. The company had outstanding 1 million shares of capital stock. Therefore, the net asset value per share as of December 31, 1959, was $10 per share. The annual report and prospectus compare this value with that of the previous quarter-year and with earlier periods, but always as of the closing date of the period.

This practice is defective in these respects: First, prices as of one moment in time are fortuitous. Such prices are determined by the conditions of the market on but a single moment of one single day. Changes in prices on any one day may be attrib­utable to factors of a most temporary character: the statement of some political leader, reported changes in credit policy, an oversupply of new security offerings, unexpectedly favorable or unfavorable earnings statements of two or three important corporations, and the like. Secondly, everyone knows that the net asset value at the close of the market is at best an approxi­mation of the prices, which would be received if immediate liquidation were to take place the following day. Thirdly, and most significant for the investor's appraisal, it must be realized that the investor uses the net asset value as a measure of what management has done, or what effect the course of the market has had on the value of the company's portfolio. The record as of any one date is not a trustworthy measure.

In the case cited, let it be assumed that the net asset value on the last day of the preceding quarter was $9.5 million, or $9.50 per share; so the increase between September and De­cember 31 was approximately 5.3 per cent.

It would be some improvement over present practices to say that the mean, or average, value of X stock from Septem­ber to December 31 was $9.75 per share, thus avoiding the one-moment valuation. An even sounder way would be to use a daily average in calculating the value during the period. Investment advice companies compute their net value daily; so this presents no problem. Use of the average over a period of time, as suggested, to supplement the conventional method "irons out" some of the differences due to unusually sharp changes in market prices in the days immediately preceding the end of the quarter-year. Moreover, a ninety-day average would present more realistic information than does the figure chosen arbitrar­ily as of a date four times during the year. The ninety-day aver­age gives the investor a better idea of what he could have purchased the stock for during the period or what he would have obtained for it, on an average day. A moving average dampens the extremes and softens the impact of random values.

To reduce the emphasis placed on the net asset value as of any particular moment would also be worthwhile. Currently, eager salesmen tend to pounce on the quarterly charges to "point with pride" when funds which they are selling show up better than other funds. There is also a tendency to use the published comparisons rather like followers of the races fever­ishly scan the racing sheets.

Unfortunately, investors use the quarterly reports to exam­ine the portfolios of investment advice companies in a way that often leads to incorrect inference about buying or selling stocks in other companies. As pointed out earlier, investment company reports are good examples of full disclosure. The companies are not responsible if investors choose to use such reports in ways that are not intended. If the investor finds that investment company X has a substantial investment or has recently acquired a sizable position in a stock, which has currently en­joyed a conspicuous rise, he is often inclined to exaggerate the significance of this development. It cannot be pointed out too emphatically that the portfolio as a whole, not unusually favor­able or unfavorable experience in one or a few issues is the important consideration.

Some investors watch portfolio changes with feverish interest to see whether they can utilize such changes as guides to then-own investments. In other words, if investment company X has bought Universal Perpetual Motion stock, such investors are inclined to buy the stock at once for their own accounts. Often, they give little weight to price or to the fact that the purchase may have been made with long holding time in view. Further­more, it is one thing for an investment company to put 2 or 3 per cent of its total funds in any one security and another for the investor to conclude that he is wise in placing 20 to 30 per cent of his relatively small capital in Universal Perpetual Motion, often selling sounder shares to pay for his new purchase.

GROWTH PROSPECTS AND THE INVESTOR

A fundamental problem of investment policy is illustrated by a question which owners of investment company stocks often ask: "From your comment about economic conditions and the outlook, you obviously believe stock prices are high. Why don't you sell stocks with the idea of repurchasing at lower prices? After all, the difference between the sales prices and the cost of repurchase may equal dividend payment not for one but for a number of years."

The answer is that dividend income of carefully chosen stocks has a considerable degree of certainty, whereas successful catch­ing of a turn in the market involves a large degree of uncer­tainty. First, stock prices may not fall, the decline may occur only after a long time. Secondly, there is no assurance that once a decline has set in, purchases will not be delayed to await a further decline, and repurchase will be delayed until prices are again as high or higher than when sales were consummated.

The problem of dilution

The investor also should be aware of a problem confronting open-end investment company managements. This problem affects both current stockholders and new purchasers of open-end company shares. There has been a fairly well defined tend­ency for sales of open-end-company shares to be higher in strong, active markets than in periods of dull, declining markets. This means that the flow of funds into open-end companies for investment is larger when prices are relatively high and when the indicated dividend return is relatively low, or at least lower than during periods when funds received from the sale of additional shares are not as large (as in 1945, 1946, 1956, 1957, or 1958, to cite a few instances). The result is a kind of dilution, insofar as the "old" holder is concerned. Income per dollar of investment is likely to be reduced, and the average cost of the shares held in the portfolio may be raised.

Solving this problem is difficult. Management may counteract incipient dilution by buying short-term Treasury or corporate obligations. This may involve the loss of income. In a sense, it also expresses doubt about the near-term course of stock prices. If so much doubt exists, is it fair to invite investment in the shares of the open-end fund? It must be conceded that the prob­lem is difficult to appraise. Evidence does not establish a clear-cut superiority in the results of closed-end over open-end companies, and the former operate without having to meet this problem. Only education in restraint on the part of investors can eliminate this variety of dilution. Perhaps, as the number of investors who buy shares in open-end investment companies continues to increase, so that the flow of funds is maintained at a steadier pace, regardless of the level of the stock market, the problem will be reduced to insignificant proportions.

The impact of discount

Having discussed a matter of some concern for shareholders in open-end investment companies, one may consider another "trouble spot," relating this time only to closed-end companies. A number of closed-end investment company shares sell at a discount from net asset value.

A good case can be made for a policy of repurchase of out­standing shares where the discount is sufficiently large, but management often does not wish to reduce the amount of capi­tal that it commands. One step further: Management believes that it could employ additional funds to advantage. The recep­tion of new stock issues by investors may have been very favor­able. The directors decide to ask stockholder approval for the sale of additional shares, and as usual, the proposal is adopted.

A specific illustration will be helpful in understanding the implications of the new financing. It is assumed that investment company X has outstanding 1 million shares with a net asset value of $25 per share. The stock is traded in the market, how­ever, at $21.25, or at a discount from net asset value of 15 per cent. The directors decide to raise $5 million of additional funds. Now, to help assure the success of the offering, the stock will be offered below the market, let us assume at 10 per cent less, or at $19,125 per share. If the stockholders have pre-emptive "rights" (the right to subscribe to additional stock), the individ­ual shareholder may either subscribe or sell his "rights." In any event, his equity is being diluted because the company is selling additional stock at less than the net asset value (underwriting commissions have been ignored to simplify the mathematics of the illustration). If the "rights" are sold, the dilution is greater. If the stock need not be offered to the present shareholders, dilution will also follow.

For many years, closed-end investment companies did not try to raise additional funds through the sale of stock. More re­cently, a number of funds whose stocks have generally sold at substantially less than net asset value have raised additional capital. A few commentators have protested, but apparently without exercising any influence. Shareholders and investors generally have tended to be uncritical. The issues have been submerged in the era of good feeling generated by a rising market.

WHERE SHOULD THE INVESTOR PUT HIS MONEY?

As a result of the division of investment companies into those whose prime object is income and those that stress capital gains, investors have perplexing problems of choice. "Growth funds" have become the popular designation of those whose policy emphasizes investment in stocks promising the greatest capital appreciation. Income is secondary. E. W. Axe, investment com­pany manager, in discussing growth stocks, warned of the dan­ger of projecting long-term trends based upon the past and pointed out that the price one must pay for a security is always very important; "The stock of the best company can be too high to be a good long-term investment."

The expected greater rise in the price of the lower-yield stock follows from the fact that the industry is more dynamic, the expectation being that the future rise in earnings of the com­pany will be more rapid; or the dividend pay-out (the percent­age of earnings paid in dividends) has been so low that a large increase in dividends may be expected, whereas the dividend pay-out in a high-yielding stock has been so high that the pres­ent rate is regarded as a maximum for the foreseeable future.

The market may alter its valuation of earnings. In other words, because an industry or a company is more favorably re­garded, each dollar of earnings may now bring a larger price than formerly. If an investment management is successful in anticipating such changes, the advantages of growth may be obtained without any actual growth in earnings having taken place.

Recently, it has been preferable to own "growth" rather than "income" funds. The difference in income, i.e. income derived from dividends, has been more than compensated for by the rise in stock prices, and this, in turn, has been reflected in the relatively faster rise in the net asset value of the shares of growth funds.

Should every prospective investor therefore cast his lot with growth funds in preference to those whose policies are directed toward emphasis on "pure" income? The writer would answer, "No," unless the investor thoroughly understands the facts that will now be discussed.

Nothing can alter the fundamental difference between in­come derived from dividends—dividends that can be counted on year after year, in the main—and gains derived from the sale of securities at prices higher than purchase prices. The former dividend income is recurring (with some variations due to changes in the business cycle), whereas dividends of the latter variety are by their nature uncertain and the product of unpre­dictable factors. Investment thinking is actually dominated by the tendency to project into the future what has happened in the recent past. In 1929, the tendency would have been—as it was—to belittle income; in 1939, capital gains would have been given lesser consideration. Even in 1949, with common stock prices still far below the level of twenty years earlier, growth had not yet captured the imagination of investors, as it did after the Korean War and after the realization that the welfare state, or mixed economy, was not to be temporary. Investors still must learn the difference between economic growth and rising stock prices due to the raising of expectations and special factors.

Among the special factors are the well-known broadening of demand for common stocks from institutions, including bank-administered trust funds, pension funds, trustees, and the in­vestment companies themselves. This demand has not been accompanied by an equivalent increase in the supply of com­mon stocks of large companies. One important reason for the slow increase in the supply of common stocks is the low net cost of raising new capital through bond issues, since, as a cost like some other expenses, interest is deductible before income taxes. A second significant reason is the ability of large com­panies to generate a large part of their capital requirements from retained earnings and depreciation funds.

In the end, the great unknown is the long-term growth of stock prices. No one knows how rapid the gains will be. The best efforts at economic analysis are full of qualifications. Super­imposed on economic analysis, if the projections are assumed to be correct, are the evaluations placed by investors on earn­ings and dividends. These evaluations are determined by psy­chological and political elements. A ten-year period is a long time in some respects. It is entirely too short a time, however, to reach conclusions as to long-term trends in the economy or in security prices. Over a long period, seventy-five years or more, it seems that a reasonable expectation was a 6 to 8 per cent rise in industrial common stock prices annually and a 4 to 5 per cent dividend return. In this period, common stocks generally sold at prices to yield more than bonds and preferred stocks. If the investment world has entered a new era, and if capital gains are to range higher on the average, it will, in all probability, be at the cost of a smaller return from dividends. Perhaps this is only a long way of saying that "scientific" pre­dictions of future stock prices are not to be taken too seriously. The expectations of 20 to 25 per cent gains in three months aroused by recent stock market history is without foundation, either in past history or in plain common sense.

Nevertheless, without attempting to forecast the course of stock prices, the writer believes a strong case can be made for a higher capitalization of earnings and a lower rate of return than in earlier years. Briefly, the Employment Act of 1946 marks a fundamental change in the economy, as foreshadowed by the legislation loosely described as "New Deal." The federal government assumed new responsibility for avoiding mass un­employment and its accompanying massive destruction of cap­ital values and security prices. The extent to which built-in stabilizers can assure stability is open to argument. The timing of credit and fiscal policy may still leave much to be desired. The nation has learned valuable lessons from the past, however, and if extreme depressions can be eliminated, it follows that the average value of common stocks should be higher. One says "should" rather than "will," because economic logic never can be counted on to govern the stock market at all times.

Finally, one may be wise to depart from economic indices and impressive charts and admit the role of pure accident. For two years, 1956 and 1957, investment companies had difficulty in raising the net asset value of their stocks appreciably. Sub­stantial changes marked the movements of individual stocks and of groups of securities, but the general market made little headway. Restrictive credit policies and excess capacity in major industry had tempered optimism in the stock market. Leading economists looked for only a gradual and moderate recovery in business. Inflation had spent some of its force as a creator of higher prices. Investors in investment company shares who had bought late in 1955 generally had little or no gains at the end of 1957 or early in 1958. Then, as on other occasions, the Communist leaders unexpectedly came to the aid of the economy and the stock market.

One reason, which makes this writer hesitant about recom­mending that the investor put all his funds into investment companies, whether closed- or open-end, has nothing to do with investment results. The writer believes strongly in die need for economic education through direct participation in ownership of American industry.

An owner of shares in an investment company is a stockholder one step removed. True, many investment companies do publish a good deal of material concerning the activities of the principal companies in which they invest. A direct share­holder receives annual and interim reports and proxy material; often, he has the opportunity to attend annual or regional share­holders' meetings. His dividend checks give him a more acute interest in company affairs than when his stake is indirect, through owning an investment company's stock. Accordingly, I believe that at least some investment should be made in indi­vidual stocks, along with investment in the shares of investment advice companies. There is no better source material on the function­ing and problems of business than the annual reports of the leading companies. Larger numbers of stockholders, who utilize these reports to get an understanding of business, will help achieve the goal of a citizenry which is economically, as well as politically, well educated.