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 varied—perhaps quite unconsciously—from one year to another. But at least he will be able to make intelligent guesses as to growth or decline, he can mark the amount (or the book value, which is not the same thing) of stock-intrade and draw doubtful inferences concerning the speed or sluggishness of sales of the company's products, and he may try to trace the financial strength of the company's position by noting the extent to which it is pledging its credit as compared with the amount that it is owed by other parties. Even here, however, it is dangerous to be too dogmatic. Critics of balance-sheets often pat companies on the back because the creditor item among the liabilities is less than the sundry debtors among the assets; and there is certainly a satisfaction in seeing that a company in which one is interested owes less than it is owed; but a big overdraft at a bank is the best guarantee of solvency that a company can have, and a large sum due from debtors may be only an indication that business is being pushed not by selling a good article cheap but by giving credit to purchasers, too many of whom will some day have to be provided for as bad and doubtful debtors.

Having wallowed so long among the quicksands which surround any attempt to test from a company's accounts the real extent of its


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113Rh difficult to manage, they reverted to an earlier phase of Bismarck's career for an example to imitate. The Prussian Landtag (incredible as it may seem) was vigorously obstreperous at the time when Bismarck first rose to power, but he tamed it by glutting the nation with military glory in the wars against Austria and France. Similarly, in 1894, the Japanese Government embarked on war against China, and instantly secured the enthusiastic support of the hitherto rebellious Diet. From that day to this, the Japanese Government has never been vigorously opposed except for its good deeds (such as the Treaty of Portsmouth); and it has atoned for these by abundant international crimes, which the nation has always applauded to the echo. Marquis Ito was responsible for the outbreak of war in 1894. He was afterwards again opposed to the new policy of predatory war, but was powerless to prevent it. His opposition, however, was tiresome, until at last he was murdered in Korea.

Since the outbreak of the Sino-Japanese war in 1894, Japan has pursued a consistent career of imperialism, with quite extraordinary success. The nature and fruits of that career I shall consider in the next two chapters. For the time being, it has arrested whatever tendency existed towards the development of democracy; the Diet is quite as unimportant as the English Parliament was in the time of the Tudors. Whether the present system will continue for a long time, it is impossible to guess. An unsuccessful foreign war would probably destroy not only the existing system, but the whole unity and morale of the nation; I do not believe that Japan would be as firm in defeat as Germany has

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 profits, let us see if we cannot arrive at a small patch of solid ground. Let us take the profit for granted on our confidence—usually well based—in the integrity and prudence of the Board, and test our opinion of the company's soundness by the use that they make of it. As a rough generalization it may be said that this soundness will be in an inverse ratio to the proportion which the profit distributed as dividend bears to the amount of the profit declared. If only half the profit is distributed to shareholders all is very well (always barring the industrial risk that may overwhelm the best financed industrial concern); if nine-tenths of the profit goes in dividend things do not look nearly so well; if all the profit is distributed and still more if the dividend is only paid by drafts on reserves or on the amount carried forward, we are justified in shaking our heads, unless this action is accounted for by special conditions which are not likely to recur. But this subject deserves a chapter to itself.


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us return to the report and balance-sheet of Messrs. Bass, Ratcliff & Gretton and see what the directors of this company do with the profit at which they arrive after making the provisions recorded in the last chapter.

According to their statement in the report the profit amounts to £537,000 before charging interest on Debenture Stock, but since interest on Debenture Stock is a charge that has to be met, unless a company is prepared to compound with its creditors or commit an act of bankruptcy, it seems to be sounder and more logical to take off this interest, which comes to £81,000 for the year, before we arrive at the profit which the Board may or may not distribute to shareholders. On this basis Messrs. Bass's profit for the year to June 30, 1925, was £456,000.

Of this sum £68,000 goes in dividend on the preference stock, and £265,000 in


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 dividends and bonus on the ordinary shares, making a total of £333,000 distributed.

Reserve Funds receive £150,000 in all, but, as the amount carried forward is reduced by £27,000, the net amount actually put away is £123,000.

Thus, out of a total profit of £456,000 the directors distribute £333,000 (or roughly 73 per cent.) and hold back £123,000, or roughly 27 per cent.

The calculation can be made still more favourable if we deduct from the Profit the sum due to the Preference shareholders, whose rights and position will be discussed in a later chapter. Preference dividends can be "passed" (that is to say, left unpaid), without involving a company in bankruptcy, since they are a payment due to proprietors or partners in the business and not to creditors; but as in this case they are cumulative, which means to say that until they are paid the ordinary shareholders can receive no dividend, and as any prosperous company pays its preference dividends as a matter of course, and as punctually as the interest on its debts, it cannot be contended that they are an optional payment in the same sense as dividends paid on ordinary capital.

On this system we arrive at £388,000 as


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 the really divisible profit, after providing for debenture interest and preference dividend. Out of this £388,000 the directors pay £265,000, or 68 per cent., in dividend and hold back £123,000, or 32 per cent.—not far off a third.

It has also to be noted that the allocation of £50,000 to Reserve Fund raises it to a million, or nearly half the amount of the ordinary capital, which stands at £2,040,000, so that shareholders who are hungry for large dividends (as all human shareholders naturally are in view of the risks that they take) may feel that the directors have done quite enough in the matter of piling up reserves out of money which might have increased the current income of shareholders. And we find in the Report a sentence which indicates that the Board feels that it has to explain its action in pursuing still further the policy of building up reserves. For they observe, after stating that the total distribution to ordinary shareholders recommended is 11 per cent. and a bonus of 2 per cent., "it is also proposed to place £50,000 to Reserve Fund (which will then amount to £1,000,000) and, in addition to the regular yearly amounts written off the Property Account, it is considered prudent to provide a further £100,000 for depreciation," etc. More


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 over they also add, what appears to be a sentence that is inserted regularly in all their reports—"the directors consider that they have made sufficient provision for contingencies which may be reasonably foreseen."

So having built up an ordinary Reserve Fund of a million pounds, they have now started a new fund called Reserve for Property Depreciation, with £100,000, of which £27,000 comes out of the amount carried forward out of past profits and £73,000 out of the profits of the year under review.

It is this policy of building up reserves which has to be explained and almost apologized for to shareholders, which gives the ordinary shareholder in a prosperous company the great advantage that the value of his property is continually increased for him by an act of periodical saving and reinvestment, which is carried out on his behalf by the Board, and brings compound interest in to work for him with its rapidly accumulative effect.

In this case it has made him not only a shareholder in what is perhaps the best-known brewery in the world, but also a part proprietor in an investment company which holds investments standing in the balance-sheet at £1,824,000 and so not far from


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114Rh proved to be. Diplomatic failure, without war, would probably produce a more Liberal regime, without revolution. There is, however, one very explosive element in Japan, and that is industrialism. It is impossible for Japan to be a Great Power without developing her industry, and in fact everything possible is done to increase Japanese manufactures. Moreover, industry is required to absorb the growing population, which cannot emigrate to English-speaking regions, and will not emigrate to the mainland of Asia because Chinese competition is too severe. Therefore the only way to support a larger population is to absorb it into industrialism, manufacturing goods for export as a means of purchasing food abroad. Industrialism in Japan requires control of China, because Japan contains hardly any of the raw materials of industry, and cannot obtain them sufficiently cheaply or securely in open competition with America and Europe. Also dependence upon imported food requires a strong navy. Thus the motives for imperialism and navalism in Japan are very similar to those that have prevailed in England. But this policy requires high taxation, while successful competition in neutral markets requires—or rather, is thought to require—starvation wages and long hours for operatives. In the cotton industry of Osoka, for example, most of the work is done by girls under fourteen, who work eleven hours a day and got, in 1916, an average daily wage of 5d. Labour organization is in its infancy, and so is Socialism; but both are certain to spread if the number of industrial workers increases without


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 covering the whole of the ordinary capital of £2,040,000. These investments are described as in "British Funds, Colonial and Foreign stocks and bonds; railway preference stock and sundry debentures and shares," and as standing "at or below current quotations or valuations." The curious, of course, would like to know something as to the proportions which these very various classes of securities bear to the total invested, and a full list of the investments held would evidently make this item in the balance-sheet much more interesting. We shall find, however, that many of even the purely investment companies think it advisable not to let the public know in what securities the funds entrusted to them by their shareholders and creditors are placed; and there may be good reasons for this reticence, that are not evident to the layman.

By the reserve fund policy the shareholder is given an increasing value in his property through the retention by the Board of money that has been earned for him and its reinvestment either in extension of the enterprise or in holdings of the shares of companies in which the enterprise is interested or in outside securities.

This policy has one drawback—it misleads


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 critics, especially those who fancy that there is something wicked about earning profits, by exaggerating the apparent return on the company's capital. For instance if a company with a capital of £1,000,000 has accumulated reserves of £500,000 and earns a profit of £150,000, it seems to be earning 15 per cent. on its capital of a million, but what it is really doing is to earn 10 per cent. on a total capital of a million and a half, because the half-million of reserves is in fact fresh capital that has been added out of profits. It is thus liable to be called a exploiter earning 15 per cent. out of the patient public, whereas it is only earning 10 per cent. for its patient shareholders who have seen part of their profits held back year by year and put into the expansion of the business.

To correct this misapprehension and secure the acquiescence of the shareholders in the continuance of the reserve fund policy, it is now a common practice for Boards of Directors to capitalize reserve funds or part of them by an issue of bonus shares, that is by an issue of shares to shareholders without payment on their part, by the conversion of reserves into shares.

If we return to the example just imagined, of a company with a capital of £1,000,000


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 (and suppose that it is in £1 shares) and reserves of £500,000, the reserve would be capitalized by the issue to the shareholders of one new share for every brace of shares held. The result would be that on the liabilities side of the balance-sheet instead of seeing

the legend would run:

and the Reserve Fund would be wiped out, leaving a clean space for the Board to begin building it up again.

This operation of capitalizing reserves is usually hailed as a "bull point" by shareholders and speculators, and is presumed to confer some juicy benefit on the former. In fact it merely gives them in the form of shares what was already theirs in the form of reserves. It has no effect whatever on the assets or earning power of the company, and unless the profits increase the shareholders will in future receive no more in dividend from their larger holding than they would have had if no such change had been made.

The real advantage of it is that it shows more clearly the true facts of the case and the true rate that the company is earning on the


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 capital that its shareholders have actually put into the business or have had put in for them by the Board. It also pleases and cheers the shareholders and makes some of them think that they are better off, and reconciles them to seeing the Board building up the reserves in later years, and so continuing the process by which their property and earning power are expanded.

Some companies can achieve the same result—an increase of capital through the channel of reserve funds—by issuing shares, to their own shareholders or to the public, at a premium. It goes without saying that in order to do so their shares must stand high in the market.

We thus find that though the profits shown as earned by a company are, as a test of its position, full of misleading uncertainties, the use that the Board makes of the profit declared has some significance. We are in touch with definite fact when we ask how much of the profit remaining after meeting all charges, including preference dividend, is paid away in dividend and how much is put to reserve or added to the amount carried forward.

In its quarterly examination of the profits of industrial companies the Economist works out the proportion of profit put to reserve.


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 The average shown by the 1,443 company reports examined during the four quarters ending June 30, 1925, came to 22.3 per cent. But the Economist arrives at its proportion by including preference dividends as part of the sum distributed out of net profit. It seems to me that one gets a fairer result by deducting preference dividend—as practically a fixed charge—from net profit in order to get the divisible balance. There is then the true balance left, which may be distributed in ordinary dividend or carried to reserve or added to the amount carried forward, and it is the division of this balance which is of some use as a test. On this basis the average performance of the 1,443 companies whose reports were investigated by the Economist works out at 72.2 per cent. to ordinary dividend and 27.8 per cent. to reserve or kept in hand.

As need hardly be said, the test is far from precise, for variations in the form of the companies' capitals and debts make the comparison, to some extent, misleading. But as a rough guide in a country where pitfalls are plentiful and signposts are mostly incorrect, it may be better than none. It leads us to the conclusion that the investor may be well advised to insist that any company in which


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 he invests is at least up to average in this respect.

It is interesting to note that in America industrial companies as a whole appear to distribute only half their earnings as dividends. So, at least, it is stated on page 142 of Messrs. Foster & Catching's lately published book on Profits. Possibly the high proportion of water in the capital, that is usual at the outset in American industrials and is squeezed out gradually by allocations from profits, accounts for this apparently austere ideal on the other side of the Atlantic.


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115Rh a very marked improvement in hours and wages. Of course the very rigidity of the Japanese policy, which has given it its strength, makes it incapable of adjusting itself to Socialism and Trade Unionism, which are vigorously persecuted by the Government. And on the other hand Socialism and Trade Unionism cannot accept Mikado-worship and the whole farrago of myth upon which the Japanese State depends. There is therefore a likelihood, some twenty or thirty years hence—assuming a peaceful and prosperous development in the meantime—of a very bitter class conflict between the proletarians on the one side and the employers and bureaucrats on the other. If this should happen to synchronize with agrarian discontent, it would be impossible to foretell the issue.

The problems facing Japan are therefore very difficult. To provide for the growing population it is necessary to develop industry; to develop industry it is necessary to control Chinese raw materials; to control Chinese raw materials it is necessary to go against the economic interests of America and Europe; to do this successfully requires a large army and navy, which in turn involve great poverty for wage-earners. And ex-


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Debts, the first form of Stock Exchange investment that we considered, were to this extent simple, that they all implied a contract by which the investor became a creditor entitled to a fixed rate of interest and usually a capital sum to be some day repaid by the debtor.

Company securities, as a preliminary to the consideration of which we have been looking for a meaning in company accounts, are complicated in that they give the investor the choice of creditorship or ownership.

For those who like to be creditors, companies provide debts, in the form of bonds, debentures and debenture stocks, similar to the bonds and stocks issued by Governments and public bodies and, occasionally, interest bearing notes, usually with an early date of maturity, similar to the Treasury bills and Exchequer bonds with which Governments cater for the appetite that likes to see its money back soon.


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 For those who like ownership with the greater risk and more luxurious prizes that are its lot, companies provide ordinary, or common, shares and stocks.

For those who love compromise and a via media—less risk than is run by the ordinary shareholder and a higher yield than is given to the debtholder—companies provide preference or preferred shares and stocks.

These are the three main divisions, and, though there are many intermediate varieties with fancy names, they nearly all fall in fact into one of these classes. The debtholder takes the first bite out of the revenue of the company (after wages, salaries, taxes and other expenses have been met): the preference holder comes next and the ordinary shareholder takes such share of the balance as is not kept in hand by the directors or placed to reserve fund.

The position of the company debtholder is, usually, much the same as that of the holder of public debts—he is entitled to a fixed rate of interest, either for all time or up to the date at which his bond or stock is due for repayment. This date is either definitely fixed, or may be determined by the hazard of a draw, when the securities are numbered and part of them is drawn yearly or half-yearly for repayment. Payment is usually at par or the face value of


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116Rh panding industry with poverty for wage-earners means growing discontent, increase of Socialism, dissolution of filial piety and Mikado-worship in the poorer classes, and therefore a continually greater and greater menace to the whole foundation on which the fabric of the State is built. From without, Japan is threatened with the risk of war against America or of a revival of China. From within, there will be, before long, the risk of proletarian revolution.

From all these dangers, there is only one escape, and that is a diminution of the birth-rate. But such an idea is not merely abhorrent to the militarists as diminishing the supply of cannon-fodder; it is fundamentally opposed to Japanese religion and morality, of which patriotism and filial piety are the basis. Therefore if Japan is to emerge successfully, a much more intense Westernizing must take place, involving not only mechanical processes and knowledge of bare facts, but ideals and religion and general outlook on life. There must be free thought, scepticism, diminution in the intensity of herd-instinct. Without these, the population question cannot be solved; and if that remains unsolved, disaster is sooner or later inevitable.


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 the bond, but sometimes a small bonus is thrown in on redemption, and £105 or so is paid for the £100 stock or bond. This is usually confined to cases in which the debtor has a right of redeeming at an early date, as when a company issues bonds redeemable, at its option, at £105 in ten years or at £100 in thirty years. In the case of Bass & Co. the 4½ and 3½ per cent. Debentures are redeemable at the option of the company at 117 and 110 respectively.

In addition to these rights and frillings, holders of company debts, such as are described as mortgage bonds or mortgage debentures, have the right of foreclosure over part or all of the company's property in the event of its defaulting in the interest payments or redemption service. The value of this right evidently depends on the price at which the property pledged could, in case of foreclosure, be sold for the benefit of the creditors. And so here we find ourselves back in the region of guesswork. And very often we do not even know the book values of the assets that we are trying to guess about. Prospectuses frequently offer notes or debentures, with the label "first mortgage" attached, and say, for example, that they are specifically charged on the freehold and leasehold property, and then give a


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 statement of assets in which the said freeholds and leaseholds are jumbled up with the machinery and plant under one heading, so that it is not possible to tell even what is the balance-sheet value of the property specifically charged. And even if we knew that, the price that would be secured by a sale, at a time when the company was in difficulties, is still a matter of surmise. As to the "first floating charge" on all the assets, with a pledge that the Board will not put any charge ahead of it, except if necessary for "advances in the ordinary course of business"—and some such phrase is often found when debentures are issued—this protection is not a very sure shield for holders, since advances in the ordinary course of business would be more than likely, if the enterprise were straitened for funds, to be on a considerable scale.

An additional protection is secured for industrial debenture holders by the appointment of trustees to watch over their interest. The efficiency of their vigilance, however, is likely to be impaired if, as often happens, one or more of the trustees is also a member of the Board. If all goes well there is no objection, because the trustees only become important when all is not well; then, the interests of the creditors and those of the shareholders are likely


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 to clash, and it is not right for one man to represent them both.

In the case of railways, mortgage rights are often of great value, especially when the property pledged to the bond or debenture issue is in a position that is of importance to the working of the whole property. In England, railway debenture stocks do not carry mortgage rights. But the first mortgages granted by the American railroads have been, in the past, a source of great strength to the holders of bonds issued under them, whose rights have been respected at times of most ruthless reconstruction. At the same time, it must not be supposed that because a bond has a first mortgage it is therefore a sound security. Mr. John Moody, that eminent authority on American and other investments, says that: "Another false notion regarding the genuineness of a given railroad bond is the theory that a bond secured by a mortgage is always better than one which is not so secured. Of course in the majority of cases this is true, but there are numerous instances where a debenture bond, which is a mere promissory note, is a far better security than one which is protected by a direct mortgage lien. For a case in point, one might mention the New York Central Railroad Debenture Sixes. These bonds were not secured by


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 any mortgage whatever on the property, and they were subject to a great mass of other obligations of prior security. And yet they were a far higher grade investment. . . than hundreds of first mortgage bonds of various other railroads throughout the country."

Then there are the income bonds or income debentures, a form of security that is rare and generally unsatisfactory because it is usually nothing but a preference share trying to look impressive by calling itself a bond. On them interest is paid if it be earned during the year or period for which it is due. On bonds and debentures it is nearly always the rule that interest, whether earned or not, has to be paid somehow sometime; it cannot be "passed" and forgotten.

But one of the most important things that an investor has to learn and to keep remembering always is not to take the names attached to securities at their face value; not to think, for instance, that because a stock is called a first mortgage bond or debenture it therefore necessarily is a first charge on the property that has issued it. If he jumps to this conclusion and acts on it he may find when it is too late that the stock once carried


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 a first charge but that in the course of a period of misfortune the Board found it necessary to raise funds by an issue ranking ahead of the first charge and probably described as a "prior lien."

Of course the consent of the first mortgage holders was required before this could be done, and no doubt they only granted it because after many meetings of protest and much correspondence in the press, they were convinced that if they did not do so any attempt to enforce their rights would lead to results disastrous to themselves. Every security has to be tested not by the names attached to it but by its actual position with regard to a share in the revenue of the concern which has issued it, and in its assets in the event of liquidation.

Preference shares are a compromise, dear to minds that love this refuge, despised by the hearty whole-hogger who says: "Give me one thing or the other." The objection to them is that if fortune frowns on the enterprise the rights of the preference holders are apt to be set aside. As we have seen this sometimes happens even to first mortgage debenture holders, in spite of the weight of their legal rights and the special protection that is given them by the existence of trustees specially


text: The Problem of China/Chapter 6

title: The Problem of China/Chapter 6


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 appointed to watch over their interests; much more is it likely when it is a matter of preference holders who are not creditors at all but only what may be called limited partners in the ownership of the concern.

A preference holder who has not a right to a "cumulative" dividend—which has to be paid, if not this year next year or some other year before the ordinary holders get anything—has, indeed, very little right that is worth assailing. He takes his fixed dividend if earned and goes without it if it is not. It is the cumulative right that makes the preference worth having, and it is the one that the holder is likely to be asked to forego if a series of bad years has piled up arrears of dividend due to him that put the resumption of dividends on the ordinary shares into the dim future. In such a case a threat of immediate liquidation held at the heads of the preference holders and an intimation that liquidation will mean that little or nothing will be saved for them from the wreck, leaves them little choice about accepting any scheme of reconstruction involving the sacrifice of all or part of their arrears of dividend, a lower rate in future and possibly the surrender for the future of their cumulative "privilege." The directors represent the ordinary shareholders and the


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 preference holders have only themselves to take care of them.

Such things happen when things go wrong. But then, when things go wrong, all the investors in all the securities of the company concerned are bound to be affected. They are like a row of ninepins—if the first one hit by misfortune, the ordinary shareholder, is hit hard enough to fall over he will hit the preference holder; and if he does so hard enough to knock him over, the debenture holder will not escape without a blow; if he still gets his interest he will not be feeling nearly so comfortable about his investment, and if he happens to want to sell, the fact the preference and ordinary are paying nothing will make a serious difference to the price that he will get in the market.

Nevertheless the right to take interest or dividend ahead of somebody else is always a comfort to those who like the safe side and are ready to pay for it by taking a lower rate of interest. When things go wrong the other fellow is hit first, and if they go only a little wrong the preference holder is not hit at all. Many investors look with satisfaction on a nice collection of well-chosen preference shares; they are confined to their fixed rate—or usually so—and may sometimes look with envy at the


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 swelling dividends of the ordinary holders who come after them. But the fact of increased dividends for ordinary shareholders makes the preference holders' dividend more certain, gives them sounder sleep on their security and enables them to sell it better if they want to turn it into cash. Preference shares in a good and successful industrial concern are, as long as it is successful, as comfortable an investment as anyone can desire, especially when there is no debenture debt ahead of them.

Moreover financial ingenuity has devised a kind of preference share which combines all the advantages of a fixed preferential and sometimes cumulative rate with a share in profits after a certain rate has been paid on the ordinary. This is the "participating" preference share. Its holder gets all the security that his position can provide and at the same time has some share in prosperity if prosperity is abundant enough to give the ordinary shareholder an adequate return for his greater risk, and leave a divisible balance over. There is a good deal of equity in this principle, and it frees the preference holder's position from the objection that is often raised against it, namely that when things go wrong his rights are invaded and


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 that when they go right he gets his fixed rate and no more.

Hitherto the participating preference share has been issued almost solely by companies which, from the nature of the enterprise conducted, are more liable to fluctuations of fortune than those which are engaged in transport or industry in the narrower sense of the word. It is a pity that this is so, because a participating preference has thus acquired a slightly speculative association, which is an obstacle in the way of its wider adoption.

Some preference shares and stocks are called "guaranteed," and get from this high-sounding name more consideration than they deserve from investors. This was shown when the real nature of the guarantee of the Grand Trunk Railway of Canada's guaranteed stock was revealed in the strong light of disaster. All that it meant was that the company guaranteed to pay the interest if it could, just as it promised to pay, if it could, the dividends on the various preference issues. Investors are apt to assume that a guaranteed stock is necessarily guaranteed by some outside authority which is not affected by the fortunes of the company, and sometimes this is so, but by no means always. The guaranteed stocks of the British railway companies rank before the preferences


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 and the dividend on them is cumulative, but the guarantee is merely that of the companies. "Guaranteed" is thus a label that needs careful scrutiny when attached to a security.

Such are the securities—giving the rights and limitations of creditorship and limited ownership—which rank ahead of the real out-and-out owner, the ordinary shareholder, who takes what is left when these limited claims have been met. He takes it either in the form of dividend paid into his pocket, or in the form of reserve funds built up by the directors to increase his property and his future dividends; or he takes it with the best grace that he can muster if it be a minus quantity or a profit too small to make a dividend. He is the "functionless" person who takes the first risk and the last profit, but the last profit, how great so ever it be, is his.

Simple as his position is, as compared with the precedences and differences by which the prior charges are distinguished, it is sometimes subject to complications. One we have seen in examining the participating preference. Where it exists the ordinary divides with it—in proportions that vary according to the terms on which the participating preference is issued—any surplus left after a fixed rate has been paid to itself.


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 Then there is the deferred or management or founders' share, usually of quite nominal face value, which also takes a share of the profits after a certain rate has been paid on the ordinary. It used to be fashionable to denounce these shares as necessarily a wicked feature of company finance, but they are not necessarily so. When issued to those who have been, or are, helpful in organizing or carrying on the company, they may be a quite legitimate form of payment for highly important services.

And occasionally—such is the incorrigible habit of using words in different senses in which finance insists on indulging—shares are called ordinary which are really preferences, entitled to a fixed rate of dividend and no more, with a deferred share behind them enjoying the real rights and risks of ownership. But this arrangement is rare. As a rule the ordinary or common shareholder is the real owner to whom the property belongs, subject to the limited claims of the creditors and preferred partners.

As has been already indicated, old-fashioned investment doctrine looked on the ordinary share as so risky that anyone who held it became a speculator; those who upheld it confined the attention of seekers after a safe income to bonds, debentures and preferences, regarding


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 preferences as a doubtful concession. Sound as this doctrine undoubtedly is, since the first and second charges on income are evidently safer than the third and last, it is possible to doubt whether comparative safety with fixed rate is necessarily and always preferable to comparative risk with possibility of expansion of income. If we could know that a company is going to be highly successful, we should certainly take its ordinary shares rather than the prior charge securities. If we have good reason to expect, from its past performances, that it is likely to be so, the question arises whether the chance of expanding success cannot fairly be weighed against the limitation imposed on the income of the debenture and preference holder.

For safety, such as is given by the best industrial debenture, is only relative. If misfortune does happen, debenture holders will be affected, directly by loss of interest and capital, or remotely by anxiety and a lower price for the security if it has to be sold. This relative safety is accompanied by an absolute limit on the income. The owner or ordinary shareholder, on the other hand, is relatively less certain to get any income, but no limit is imposed, by the terms of his holding, on the possibility of its expansion, and this possibility,


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 as we have seen, is favoured by the reserve fund policy, which continually expands the earning power of any business to which it is consistently and successfully applied.

There is thus a good deal to be said for the view that, if one goes into industrial investments at all, the greater risk plus possible expansion carried by the ordinary share is a sounder business proposition, if adequate skill and knowledge can be applied to selection, than the smaller risk plus limit on income carried by the debenture and preference.

This view has been supported by the striking results of investigations lately carried out in America and referred to on page 14 of Chapter I. It is time to examine them more closely.


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was shown in our chapter on Trade Cycles and Price Fluctuations, when commodity prices fall there is a tendency for fixed rate investments to rise, because money becomes plentiful and cheap and pushes them up, but for the profits and consequently the prices of ordinary shares to be diminished, because the lower prices make the finished article fetch less than would otherwise have been the case by the time it has gone through the process of manufacture, while food and materials are losing value all the time that they are moving through the hands of merchants and middlemen. If these tendencies act with sufficient strength and are not balanced by counteracting influences, one would therefore expect, in periods of falling commodity prices, fixed interest securities to rise and ordinary shares to fall and to disappoint their holders in the matter of income.


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 Mr. Edgar Lawrence Smith, author of Common Stocks as Long Term Investments, relates in his Introduction that his book is the record of a failure—the failure of facts to support a theory. The theory was the one just referred to, that at a time when the buying power of money is rising, that is, when the prices of goods and services are falling, bonds are a better investment than common shares, as they were, in the belief of the theorist, from the close of the American Civil War in 1866 up to 1896, a time when the buying power of the dollar rose steadily.

Mr. Smith subjected this theory to the test of historical investigation, covering the period from 1866 to the end of the century, and found that high grade bonds failed to demonstrate themselves as having been the better investment. So he went on with his tests because he felt that "the facts assembled seemed worthy of further investigation. If they would not prove what we had hoped to have them prove, it seemed desirable to turn them loose and to follow them to whatever end they might lead." So he made a series of tests to see "how it would work out, if our fathers had invested solely in common stocks, not with the thought of immediate speculative gain, a thought


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 that is unfortunately most difficult to eliminate from the choice of common stocks, but with the sober-minded purpose of providing (1) constancy of income, and (2) safety of principal."

In making these tests he had to be careful to avoid what the Stock Exchange calls "jobbing backwards"—that is applying what we know to-day to problems of yesterday or yesteryear. If he had attempted to let his imaginary investor in the past choose stocks that seemed to be the best to buy, he would almost certainly have been influenced by what is known now about their subsequent history. So the only principle of sound investment that he could apply to the choice of stocks was that of diversification. Each test assumed the investment of approximately $10,000 (£2,000) in ten different common stocks of large companies and of an equal amount in "high grade bonds." The stocks chosen were selected by some quite mechanical method—those in which there had been the largest number of transactions during the week in which the investment was supposed to have been made, or those which showed the highest yield on the basis of the previous year's dividend, with the most consistent dividend record.

It was also thought necessary to assume that the supposed investor had no further funds


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 beyond his $10,000 for subscribing to additional stock if offered by his companies, and therefore had to sell his "rights" on these occasions at the average price that they would have fetched during the first thirty days in which they were quoted; and for the same reason he was forced to sell any fractional shares that might come to him by way of stock dividend; the proceeds of these sales were added to current income. Whole shares received by way of stock dividend were retained and increased the value of his capital holding and the amount of his income in after years. As he has no funds out of which to meet "assessments," the American term for further capital demanded from stockholders, in the event of reconstructions, he has to sell out whenever these unfortunate experiences occur, and he naturally does so at considerable losses. Otherwise he makes no change in his holding of common stocks during the periods which range from seventeen to twenty-two years; when his bonds are paid off he has to reinvest, but he leaves his shares alone and they are only changed by consolidations and amalgamations.

The remarkable result of these tests is that in every case out of the twelve tests given the investor would have had a higher income from common shares than from bonds; in every case except one the advantage is on the side of the


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 common shares when income and increase in capital value are added together. In one case only is the advantage on the side of the bonds, and that is because the rise in capital value of the bonds was great enough to offset the larger income from the shares.

The first test is made by the investment of $10,000 in the first full week of January, rgor, on the top of a quick rise in security prices during the last months of 1900. The investor is supposed to have put as nearly as he could $1,000 each into the ten industrial stocks in which there had been most transactions. These were American Sugar, American Tobacco, Continental Tobacco, People's Gas, Tennessee Coal and Iron, Western Union Telegraph, Federal Steel, Amalgamated Copper, American Smelting and American Tin Plate.

At that time fifteen high grade railroad bonds were selling at prices yielding 3.95 per cent. But in order to give the bond every chance, the investor was supposed to have made his bond investment so as to earn 4 per cent. and to have chosen his bonds so well that during the period from January, 1901, to December 31, 1922, none of them lost any value owing to poor credit or high interest rates.

The result of this test is that the holding of common stocks, which were bought for $10,002


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 in January, 1901, had a market value on December 31, 1922, of $15,422—an increase of over 50 percent. The total income received from them was $19,781, averaging a shade less than 9 per cent., as compared with 4 per cent. on the bonds, and the total advantage on the side of the shares, capital increase and extra income together, was $16,401. And this is on the assumption, probably highly flattering to them, that there had been no decline in the prices of the bonds in a period during which the biggest war that ever happened had raised the rate of interest on gilt-edged securities.

It was to be expected that in this period, 1901-22, ordinary shares would be a more profitable investment than bonds, because it was a time of rising commodity prices and interest rates and of feverish industrial activity. Mr. Smith, while freely admitting this, maintains that "regularity of income in this first test was maintained through two severe industrial depressions and the greatest war in history." In claiming regularity of income, however, he seems rather to strain the meaning of the word, as is shown by his own very clear statement year by year of the cash income received from the shares. For the first year it was just over 8.2 per cent., and it went on as follows year by year: 5.9, 5.6, 5.1, 7, 10, 8.8,


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 8.6, 9.1, 10.7, 8.7, 10.4, 10.5, 8.8, 7.4, 10.5, 14.1, 14.1, 9.3, 9.6, 7.8 and 7.4. The "peak years," when 14 per cent. was earned, were 1917 and 1918, when American industry was making abnormal war profits, and an income which starts at 8 per cent. and leaves off at 7½ per cent., having touched 14 and 5 per cent. in the meantime, can hardly be called regular. The really striking point, however, is that the share income at its nadir in 1904 was still above 5 per cent., and so better than the 4 per cent. which was credited to the bond investment.

The more interesting tests, however, are those which are taken for periods in which commodity prices were falling, so that industrial profits might be expected to have been on a much lower scale. And so we find them, though not low enough to bring the income from them below that which would have been earned by bonds. In Test No. 4, from 1880 to 1899, the total income from shares in twenty years comes out at $14,528, an average of $726.4 on an investment of $10,163, or roughly 7¼ per cent. as compared with 9 per cent. in the first test. Fluctuations are also much less lively, the highest point being $923 in 1882, and the lowest $622 in 1886. But it should be noted that in this test railroad shares were


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 included owing to the scarcity of industrial companies in those remote days. At the time of this test, bonds could be bought to yield 505 per cent., and are estimated to have shown no change in market value during the period. Thus the yield from the shares was substantially higher on the average and materially higher in their least profitable year, while their original purchase price of $10,163 in 1880 compares with a market value of $13,616 at the end of 1896, and $18,817 at the end of 1899.

Mr. Smith considers that the results of Test No. 5, covering the period from 1866 to 1885, are by far the most significant, since this was a period which witnessed a recovery in the buying power of the dollar, which "had had no counterpart since the Napoleonic Wars and has as yet had no other. . . . Based upon the change in the purchasing power of the dollar, there has never been a period which so favoured the purchase of long term bonds as against the purchase of common stocks as the period from 1866 to 1885."

Nevertheless, even in this test, common stocks more than held their own, their advantage in aggregate income offsetting the greater capital appreciation in the case of the bonds. They even succeeded in showing a small capital increase, a fact which seems to have surprised


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 the investigator considerably, for he says: "We find, after the greatest increase in the purchasing power of the dollar that this country has ever experienced or is ever likely to experience, that his [the imaginary investor's] holdings in 1885 have a market value of $10,936, an actual increase, where, if no other factor than the appreciating dollar were in force, a drastic decrease was to have been expected." Whether a drastic decrease in prices of industrial shares was to be expected would depend, however, rather on the view that one takes of the probability that the fall in the rate of interest which almost always accompanies a fall in commodity prices would tend to maintain the prices of shares by making money plentiful and cheap. It or some other influence certainly did so in this case, in spite of a considerable decline in the earning power of the ten selected investments. Just as in England in the spell of low prices and cheap money which culminated in 1896-97, when 23 per cent. Consols rose to 114, those which were thought to be the soundest Home Railway ordinary stocks rose to a level at which they only returned about 3 per cent. to the buyer.

With regard to the income received under this test, Mr. Smith seems to depart for a moment from the serene impartiality with which


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 he reviews the results of his investigation. For he says on page 46: "We have seen how steady an income return was paid during the period on the diversified list of stocks, selected for Test No. 5." But in fact the annual return was, from his figures, as follows:

If this be a "steady" income it is one which may well have made its owner feel uncomfortable. For if we add the receipts of the last two years of the period together we find that they are $1,084, just nine dollars less than the income received in the first single year of the period and twenty-two dollars less than in the second. In other words the income at the end of the period was half what it had been at the beginning. On the other hand the fall in income would have been balanced by the fall in prices. But the bond-holder, whose money income would have been constant at 607.7, would have had a much fuller benefit from this increase in its buying power.

Mr. Smith's tests, however, should be


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 examined in detail by those who wish to study this interesting problem of the relative advantages of industrial ordinary shares and prior charges and the question whether the, only comparatively, greater risk carried by the former is or is not outweighed by the possibility of indefinite expansion in income and value attached to them, if they imply ownership in a well-conducted and well-financed business.

We have seen the broad result reached by his investigations, that out of twelve tests only one ended in favour of the bond, and that was only so because their greater capital appreciation had more than offset a larger income received from the shares.

The conclusion at which he arrives is that these tests are not in themselves conclusive, but "cumulatively they tend to show that well-diversified lists of common stocks selected on simple and broad principles of diversification respond to some underlying factor which gives them a margin of advantage over high grade bonds for long term investment."

This underlying factor he finds in the reserve fund policy—in the fact that the "directors of conservatively managed corporations over a period of years will never aim to declare all the company's net earnings in dividends.


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 They will turn back a part of such earnings to surplus account, and invest this increasing surplus in productive operation. Such a policy successfully carried out is in fact a practical demonstration of the principle of compound interest" (p. 77).

Nevertheless, before we accept Mr. Smith's conclusion that there is a margin of advantage in favour of common stocks and shares, certain features about his tests have to be noted.

First, that they all refer to the United States, a country which has, ever since the end of its Civil War in 1865, enjoyed amazing growth and prosperity, tempered by short-lived panics and setbacks. This prosperity was due to the activity of a highly intelligent and enterprising people in opening up, with the assistance of a great stream of immigrants and of capital from the Old World, a country of enormous potential resources which at the beginning of the period had hardly begun to be tapped.

Second, that the industries whose securities have been used as tests have thus been especially favoured by the circumstances under which the population for which they catered has grown in numbers and in wealth with the assistance of foreign credit and capital, and


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 have also in some cases been granted artificial advantages, at the expense of the consuming public, by the high tariff policy of the United States.

Third—and perhaps most important—eight out of the twelve test periods chosen ended in 1922, and so covered a time in which American industry was making extra-special and abnormal profits out of the European belligerents during the war and then during the after-war boom. It was not only the directly war industries—the growers of food and materials and the makers of munitions—that reaped these profits, but all the industries of the country benefited by the stream of wealth which the war poured into America, converting her from a debtor country into one which holds all the world in fee.

For these reasons I venture to think that we should add a few words to the conclusion quoted on p. 182 and say that diversified lists of common shares in the industries of a country that is enjoying exceptional growth and prosperity give them a margin of advantage over high grade bonds.

With this modification the conclusion represents much more exactly what Mr. Smith has really proved. How far does it help us in trying to secure the ideal which we have


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 sketched for the investor of securing from his investments an increasing income and growing capital value?

Shall we be justified by it in selling all the gilt-edged securities that we hold, putting the proceeds into ordinary stocks and shares representing ownership in industry, commerce, transport and agriculture, and expecting the Board of our companies to do the trick for us by steady additions to reserves which will put compound interest on our side?

It should be noted that Mr. Smith suggests (p. 104) that the annual excess income from stocks should be treated "as a genuine reserve against the supposed risk of holding common stocks." He proposes to grant the investor only the right to spend the amount that he would have received from an investment in bonds, and to make him reinvest the annual surplus income from stocks each year as he receives it. But how many ordinary investors—could be trusted to carry out this policy, or even, if the necessary self-control were present, to make all the calculations and adjustments that would be required?

But apart from this after-thought, we have to remember that the industrial risk which is inseparable from an investment in any particular industry cannot be eliminated by the


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 process of diversification. It is lessened by diversification, but in these times there is nearly always a good deal of sympathy between one industry and another.

Moreover, excellent as the effects of the reserve fund policy are when successfully carried out, its success, and the power of the directors to carry it out at all, depend on the efficiency with which the industry is conducted on its technical side. If profits are not earned there is nothing to put to reserve; and if the sums put to reserve are invested in expansions of the business that do not pay, they bring no advantage to shareholders, whose dividends have been diminished to provide them. Ordinary shares in a company that is profitably conducted and continually puts part of its profit into expansion are as good an investment as can be found, but profitable operation in any particular industry is evidently a factor that can be relied on with much less confidence when we try to peer into the future than, for example, the total taxable capacity of a great and wealthy people.

With these reservations it seemed to be desirable to make a test of our own, applying the reserve fund policy as a practical guide in the selection of industrial ordinary securities.


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 So I asked my friend and former colleague, Gilbert Layton of the Economist, who spends much of his time on company accounts, to see what would have happened to an investor who had, in 1910, invested in six industrial ordinary shares or stocks, with this principle to guide him.

The imaginary investor took the six companies which had put to reserve the largest proportion of their available balance, after payment of preference dividend, during the years 1905 to 1909. The accounts tested were those of concerns with a paid-up capital of £1 million and upwards, and companies paying an ordinary dividend of less than 5 per cent. were excluded. Some such limit is evidently essential; since otherwise a company which had fared so ill that it paid nothing, and carried forward all its small earnings, would be hailed as a model of good finance. The companies are shown in the order of the proportions reserved, the Eastern Telegraph having reserved the largest and Pease & Partners the smallest percentage of the six companies.

The price of purchase is assumed to be the middle price of December, 1910, thus giving the supposed investor time to make his investigation into the accounts of the companies for the


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 preceding five years. Here is the result of the test:—

The year by year performance of the companies was as follows:—

The Eastern Telegraph Company paid a dividend of 7 per cent. for the first four years, 8 per cent. for the next four, and 10 per cent., free of income tax, for the remaining six years.

Howard & Bullough paid 15 per cent. for the first two years, and with the second dividend distributed a bonus of 33⅓ per cent. In the following year the rate was 15⅚ per cent., but for the next four years it dropped to 10 per


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 cent. In 1918 the dividend was 15 per cent., and there was also a capitalized bonus of 33⅓ per cent. Then followed three years of 10 per cent. on the larger capital, the dividend being increased to 17½ per cent. in 1922 and to 20 per cent. in 1923. In 1924 the ordinary capital was increased to £1,250,000 and the dividend fell to 124 per cent.

Our investor was fortunate in his holding of Babcock & Wilcox, for in the first year he received a capitalized bonus of 100 per cent. in addition to a dividend of 28 per cent. on his original purchase. Throughout the fourteen years this company paid its ordinary dividend free of income tax. In the second and third years the rate fell to 16 per cent. on the larger capital, dropped to 14 per cent. for the next year, rose to 15 per cent. for the next five, then to 16 per cent. for two, and then to 20 per cent. for 1922, when once again a capitalized bonus of 100 per cent. was distributed. In the last two years the dividend on the quadrupled capital was at the rate of 12 per cent.

The capital of Bradford Dyers' Association remained unchanged throughout the period, while the dividend increased in several stages from 6 per cent. in 1911 to 22½ per cent. in 1919. It then fell to 20 and 10 per cent. in the two following years, rose to 35 per cent. in


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 1922, and dropped to 25 per cent. in the last two years.

The dividend of the Fine Cotton Spinners' & Doublers' Association was at 8 per cent. in 191 and remained at that figure until 1917, when it was raised to 10 per cent. for two years. In 1919 the rate was 12 per cent., followed by 20 per cent. in 1920. Then came a drop to 10 per cent. for 1921 and 8 per cent. for 1922, followed by 12½ and 14 per cent. for the last two years respectively. In 1913 and 1919 the shareholder received bonuses of one 5 per cent. Preferred Ordinary share for every five ordinary shares held.

The Pease & Partners' dividend was 8 per cent. for the first two years, then 12 per cent. for two years, followed by 10 per cent. and 15 per cent. In 1917 and 1918 the rate was 17½ per cent., and in 1919 12½ per cent. free of tax, together with a capitalized bonus of 20 per cent. In 1920 the rate went up to 18 per cent., but fell to 14 and 5 per cent. in the two following years. In 1923 it rose to 6 per cent., and in 1924 to 8 percent. This, as may be seen from the table, is the only case in which our investor's capital has suffered depreciation over the fourteen years; it is accounted for by the fact that in 1925 the dividend fell away to 1½ per cent., owing to the severe depression in the iron and


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 steel trades. The aggregate investment in the six companies, however, has appreciated by over 50 per cent. and our investor has received a dividend rising from 5.9 to 11.4 and averaging over 9 per cent.

The investigation is on too small a scale to prove much. But, as far as it goes, it is interesting and encouraging, especially when we consider that the period covers two cataclysms—the beginning of the war and the after-war collapse—and a spell, still continuing at the end of the test in June, 1925, of severe industrial depression.


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have seen that the margin in favour of ordinary shares and stocks which seems to have been established by Mr. Smith's extremely interesting tests was based on earnings made under conditions so exceptional that it can hardly be taken as proved in the case of the industries of any other country. Even in America one does not feel quite certain that industrial profits are going to be so fat in the future, when once the exceptional circumstances now in favour of the United States have given way to more normal conditions. We have yet to see the effect of the restrictions on immigration by which one of the causes of amazing economic expansion has been seriously weakened.

All that, for the purposes of really fastidious investors, has been proved by these investigations is that ordinary shares have advantages which make it impossible to regard them as necessarily so speculative that we ought to feel rather ashamed of possessing them.

At the same time, the preceding pages have


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 been written in vain if they have not shown how difficult it is for the ordinary investor to weigh the real merits of any security from a public debt down to a share in a mine that is some day going to flood the world with platinum. We have seen how many guesses we have to make in considering the taxable capacity of a country and the policy that its rulers are likely to follow in husbanding its resources; and that the earning power of a company is to a great extent dependent on the opinion of the directors concerning the figures at which the assets should be stated in the balance-sheet; and a great accounting authority has been quoted who said that the amount taken credit for in respect of one asset alone—stock-in-trade—may double or treble the apparent profit if it be put too high. With his feet in these quicksands and his head in this fog, through the rifts in which he can only get glimpses of what may be fact and may be mirage, the ordinary investor may well hesitate about any attempt at industrial investment, even when his hand be held by a most cautious and intelligent stockbroker.

To the author of Common Stocks as Long Term Investments, the dangers surrounding the choice by any individual investor were so evident that he ends his book by advising him


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 to put the task of investment management into the hands of bodies specially organized for this purpose.

"It is," he says, "a task that can be properly undertaken only by an organization in which men of varied experience and training in the financial field unite with the single purpose of applying their best combined judgment continuously, with the least managerial complications, to the supervision of a single investment fund in which a large number of individual investors may participate. Thus, alone, may the best results be obtained."

This conclusion points the way for the investor in favour of investment in something like the British Trust Companies, by means of which he acquires ownership in companies which exist for the purpose of taking off his shoulders the burden of choosing investments, and becomes at once associated with a co-operative investment body of the kind indicated by Mr. Smith. By this system he passes over to hands which certainly are more skilful and experienced than his own the task of making a selection among the thousands of investments which will do so well for him if he chooses well and will inflict disappointment upon him if he makes mistakes.

That a holding in a prosperous and well


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 established Trust Company should form part of the collection of investors who aim at increase of income and capital will be readily agreed, and the advantages of these companies will be set forth fully later. For the moment, however, it must be observed that a blind purchase of Trust Company ordinary stocks or shares can by no means be relied on as a royal road to investment salvation. The history of the British Trust Companies has been marked by striking successes, but has also been strewn with wreckage and disaster. In fact the difficulties that face the ordinary investor are never more clearly shown than when we contemplate the mistakes that have been made in the past by the skilful and well-informed managers of investment companies.

What we are looking for at present is some kind of investment by which it may be possible to secure the compound interest advantage that is achieved by the reserve fund policy for ordinary shareholders, while eliminating as far as possible the industrial risk which we saw to be inseparable from the privilege of ownership in any industrial enterprise.

Such investments are to be found in the shares of banks and discount companies and of insurance companies. Their service to industry is obvious, since industry as at present


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 organized could not continue for a day without them; and at the same time this service is so widely spread over industry as a whole that the principle of diversification is introduced by the holding, for example, of shares in a single great bank to a much greater extent than any ordinary investor could hope to secure by subdivision of his investments into different industries.

This very wide spread of the net with which banking, bill-discounting and insurance sweep the waters of industry and commerce does not by any means eliminate risk. Those who know most about the conduct of these enterprises will acknowledge most readily that it is very easy to make mistakes in carrying them on; but if investment is confined to the shares of the large and well-established companies, then the vast resources handled, the great body of tradition and experience at the disposal of those who manage them, and the inevitable demand for their services by trade as a whole, whatever may be the fluctuations in the fortunes of its various branches, give a solidity and stability to their earning power such as no form of purely industrial investment can rival.

Competition among them is keen, but the position of the leading companies is so firmly established that there seems to be little likeli-


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 hood that it can be dangerously assailed by the emergence of new stars in this firmament. In the great increase in production and exchange that seems now to be possible, if mankind will give more attention to production and less to quarrels about the division of the product, these great financial institutions should play an enormously important and reasonably profitable part. And out of the profits that they make we may be as sure as we can be of anything about the financial future that they will continue, in the interest of the invincible strength that is necessary to their existence, the policy of building up reserves which is conducive to the expansion of the shareholders' income.

One serious drawback most of their shares carry, from the point of view of the investor who likes to feel that, within the limits of investment conditions, he has not left a single chink in his armour through which he can be smitten. They nearly all carry a liability which in some cases is considerable in amount. It may be true—probably is true—that this liability is purely nominal—that in view of the terrific shocks which have been successfully met in the last dozen years by the financial machine without any question even remotely arising of a demand on the shareholders of the banks and discount companies and insurance societies that they


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 should meet the liability on their shares, it is not possible to think of any cataclysm which would put any one of them into liquidation. But there the liability is, and it cannot be forgotten altogether.


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at a bank balance-sheet shows at once one of the great advantages that shareholders in these institutions enjoy, namely, the enormous sums handled in relation to the amount of the shareholders' capital employed. The consequent diversification of risk is evident. Here are the figures on December 31, 1924, of the Westminster Bank, which we will take as the oldest of the London Joint Stock Banks, apart from the Bank of England, which stands by itself.


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 It will be seen that the total of the balance-sheet is more than thirty times the size of the paid-up capital, so that every £1 share in the bank gives its holder what may be called a remote reversionary interest in more than £30 worth of assets. He has, of course, no claim on a pennyworth until the holders of current and deposit accounts have been paid the whole of their £273 millions and all other liabilities have been met, so that if the assets were sold at the prices set against them his share would not amount to much more than £2; in fact, as we shall see later, the assets would probably fetch more, and it may be noted that besides the paid-up capital contributed by shareholders they have added just as much again out of profits held back and put into reserve fund. But the fact that for every pound that the shareholders have so invested in capital and reserve the public has put more than fifteen pounds into the hands of the bank for temporary employment enables the bank to spread the shareholders' risk by pouring out its funds over an enormous body of first-class securities and well-selected borrowers, and at the same time to earn a satisfactory profit by means of a narrow margin between the earnings on the assets and the payments due to depositors.

Looking more closely at the assets we see that


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 in the full balance-sheet as set out by the bank, the investments were subdivided into War Loans and other securities of or guaranteed by the British Government, which account for 51¾ millions of the total, the balance of a million and a half being composed of "Colonial Government securities, British Corporation stocks and other investments." As a matter of interest and guidance for the public it would be kind of the banks to tell us exactly what investments they hold, instead of leaving us wondering what those "other investments" mean.

The items which I summarized as "shares in other banks," amounting to nearly three millions, consist in fact of shares in the Westminster Foreign Bank (£1,080,000), an institution founded to carry the Westminster's prestige and services abroad, and in the Ulster Bank £1,911,706.

It will be noted that by far the largest item £122 millions out of a total of £308½ millions—is made up of Advances to Customers. Those hundred and twenty-two millions are the means by which the bank gives the most direct assistance to the country's industry, and the large total shows how a shareholder in one bank is able to feel that he owns part of a machine which distributes credit to thousands of borrowers in different parts of


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 England for the financing of various kinds of industry.

Bills discounted perform the same function to some extent; but in the first place they probably contain a large proportion of Treasury bills and thereby finance the Government rather than industry; and in the second, it is likely that a large part of the commercial bills held are drawn to finance foreign trade, and so, though of enormous importance to a country which could not live without foreign trade, are less directly a home product, though at the same time widening still further the diversification of risks which is provided by investment in bank shares.

Money at call and short notice means loans to discount houses, bill-brokers and—stockbrokers engaged in financing the floating mass of bills of exchange and securities which form the stock-in-trade of Lombard Street and Capel Court.

It is interesting to look back at our investigation of an industrial balance-sheet, and to compare the assets shown by a bank in the light of the difficulty that we found in the case of a well-known brewery of being certain as to the likelihood that the assets if realized would fetch the sums set against them.

The assets of Messrs. Bass came to a total


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 of over 84 millions, of which rather more than £585,350 was in cash, and £1,823,926 was in investments in British Funds, Colonial and Foreign stocks and bonds, railway preference stocks and sundry debentures and shares "at or below current quotations or valuations." The other six millions were made up of bills receivable, debtors on trade account, stocks of material, stores and movable plant, freehold and leasehold premises and fixed plant, licensed properties, trade loans, goodwill and trade marks.

We found that the figures set against all these items depend to a great extent on the opinion held by the Board and the managers concerning the value that should be set upon them for balance-sheet purposes, and that this was an inevitable feature in the great majority of industrial balance-sheets. We also saw reason to believe that most Boards and managers would err on the side of undervaluing rather than overstating these necessarily doubtful assets.

In the case of the banks, the proportion of doubtful assets is much smaller. There is no doubt about the cash and practically none about the loans at call and short notice, which are lent to first-class firms on first-class security. The bills of exchange are also for


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 definite sums due, from the British Government or from accepting houses, usually of the highest credit. The investments are nearly all obligations of the British Government and the small outside minority are pretty certain to be publicly quoted and easy to deal in at the quoted price. The Advances to customers are also loans for definite amounts made to customers, concerning whose standing and solvency the banks have exceptionally good opportunities of satisfying themselves; and the liability of customers against acceptances is in the same category, though, in this case, the bank has not lent its money, but only its name, thereby incurring a liability to pay a sum if the customer fails to do so, and this liability appears on the debit side of the balance-sheet.

All these items, representing more than 300 millions out of the 3084 millions which is the sum total of the assets, are a matter of a definite sum owned by or owed to the bank, or represented by securities saleable at or above the figure set against them. In the case of the advances to customers and the customers' liability on acceptance there must be, and in those of the short loans and discounts there may be, some question whether all the multifarious borrowers who have had


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 credit supplied by the bank will be able to meet their obligations in full, in view of all the widespread industrial and commercial risks that they are facing.

But there are two important differences between the doubtful assets of a bank and those of an ordinary industrial company. The directors and managers of a bank have a better chance of being able to judge of their value; they are experts in credit, that is, in the solvency of the people to whom they lend, or for whom they accept bills, or whose bills they discount. They are thus only doing what is their own regular job when they make estimates of the value of their promises to pay; whereas an industrial director, in putting a figure against land and buildings, plant and machinery and trade debtors, must often be called on to decide the values of articles on which his opinion, as valuer, is not quite that of an expert.

And the second difference is, that whereas we have reason to hope that the Boards of most industrial companies—at least those which have stood the test of time through a reasonably long life—err on the side of prudence and caution in valuing their assets for balance-sheet purposes, with the banks it is a matter of common knowledge; doubtful


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 assets are written down ruthlessly, and they hold, in fact, large hidden reserves owing to the lowness of the figure set against their Advances to Customers, their premises and every other item which gives them an opportunity of exercising a damnatory imagination. They have also a habit of putting away profits earned on sales of investments. The Economist Banking Supplement of May 9, 1925, quoted Mr. Beaumont Pease, of Lloyds Bank, as having told his shareholders that such sales had "yielded substantial profits; but these," he added, "we have not brought into our profit and loss figures, preferring the more conservative method of keeping them in our internal reserves. . . . They are safely there, however, employed in the business, ready for any emergency, earning you extra profits."

The liabilities' side has already been explained, sufficiently for our present purpose, in commenting on the assets. Perhaps it is worth while to add that the tiny item of notes in circulation is a rara avis in the balance-sheet of a leading English bank, since those with London offices are not allowed to issue notes in England, this privilege being reserved to the Bank of England. The notes outstanding in this case represent the circulation of an


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 Isle of Man bank, which has been absorbed by the Westminster.

The outstanding feature on the debtor side is the huge total of the deposit and current accounts, money placed with the bank by the public, which has the right to demand its repayment at once in the case of current accounts and practically at once in that of deposit accounts, since no bank could refuse a depositor who was in a hurry the power to waive the necessary notice in return for some sacrifice of interest. It is the ever-present possibility of a demand for cash by holders of current and deposit accounts that compels the banks to keep their assets so liquid and so well written down, that their shareholders can read the figures set against them with a different feeling from that with which they regard the values on the right side of the ordinary commercial balance-sheet.

Another item that is what advertisers call a "talking point" is the reserve fund standing at the same figure as the paid-up capital. Some banks have reserve funds which exceed this cent per cent. of capital—the Ulster Bank in which the Westminster holds a considerable share showed in its balance-sheet, dated November 29, 1924, capital paid up £500,000 and reserve fund £900,000. The latter has


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 since been increased by £100,000, and now stands at 200 per cent. of capital paid up. The Westminster, as we shall see when we look at the Profit and Loss Account, left the Reserve Fund at the figure shown in the balance-sheet, but put away £625,000, out of a net profit of £2,013,5O2, in allocations to Bank Premises Account, Rebuilding Account, Contingent Fund, and addition to carry forward, besides £100,000 placed to Provident Fund, presumably for the benefit of the employees.

This policy of building up big reserves, the benefits of which to the shareholder have already been dilated on with "damnable iteration," has a disadvantage, also already noted, of giving an appearance of a much higher rate of profit earned than is derived from the capital actually invested. The banks declare dividends on their paid-up capital, but they earn them on capital plus reserve fund plus hidden reserves, all of which have been put in directly or indirectly by the shareholders.

For example, in the report now before us the Westminster directors propose to pay a dividend which will make, with the interim distribution already paid, 20 per cent. for the year on the £20 shares £5 paid, and 12½ per


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 cent for the year on the £1 shares. This looks like a very handsome rate and gives a misleading view of the profit to be earned by banks because, as we have seen, the reserve fund is as big as the paid-up capital and there are hidden reserves besides, so that the real rate of dividend has to be found by dividing the apparent rate by something over 2.

The Profit and Loss Account may be summarized thus:—

It will be noted that the banks are far from lavish in the information that they supply in their profit and loss accounts. They tell their shareholders the amount of the net profit and what has been done with it and "the rest is silence." As to the amount of the gross profit and of the expenses—how much went in taxes, directors' fees, salaries, etc., and how much was appropriated to provision for bad and doubtful debts—on all these matters the Profit and Loss Account that is now before us


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 lies low and says nothing, following the prevalent practice of its peers. "Very few of the British banks," says the Economist Banking Supplement of May 9, 1925, "published the figures of their gross profits. Barclays still sets a good example in this respect."

Perhaps this dignified reticence on the part of the banks is necessitated by their peculiar position; living and trading, as they must, on a reputation which is beyond a breath or whisper of suspicion, they have to be not only above reproach but above the possibility of misunderstanding by some irresponsible person with a pen in his hand who might make misleading and damaging comments if he saw that a bank, or several banks, had been obliged, for example, to make a considerable amount of provision for bad debts. And in pursuing a policy of reticence the banks can plead the example of the Bank of England, which never publishes a Profit and Loss Account at all, or anything else besides a weekly account which is largely incomprehensible. An official of the Bank, who had a keen eye for the absurdities of life, once told me that he had two weekly treats, one on Wednesday when he enjoyed his Punch, the other on Friday when he read the attempts of


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 an intelligent Press to expound to its readers the meaning of the Bank return.

Whether justified or no, this reticence of the banks concerning the details of their business is not helpful to those who are considering investment in their shares. Combined with the mystery which the possession of large hidden reserves enables them to throw over the process of meeting losses, it gives the whole business an appearance of easily earned and regularly accruing profits and so whets the appetite of those reformers who want to nationalize the banks, and think that their job is so simple that even a Government office could do it. It is true that Mr. Sidney Webb, when he put forward a scheme for their nationalization in the Contemporary Review of July, 1918, proposed that the most difficult part of banking, the lending of money to industry, should be left to "a series of financial concerns, whose business it should be to discount the bills and satisfy the requests for loans of those profit-makers who now appeal to the bankers." But younger enthusiasts have been more daring.

The possibility of nationalization is thus one which a doubting purchaser of bank shares


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 has to consider. It is, I believe, a plank in the programme of the Labour Party, but recent experience has shown that Socialist Governments that have taken office on the Continent have been not at all in a hurry to nationalize anything, and the separation of central banks—and still more of the outer banking machinery—from political influence is now recognized as essential, if the monetary world is to be saved from the wild-cat achievements of Governments in currency debasement, that marked the war and after-war period. I think it would be pretty safe to bet against the nationalizaionnationalization [sic] of our banks during the next twenty years, but one cannot be certain about the jump of the political cat.

A more immediately practical fact, for the possible investor, is the notion that one finds current among bankers, arising partly out of the talk about nationalization, that it is a questionable policy for them to increase their dividends and that they should rather regard their business as an enterprise to be carried on purely in the public interest.

Over a long period of years increases in dividends by the English bank have been scarce; for some time before the war the banks were writing down their investments, having made the mistake (as we all see now) of


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 thinking that Consols and other undated or long-dated securities were nice securities for them to hold; and during and since the war—a period which covered the commercial cataclysm of 1920 and 1921, when the prices of commodities were halved—they must have had a good deal of provision to make for the consequences of mishaps to their customers in and after that appalling time.

Now, their position must be greatly strengthened by the writing down of the last twenty years, but if they propose to adopt a self-denying ordinance in the matter of future increases of dividends, shareholders who are buying fully paid shares in English banks which pay them less than 5 per cent. will perhaps feel aggrieved. They will certainly have a strong ground for arguing that part of any increased profit that may be earned during less trying times ahead should fall into the pockets of shareholders.

This view about dividends, however, does not yet seem to have crossed the border, for the Royal Bank of Scotland makes the timely announcement, as I end this chapter, of an increased dividend, following four successive increases.

Moreover, since the above was written the Westminster has announced, with its report for


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 1925, a bonus to shareholders in the form of new shares.

On a smaller scale the discount companies enjoy the same advantages as the banks, of handling a mass of money many times the size of their capital We saw that the Westminster Bank, with a paid-up capital of nine millions, held nearly 273 millions deposited with it by the public. When we look at the balance-sheet of the Union Discount Company, the largest of the joint stock companies that engage in this kind of business, we find that, with a paid-up capital of £1,125,000, it held forty millions "in loans and deposits, including provision for contingencies." Let us summarize its balance sheet of December 31, 1924:—

The position of the company is clear and pleasant; it has borrowed forty millions, put a net sum of thirty-six millions into bills


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 of exchange (this being the total of bills discounted less bills ) and six millions into investments and loans, and it holds more than its paid-up capital in cash at bankers.

We thus see at a glance the function that is performed by these companies and the private firms which engage in the same business. They act as merchants in the market for bills of exchange, which are the currency of international trade, keeping a large stock of them in hand so that they may be able to provide, for the banks and other purchasers, bills of the date and class that are required by the buyer.

In order to finance this mass of credit-merchandize, they borrow from the banks and finance houses and from the India Council and anyone else who wants to place funds for a time. Their utility is obvious—they provide a reservoir into which the floating cash of Lombard Street may be poured to earn the current rate of interest for short loans, and another reservoir which holds the floating supply of bills of exchange which finance the home and foreign trade of Great Britain, and of many other countries, and (at present in the form of Treasury bills) form the greater part of this country's floating debt.


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 They thus have two considerable advantages over their big brothers, the banks, whom they serve both as borrowers of surplus cash and providers of bills of exchange.

In the first place they have nothing to do with the queer old public and have not always to provide against its whims about the custody of its money. Their liability is not to thousands of depositors all over the country, but to a few banks and first-rate firms in the city or in the world of finance, from whom they borrow and from whom they can, more or less, rely on reasonable treatment in times of difficulty. Their chief asset is not, like that of the banks, a mass of advances to industrial, commercial and other customers, with exacting ideas about the extent and price of the credit that they ought to be granted, but a portfolio of bills of exchange, most of them accepted or endorsed by the British Government or by banks and accepting houses so eminent and respected that the "bank bills" which they create, for financing the trade of the world, are often quoted at a higher price than British Treasury bills, now that the latter are so enormously plentiful. Moreover, their assets, in bills and securities, being constantly used as pledges for advances, are subjected to continued scrutiny by lenders.


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 Their second advantage is that most of their business is done within a square mile of their offices, and that they have none of the difficulty involved by scores of branches but are in close and constant personal touch with their most important connections.

Although it would be interesting to know how much of the Union Discount's investments consists of British Government and how much of other securities and of what kind these latter may be, it will be noted that owing to the high standing of those responsible for meeting the bills which make up the greater part of the company's assets, the question of doubtful assets hardly arises in the balance-sheet of a discount house. Acting as they do as intermediaries for the banks, it is an essential of their business to be above reproach in its conduct, and to add continually to the strength of their position by an active reserve fund policy and by caution in the question of rebating—that is estimating the present value of—their bills of exchange.

From the Profit and Loss Account of the Union Discount it appears that it made a gross profit for the year 1924, after making provision for contingencies, of £753,000. Deducting expenses, £76,000, and rebate £423,000, we find a net profit of £254,000. The company


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 pays £172,000 in dividend and bonus, puts £60,000 to reserve and premises and £10,000 to provident fund, and adds £11,000 to carry forward.

The disadvantages of these companies from the investor's point of view are:—

(1) There is a liability on the shares, most unlikely to be enforced, but still there.

(2) There are only three of them to be invested in, and

(3) The market in the shares is far from free.

But in the matter of stability of the business their advantage over any ordinary industrial investment is evident since, whatever may happen to this trade or that, there is always a mass of trade to be financed. The distribution of risk is world-wide in extent, and the elimination of risk is the constant aim of the experts, trained to tell a good bill almost by the feel of it, who manage these companies.


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we saw in Chapter II, life insurance is a form of investment that should come first on the list of those undertaken by anyone who has dependents to provide for in the event of his demise; and the shares of the companies which provide life and other kinds of insurance will also be found to be highly attractive to anyone who wants the advantage carried by ordinary shares but seeks to reduce the risk that necessarily goes with them.

This attraction consists, as in the example of banks and discount companies, in the fact that enormous funds are handled in proportion to the capital invested, and that insurance is a great huge world-embracing business and is always going on, with a certain ebb and flow of activity and profit, but free from the wide fluctuations that may affect a particular industry. Whether trade is good or bad, those who carry it on have to insure against fire and shipwreck


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 and other trade risks; though if trade is bad there are fewer ships sailing and fewer goods in transit, though there may be more in the warehouses.

Insurance is a very complicated and difficult business, and the complications and difficulties reflect themselves in the accounts and balance-sheets published by the companies, especially those of the kind usually described as composite, because they usually carry on several different kinds of insurance business, the main divisions being life, fire, marine, employers' liability and sickness and accident.

All these different divisions require highly specialized skill, though the life department is now comparatively simple owing to the mass of knowledge that has been acquired, through more than a century of investigation and record, concerning the probabilities of the length of human life. Given the requisite medical skill to judge whether an applicant for insurance is sound in wind and limb—and a few other particulars—or how much allowance should be made for any weakness that may be detected, a skilled actuary can easily work out his expectation of life—barring accidents. Moreover, as the mortality tables on which the companies work are necessarily the result of past experience, and as improved sanitation, medical


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 knowledge and surgery are continually adding to the span of human life, those who sell life insurance have long been selling an article which was really rather less valuable than they believed it to be; and so we constantly find the companies reporting that their mortality experience has been considerably below expectation. Which means to say that the bargain made with the assured has been in favour of the companies, though the assured have been able to share in this advantage by means of "with-profit" policies.

Another factor in their favour is that those who insure their lives are likely from this very fact to be good lives, because they are likely to apply to living the same prudence and forethought and intelligence concerning responsibilities that led them to the act of insuring. So that the life risk is "selected." On the other hand, though the Black Death no longer ravages Europe, influenza sometimes has an appreciable effect on the death-rate.

In other forms of insurance, this favourable selection does not help those who provide them. All ships of any value that sail are insured with their cargoes and in some cases the selection is the other way. At least I have heard it suggested that an owner driver who has insured