chapter-05.md

Chapter 5

Classification of Securities

Securities are customarily divided into the two main groups of bonds and stocks, with the latter subdivided into preferred stocks and common stocks. The first and basic division recognizes and conforms to the fundamental legal distinction between the creditors’ position and the partners’ position. The bondholder has a fixed and prior claim for principal and interest; the stockholder assumes the major risks and shares in the profits of ownership. It follows that a higher degree of safety should inhere in bonds as a class, while greater opportunity of speculative gain—to offset the greater hazard—is to be found in the field of stocks. It is this contrast, of both legal status and investment character, as between the two kinds of issues, which provides the point of departure for the usual textbook treatment of securities.

Objections to the Conventional Grouping: 1. Preferred Stock Grouped with Common. While this approach is hallowed by tradition, it is open to several serious objections. Of these the most obvious is that it places preferred stocks with common stocks, whereas, so far as investment practice is concerned, the former undoubtedly belong with bonds. The typical or standard preferred stock is bought for fixed income and safety of principal. Its owner considers himself not as a partner in the business but as the holder of a claim ranking ahead of the interest of the partners, i.e., the common stockholders. Preferred stockholders are partners or owners of the business only in a technical, legalistic sense; but they resemble bondholders in the purpose and expected results of their investment; but they resemble bondholders in the purpose and expected results of their investment.

2. Bond Form Identified with Safety. A weightier though less patent objection to the radical separation of bonds from stocks is that it tends to identify the bond form with the idea of safety. Hence investors are led to believe that the very name “bond” must carry some especial assurance against loss. This attitude is basically unsound, and on frequent occasions is responsible for serious mistakes and loss. The investor has been spared even greater penalties for this error by the rather accidental fact that fraudulent security promoters have rarely taken advantage of the investment prestige attaching to the bond form. It is true beyond dispute that bonds as a whole enjoy a degree of safety distinctly superior to that of the average stock. But this advantage is not the result of any essential virtue of the bond form; it follows from the circumstance that the typical American enterprise is financed with some honesty and intelligence and does not assume fixed obligations without a reasonable expectation of being able to meet them. But it is not the oblication that creates the safety, nor is it the legal remedies of the bondholder in the event of default. Safety depends upon and is measured entirely by the ability of the debtor corporation to meet its obligations.

The bond of a business without assets or earning power would be every whit as valueless as the stock of such an enterprise. Bonds representing all the capital placed in a new venture are no safer than common stock would be, and are considerably less attractive. For the bondholders could not possibly get more out of the company by virtue of his fixed claim than he could realize if he owned the business in full, free and clear. This simple principle seems too obvious to merit statement; yet because of the traditional association of the bond form with superior safety, the investor has often been persuaded that by the mere act of limiting his return he obtained an assurance against loss.

3. Failure of Titles to Describe Issues with Accuracy. The basic classification of securities into bonds and stocks—or even into three main classes of bonds, preferred stocks, and commons stocks—is open to the third objection that in many cases these titles fail to supply an accurate description of the issue. This is the consequence of the steadily mounting percentage of securities which do not conform to the standard patterns, but instead modify or mingle the customary provisions.

Briefly stated, these standard patterns are as follows:

1. The bond pattern comprises:
1. The unqualified right to a fixed interest payment on fixed dates.
2. The unqualified right to repayment of a fixed principal amount on a fixed date.
3. No further interest in assets or profits, and no voice in the management.
2. The preferred-stock pattern comprises:
1. A stated rate of dividend in priority to any payment on the common. (Hence full preferred dividends are mandatory if the common receives any dividend; but if nothing is paid on the common, the preferred dividend is subject to the discretion of the directors).
2. The right to a stated principal amount in the event of dissolution, in priority to any payments to the common stock.
3. Either no voting rights, or voting power shared with the common.
3. The common-stock pattern comprises:
1. A pro rata ownership of the company’s assets in excess of its debts and preferred stock issues.
2. A pro rata interest in all profits in excess of prior deductions.
3. A pro rata vote for the election of directors and for other purposes.

Bonds and preferred stocks conforming to the above standard patterns will sometimes be referred to as straight bonds or straight preferred stocks.

Numerous Deviations from the Standard Patterns. However, almost every conceivable departure from the standard pattern can be found in greater or less profusion in the security markets of today. Of these the most frequent and important are identified by the following designations: income bonds, convertible bonds and preferred stocks; common stocks with preferrential features; nonvoting common stock. Of recent origin is the device of making bond interest or preferred dividends payable either in cash or in common stock at the holder’s option. The callable feature now in most bonds may also be termed a lesser departure from the standard provision of fixed maturity of principal.

Of less frequent and perhaps unique deviations from the standard patterns, the variety is almost endless. We shall mention here only the glaring instance of Great Northern Railway Preferred Stock which for many years has been in all respects a plain common issue; and also the resort by Associated Gas and Electric Company to the insidious and highly objectionable device of bonds convertible into preferred stock at the option of the company which are, therefore, not true bonds at all.

More striking still is the emergence of completely distinctive types of securities so unrelated to the standard bond or stock pattern as to require an entirely different set of names. Of these, the most significant is the option warrant—a device which during the years prior to 1929 developed into a financial instrument of major imporatnace and tremendous mischief-making powers. The option warrants issued by a single company—American and Foreign Power Company—attained in 1929 an aggregate market value of more than a billion dollars, a figure exceeding our national debt in 1914. A number of the newfangled security forms, bearing titles such as allotment certificates and dividend participations, could be mentioned.

The peculiarities and complexities to be found in the present day security list are added arguments against the traditional practice of pigeonholing and generalizing about securities in accordance with their titles. While this procedure has the merit of convenience and a certain rough validity, we think it should be replaced by a more flexible and accurate basis of classification. In our opinion, the criterion most useful for purposes of study would be the normal behavior of the issue after purchase—in other words its risk-and-profit characteristics as the buyer or owner would reasonably view them.

New Classification Suggested. With this standpoint in mind, we suggest that securities be classified under the following three headings:

	Class	Representative Issue
I. Securities of the fixed-value type	A high-grade bond or preferred stock.
II. Senior securities of the variable-value type
A. Well-protected issues with profit possibilities.	A high-grade convertible bond.
B. Inadequately protected issues.	A lower-grade bond or preferred stock.
III. Common-stock type.	A common stock.

An approximation to the above groping could be reached by the use of more familiar terms, as follows:

1. Investment bonds and preferred stocks.
2. Speculative bonds and preferred stocks.
1. Convertibles, etc.
2. Low-grade senior issues
3. Common stocks.

The somewhat novel designations that we employ are needed to make our classification more comprehensive. This necessity will be clearer, perhaps, from the following description and discussion of each group.

Leading Characteristics of the Three Types. The first class includes issues, of whatever title, in which prospective change of value may fairly be said to hold minor importance. The owner’s dominant interest lies in the safety of his principal and his sole purpose in making the commitment is to obtain a steady income. In the second class, prospective changes in the value of the principal assume real significance. In Type A, the investor hopes to obtain the safety of a straight investment, with an added possibility of profit by reason of a conversion right or some similar privilege. In Type B, a definite risk of loss is recogninezd, which is presumaby offest by a corresponding chance of profit. Securities included in Group IIB will differ from the common-stock type (Group III) in two respects: (1) they enjoy an effective priority over some junior issue, thus giving them a certain degree of protection. (2) Their profit possibilities, however substantial, have a fairly definite limit, in contrast with the unlimited percentage of possible gain theoretically or optimistically associated with a fortunate common-stock commitment.

Issues of the fixed-value type include all the straight bonds and preferred stocks of high quality selling at a normal price. Besides these, there belong in this class:

1. Sound convertible issues where the conversion level is too remote to enter as a factor in the purchase. (Similarly for participating or warrant-bearing senior issues).

2. Guaranteed common stocks of investment grade.

3. “Class A” or prior-common stocks occupying the status of a high-grade, straight preferred stock.

On the other hand, a bond of investment grade which happens to sell at any unduly low price would belong in the second group, since the purchaser might have reason to expect and be interested in an appreciation of its market value.

Exactly at what point the question of price fluctuation becomes material rather than minor is naturally impossible to prescribe. The price level itself is not the sole determining factor. A long-term 3% bond selling at 60 may have belonged in the fixed-value class (e.g., Northern Pacific Railway 3s, due 2047 between 1922 and 1930), whereas a one-year maturity of any coupon rate selling at 80 would not because in a comparatively short time it must either be paid off at a 20-point advance or else default and probably suffer a sever decline in market value. We must be prepared, therefore, to find marginal cases where the classification (as between Group I and Group II) will depend on the personal viewpoint of the analyst or investor.

Any issue which displays the main characteristic of a common stock belongs in Group III, whether it is entitle “common stocck,” “preferred stock” or even “bond.” The case, already cited, of American Telephone and Telegraph Company Convertible 4½s, when selling about 200, provides an apposite example. The buyer or holder of the bond at so high a level was to all practical purposes making a commitment in the common stock, for the bond and stock would not only advance together but also decline together over an exceedingly wide price range. Still more definite illustration of this point was supplied by the Kreuger and Toll Participating Debentures at the time of their sale to the public. The offering price was so far above the amount of their prior claim that their title had no significance at all, and could only have been misleading. These “bonds” were definitely of the common-stock type.

The opposite situation is met when issues, senior in name, sell at such low prices that the junior securities can obviously have no real equity, i.e., ownership interest, in the company. In such cases, the low-priced bond or preferred stock stands virtually in the position of a common stock and should be regarded as such for purposes of analysis. A preferred stock selling at 10 cents on the dollar, for example, should be viewed not as a preferred stock at all, but as a common stock. On the one hand it lacks the prime requisite of a senior security, viz., that it should be followed by a junior investment of substantial value. On the other hand, it carries all the profit features of a common stock, since the amount of possible gain from the current level is for all practical purposese unlimited.

The dividing line between Groups II and III is as indefinite as that between Groups I and II. Borderline cases can be handled without undue difficulty however, by considering them from the standpoint of either category or of both. For example, should a 7% preferred stock selling at 30 be considered a low-priced senior issue or as the equivalent of a common stock? The answer to this question will depend partly on the exhibit of the company and partly on the attitude of the prospective buyer. If real value may conceivably exist in excess of the par amount of the preferred stock, the issue may be granted some of the favored status of a senior security. On the other hand, whether or not the buyer should consider it in the same light as a common stock may also depend on whether he would be amply satisfied with a possible 250% appreciation, or is looking for even greater speculative gain.

From the foregoing discussion the real character and purpose of our classifciation should now be more evident. Its basis is not the title of the issue, but the practical significance of its specific terms and status to the owner. Nor is the primary emphasis placed upon what the owner is legally entitled to demand, but upon what he is likely to get, or is justified in expecting, under conditions which appear to be probable at the time of purchase or analysis.