( Originally Published 1918 )
With the invention of the steam engine and the application of mechanical power to production and transportation, the corporate form of organization became necessary, because much larger sums of capital were required than could be conveniently contributed by a few men.
Some people were in a position to take more risk than others, and therefore the corporate capital was divided between bonds and stocks. Bonds were offered to those willing to lend money on the promise to repay the sum loaned on a certain future date, the promise being secured by a mortgage or lien on the property or assets of the corporation. In view of the security offered and the obligation to repay the money, the bondholders were given merely an investment return upon the capital furnished by them. Stocks were offered to those willing to take a limited partnership interest in the corporation. They were to share the risks of the business to the extent of the amount of money they put into the stock of the corporation. Their rights in the assets were subordinated to the rights of the bondholders. There was no obligation to return the capital invested by the stockholders on any future date. They did, however, receive a larger profit, varying according to the nature of the business and the success which attended the enterprise.
Experience showed that there was a limit to the amount of bonds which could safely be issued in proportion to the stock of a corporation. It is recognized that a mortgage on desirable real estate to sixty per cent, or even seventy-five in some cases, of the total appraised value, is a safe loan. This general plan is followed in considering the relative safety of corporate securities where the principal assets are in fixed property. The par value of the bonds and the market value of the stocks are used in determining the percentage in a given case.
The desire of corporations to keep down the proportion of securities bearing a fixed obligation to pay the interest and principal, and the fact that there are more people willing to buy investment securities than to assume the risks involved in the purchase of ordinary stock, gave rise to the development of the modern preferred stock.
Corporations engaged in all fields have had recourse to this form of security.
The first characteristic of a preferred stock is that it is preferred over the common or ordinary shares as to the payment of full par value in any liquidation of the company, thus ranking it ahead of the common stock in respect to the assets.
The second distinguishing feature is that the preferred stock is entitled to a fixed rate of dividend before any dividend can be paid on the common stock.
Some years ago a new provision made its appearance, which has made preferred stocks considerably nearer to the rank of bonds. This provision made the dividend cumulative, requiring that all dividends must be paid in full to date before any dividend can be paid on the common stock.
In the case of a bond, the corporation is obligated to pay the interest at fixed and regular dates. If it has not earned enough to gay the interest in any particular year, it may draw on the surplus earnings of past years. Failure to make payments gives the bondholders the right to fore-close the lien securing their bonds and sell the property which has been pledged. However, in these days corporations have attained such large proportions that it is practically impossible to find an individual or corporation with funds sufficient to buy the property at a public sale. Experience has shown that the security holders in practically every case must reorganize the property, agreeing, if necessary, to scale down or defer payment of the interest and principal of the bonds.
The directors representing the common stock-holders who own the equity in the property are, under all circumstances, trying to meet the payments to the bondholders; but the property itself must be capable of sustaining its fixed interest requirements. The bare fact that the security is in the form of an obligation does not alter a situation where earning power or assets are not sufficient to meet the requirements of the obligation.
In the case of a modern preferred stock, the dividend is paid out of the year's earnings; but if these are insufficient, the directors may, where the dividend is cumulative, draw on the accumulated surplus. They are just as anxious to pay the dividend on the preferred stock as they are to pay the interest on bonds. It is necessary to pay the dividends regularly to maintain the investment standing of the security. The cumulative dividend provision prevents the common stock-holders from gaining any additional profit by passing the payment of a preferred dividend. However, the directors cannot pay dividends any more than interest if the property will not pro-duce sufficient revenue. In the case of the preferred stock, the directors may defer the payment of the regular dividend if in their judgment the facts warrant such action. The preferred stock-holders cannot thereupon throw the corporation into receivership and bankruptcy, as bondholders can do in case of the non-payment of interest on bonds.
Another provision in many preferred stocks relates to the establishment of a sinking fund for the retirement of the preferred stock. Sinking funds are designed to the end that ultimately the entire issue will be retired. This provision may be said to take the place of the obligation to pay the principal at maturity, which, with the obligation to pay interest, forms the principal distinguishing features of bonds. Some bonds also have a sinking fund.
In the case of preferred stock sinking funds the provisions vary greatly. Generally speaking, the operation of the sinking fund is conditional upon earnings being sufficient to provide for the payment. The sinking fund requirement generally has priority over dividends on the common stock and is frequently made cumulative. It sometimes provides for the retirement of a fixed amount of stock each year, or a fixed percentage of the earnings of the corporation are to be used for this purpose. The stock for the sinking fund is usually bought in the open market up to a certain price, and as this price is usually considerably above the price at which the stock is first sold, it often proves a very attractive feature for profit to the investor.
There are many other provisions surrounding preferred stocks which are more or less technical. Some of them relate to certain conditions under which the powers of the preferred stockholders may be enlarged in voting; restrictions as to placing obligations ranking ahead of the preferred stock and of making payments on the common stock which might deplete the cur-rent assets, etc.
It is evident from the above brief description that modern preferred stocks possess many advantages. But it must not be understood that they are free from all dangers. When issued by industrial companies, many elements of weakness may exist which are not discernible from a study of the protective provisions or earning statements, since the character of the business must of necessity have an important bearing upon the question of security.
There are three principal classes of corporations which issue preferred stock: (1) Railroad; (2) Public Utility (Electric Railway, Light, Power, and Gas and Water) ; (3) Industrial and Mining.
A full discussionof the relative advantages of securities issued by corporations in these various classes will not be undertaken here. There are preferred stocks in each class which rank as practically as safe investments as some first mortgage bonds in their respective classes. Preferred stocks naturally rank junior to the mortgage bonds of the same corporation, whether first, second, debenture, or short-time paper.
A more liberal rate of income, without sacrifice of safety of principal, is obtainable by a careful selection of modern preferred stocks, -after scrutiny of the source of issue.