The Stock Exchange

by Charles Duguid

Ranking next to them, perhaps, are the first debenture stocks of the railway and other companies which do not come within the Trustee Act. Such a statement as this is naturally only general. Some debenture stocks of industrial and mining companies are far less sound and secure than the shares of the lowest rank of some well-established undertakings. There are mortgage debentures and debentures which carry no right of mortgage, and there are, in the case of many companies, mortgage debentures of various classes, one class carrying a first mortgage, another a second, and so on. Mortgage debentures are secured by a specific charge on certain properties definitely scheduled, and in case of default in the interest payment the Court will appoint a Receiver in respect of such properties for the protection of the mortgage debenture holders. Debentures which are not mortgage debentures are secured by a floating charge over the properties and assets of the company, and in the case of its default they rank as ordinary creditors, being entitled to proceed against the company and levy execution. The mortgage debenture and debenture stocks of a company are frequently described as its fixed charge stocks, because not only does the interest never vary in rate, but has to be paid whatever the profits of the company. In fact, debenture holders, being creditors and not shareholders, receive interest and not dividend.

These debenture stocks, like the loans issued by Governments and Municipal Corporations, may be redeemable at a specified date or after it. The approach of the redemption date naturally affects the market price. If a stock at present quoted at 95 is redeemable ten years hence at 100, the tendency of the price is, of course, to rise to the 100, and one who buys the stock at 95, in calculating what it will yield him, takes into account, of course, not only the annual interest, but the fact that he must receive, as it were, a bonus of £5 when the company buys the stock on the date of redemption. Similarly, if the stock is bought at a higher price than that at which it is redeemable at some future date, the buyer must regard the yield which it gives him as so much less, for when the date arrives he must take for the stock less than he gave for it. Some stocks are irredeemable, which means, of course, that they go on bearing the rate of interest for ever. The holder of the stock may sell it and thus get rid of the arrangement, but the company or corporation is saddled with the debt and the obligation of paying the fixed rate of interest upon it for all time. This may prove inconvenient and unprofitable if the borrower can obtain loans at a lower rate, but the only way to get rid of the burden is to make some arrangement acceptable to the stockholders. Certain of the Government stocks are redeemable at a comparatively early date, Consols themselves being redeemable in 1923, but only at the option of the Government.

Although debentures are called fixed charge stocks, partly because their rate of interest is fixed, and partly because it is a charge on the income of the company before any consideration can be entered into as to what profits there are to be divided among the shareholders, the rate of dividend on certain classes of mere shares which rank after the debentures is also fixed. A company may issue 4 per cent. or 5 per cent. preference shares, and their claim upon the profits, as their name implies, is preferential to that of the ordinary shares, which rank after them. They must receive their 4 per cent. or 5 per cent., as the case may be, out of the profits, and the ordinary shareholders have to look for their dividend to any profits that remain. At the same time, whereas debenture holders are entitled to their interest as a right, and may proceed for it legally as for a debt, the shareholders, even preference shareholders, go without their dividend if there are no profits—and there is an end of it.

Many preference shares, however, are cumulative preference shares, which means that if the profits in any year are insufficient to provide their dividend, the stipulated rate must be made up out of succeeding profits before the ordinary shareholders can receive anything. In the case of preference shares which are not cumulative, each year is complete in itself. They may be entitled to 4 per cent., but if the profits of the year suffice to pay only 3 per cent., that is all they get. Even if the profits of the next year are so good as to enable the payment of the full 4 per cent. dividend on the preference shares, and 2 per cent. or even 5 per cent. on the ordinary shares, the preference shares receive only their 4 per cent., because they are not cumulative. If they were cumulative, they would receive 5 per cent. to make up for the 1 per cent. lacking in the preceding year, and the ordinary dividend would be reduced accordingly. Of course, there may be first, second, and third preference shares, cumulative or non-cumulative, just as there can be different series of debentures, one ranking after another.

It will be seen that while the dividend on preference shares is more certain than that on the ordinary shares of a company, it is at the same time limited, whereas the dividend on the ordinary shares is only limited by the profit-earning capacity of the company. In the case of a well-established and prosperous concern, therefore, the price of the ordinary shares may be very much higher than the price of the preference shares ranking before them. In such a company the preference shares may receive a certain 4 per cent., while the ordinary shares may receive 10 per cent., which, although by no means so certain, may be certain enough for all practical purposes. In the case of many companies, of course, the dividend on the ordinary shares varies considerably year by year, and the price of the shares accordingly fluctuates widely.

Some companies, in order to meet this, have divided their ordinary shares into two new classes, one called preferred ordinary, bearing a fixed rate of dividend, and the other called deferred ordinary, taking what remains for division. In fact, the preferred ordinary bears the same relation to the deferred ordinary as preference shares bear to ordinary shares. Suppose a company has paid a dividend on its ordinary shares or stock averaging over a number of years 6 per cent. In one year it may have paid 4-1/4 per cent., in another year 8 per cent. This ordinary stock with its fluctuating dividend is divided into two parts. Each holder of £100 worth of stock receives £50 worth of preferred ordinary, entitled to a fixed dividend of 6 per cent., and £50 of deferred ordinary, entitled to the remainder. Thus in the year when the company paid 4-1/4 per cent., a dividend of 6 per cent. would be paid on the preferred ordinary and a dividend of 2-1/2 per cent. on the deferred ordinary—this making an average of 4-1/4 per cent. on the whole. In a year when a company pays 8 per cent., the preferred ordinary still receives 6 per cent. and the deferred ordinary 10 per cent. Instead of the stock being thus divided, the same object is attained by its duplication or watering. For each £100 of ordinary stock is issued a nominal £100 of preferred ordinary and a nominal £100 of deferred ordinary. In the case of the 4-1/4 per cent. dividend, the preferred ordinary would receive its fixed 3 per cent., and the deferred ordinary the remaining 1-1/4 per cent. Of course, this stock-splitting or stock-watering enables the holder of the original stock to dispose, if he chooses, of either the more speculative or the more stable security.

Even this list of Government loans, home and foreign, of trustee stocks, of mortgage debentures, of debentures, of cumulative preference shares, of preference shares, of ordinary shares, of preferred ordinary and deferred ordinary, by no means exhausts the various kinds of wares dealt with in the market. For instance, there are founders' shares, which are usually issued at the time of the flotation of a company to those specially interested in its promotion. Their peculiarity is that they usually participate with the ordinary shares in any profits remaining after a certain rate of dividend has been paid upon those ordinary shares. There may be 100,000 ordinary shares of one pound each and 100 founders' shares also of one pound each. It may be stipulated that the founders' shares participate equally with the ordinary shares after the latter have received a 7 per cent. dividend. Suppose the divisible profits amount to £20,000, the ordinary shares take their 7 per cent., which amounts to £7,000, and the remaining £13,000 has to be divided equally between the ordinary shares and the founders' shares. The 100,000 ordinary shares receive a further £6,500, raising their dividend to 13-1/2 per cent., and the 100 founders' shares receive the other £6,500, making their dividend 6,500 per cent. Had the company earned only £7,000, that would have sufficed to pay only the dividend on the ordinary shares, and the founders' shares would have received nothing.

An objection to the system is at once evident. If the directors were under the influence of the holders of the founders' shares, as they usually are, they would not be content to earn a steady profit of £7,000 for the advantage of the large number of ordinary shareholders, but would strain to divide a large profit in one year, even at the expense of making an actual loss in the next. For this and other reasons founders' shares are objectionable, especially in the case of those finance companies which earn their profits by speculation. These founders' shares are not to be confused with legitimate management shares entitled to a fair rate of dividend, and issued to the officials of a company to provide them with an incentive to work well in its interests.

There are also vendors' shares—shares allotted to a vendor in payment, or part payment, for the property which he sells to the company. If he is willing to take shares instead of cash for the property, it is a good sign, for he shows that he believes in it and desires to continue interested in it; that he does not wish merely to pocket the cash and walk off. When these shares come upon the market for sale, however, it is an obvious sign that the man who probably knows most about the property is clearing out. The rules of the Stock Exchange recognise this aspect of affairs by laying it down that no special settlement may be granted in vendors' shares until six months after the settlement of the shares issued to the public.

Sometimes amongst the wares of the market there are actually found stocks and shares which do not exist. A big Government loan is known to be impending, and although no prospectus has been issued and the market knows nothing about the terms, dealers, confident that these terms will be reasonable, and sure that there will be a big public demand for the stock, offer to sell it or to buy it at a fraction over the issue price, although they do not know what that issue price will be. Transactions of this kind sometimes occur not only in the case of a big Government loan but in the case of the flotation of an important company. After the prospectus appears, and the applications for allotment of the stock have been sent in, the dealings become quite general, although no one is yet in possession of the stock which he sells, nor do even the applicants know whether they will get the whole of the amount for which they applied, a part of it, or none at all. Some are tempted by the premium to sell the full amount for which they have applied, in the hope that they may get all of it, or, at all events, that they will get some and be able to buy the balance in the market. Others more cautious can often arrange to sell at a lower premium whatever amount of stock they may be allotted. These, of course, are on surer ground, and so are those who deal in the allotment letters themselves when they actually come out.