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War-Time Financial Problems - XI


2. I

3. II

4. III

5. IV

6. V

7. VI

8. VII


10. IX

11. X

12. XI

13. XII

14. XIII

15. XIV

16. XV

17. XVI

18. XVII


20. XIX

21. XX



_July_, 1918

A Deluge of Bonus Shares--The Effect on the Market--A Problem in
Financial Psychology--The Capitalisation of Reserves--The Stock
Exchange View--The Issue of Bonus-carrying Shares--The Case of the
A.B.C.--A Wiser Variation from Canada--Bonus Shares on Flotation--An
American Device--Midwife or Doctor?--The Good and Bad Points of Both

Of the many kinds of Bonus shares, the one which has lately been
most prominent in the public eye is that which is produced by the
capitalisation of a reserve fund. There has lately been a perfect
epidemic of this kind of Bonus share, which is almost as plentiful as
the caterpillars in the oak trees and the green fly on the allotments.
The reason for this outburst is apparently the anxiety which the
directors of many prosperous industrial companies feel lest the high
dividends which good management and sound finance in the past have
enabled them to pay should lay them open to misunderstanding and
attack by well-meaning people who think that it is a crime for a
company to earn more than a certain percentage on its capital.

This explanation was very frankly given by the directors of Brunner,
Mond and Company, when they lately capitalised part of their reserves.
The company, they stated, has for many years paid a dividend on its
Ordinary shares of 27-1/2 per cent., and "the directors feel that
there is a widespread impression that this is the rate of profit
earned on the total of the capital invested, and consequently that the
company is making an unfair profit out of its customers and the labour
it employs. This is by no means the case." It is a lamentable proof of
the backward state of the economic education of this country that it
should be necessary for well-financed and prosperous concerns to take
steps to make it quite clear to the public that they are not earning
more than they appear to be. In a well-educated community it would
be perceived at once that it is the well-financed and prosperous
companies which improve production in the interests of their
shareholders, their workmen, and the public; that the price which the
public pays for a commodity is ultimately the price at which the worst
financed and worst managed companies can just manage to keep alive;
that the higher profits earned by the better companies are not wrung
out of the pockets of the community, or their workmen, but are the
result of good management and good finance; and that the more the good
companies are encouraged to go ahead and drive the bad ones out of
existence, the better will the community be served, and the better
will be the chance of the workmen to get good wages. These platitudes
are of course, only true in a state of free competition. If there is
anything like monopoly the public and the workers are fully justified
in being suspicious and examining the source from which high dividends
are produced.

Such being the reason why this outburst of capitalisation of reserves
first began--since in these days all capitalists and those who have to
manage capital feel that they are working under criticism, which is
not only jealous and suspicious (as it should be), but is also too
often both ignorant and prejudiced--it is interesting to note that
the movement which was so started has been stimulated by its very
exhilarating effect on the market in the shares of the companies
concerned. Why this should be so it is difficult at first sight to
say. What happens is merely this--that a company, let us suppose, for
the sake of simplicity, with a capital consisting wholly of 3,000,000
Ordinary shares, has accumulated out of past profits, or out of
premiums on new issues of shares, a reserve fund of L1,000,000. Its
net profit has lately averaged L400,000, and it has, year by year,
distributed L300,000 in the shape of a 10 per cent. dividend to
its shareholders, and put L100,000 into its reserve fund, which is
represented on the other side of the balance-sheet by buildings
and plant and a certain amount of first-class investments. If the
directors now decide to capitalise that L1,000,000 of reserve fund,
the only effect is that each shareholder will be given one new share
for every three which he holds in the existing capital, the reserve
fund will be wiped out, and the ordinary capital will be increased
from L3,000,000 to L4,000,000. None of the shareholders will be in
actual fact better off to the extent of one halfpenny, because all
will be in the same position with regard to one another; their
relative shares in the enterprise will not have been altered. If we
imagine, by way of simplifying the problem, that all the Ordinary
shares were in one hand, that one holder would have had in his
Ordinary shares a claim to the total assets of the company, that is
to say, to its earning power as long as it is a going concern, and to
whatever its assets realise if it went into liquidation; the fact that
L1,000,000 worth of the assets had been bought out of past profits or
premiums paid on new issues of shares would have already added to the
value of the claim that he had on the property of the company, and no
addition would be made to that value by turning the reserve fund into

In other words, the reserve fund is already the property of the
shareholders, and to convert it from reserve fund into capital, making
them a present of new shares, which merely represent their claim
to the assets held against the reserve fund, is as empty a gift as
presenting a man with a piece of paper informing him that he is the
owner of his own hat. All this remains equally true if, besides the
ordinary capital, there is a considerable amount outstanding of
Preference shares and Debenture debt. In any case, the Ordinary
shareholders possess a claim to the earning power of the company when
prior charges have been satisfied, and to whatever surplus may remain
on liquidation after first charges have been paid off in full. Whether
that interest of theirs is represented by a larger or smaller number
of shares, or by shares of a larger or smaller denomination, or by a
reserve fund upon which they have a claim when all other claims have
been settled makes no difference whatever as a matter of academic
fact. Apart from the sentiment of the matter, there is no reason why
ordinary capital should have any nominal value.

As to the earning power of the company, that, of course, is not
affected one whit by the process. The earning power of the company is
all in the assets--the plant, machinery and other property--plus
the elusive qualities which are bound up in the word "goodwill,"
representing the selling power, organisation, and the expectation of
future profits. The capitalisation of the reserve simply affects the
manner in which the liabilities of the company are arranged, and
the existence of a reserve fund merely means that the Ordinary
shareholders have a claim to a larger amount than their nominal
holding in case of liquidation. It does not matter in the least
whether this larger claim is handed to them in the shape of a
certificate, since the nominal amount of their claim has nothing
whatever to do with the amount that their claim realises to them
annually in the shape of dividends, or in the event of liquidation,
from the realisation of the company's assets.

In fact, the capitalisation of reserves is sometimes criticised by
economic purists as a retrograde step because it seems likely to
encourage the directors to be extravagant in the matter of dividends.
In the example which we supposed above of the company with a capital
of three millions and reserve fund of one million, if the reserve fund
is turned into Ordinary shares and the earning power of the company
remains the same there may obviously be a temptation to the directors
to modify the prudent policy under which they had hitherto placed one
hundred thousand a year to reserve, because if they continued it the
shareholders would discover they were really no better off and that
they simply got a lower rate of dividend on the larger amount of
shares, and that their actual receipts from the company were exactly
the same as before. And if the earning power of the company remained
the same and the directors left off placing the one hundred thousand
a year to reserve, and paid away the whole of the net profit in
dividend, it is clear that the progressive expansion of the company's
business would be to that extent checked. On the other hand, there is
a contrary argument that as long as the company has a large reserve
fund there is a possibility that dissatisfied shareholders may agitate
for a realisation of sufficient assets to enable that reserve fund to
be distributed, especially if it has been wholly acquired out of past
profits. In this case the capitalisation of the reserve fund puts this
temptation out of their reach since, when once the reserve fund has
been capitalised, it can only be got at by greedy shareholders through
the process of liquidation. Since, however, the shareholder in these
times is not quite so short-sighted as he used to be, there is not
perhaps really very much advantage in this point.

But since, as has been shown, capitalisation of reserves has no effect
upon the earning power and assets of the company, it is interesting to
try and discover why the rumour and announcement of such an intention
on the part of the board of directors is nearly always accompanied by
a rise in the shares of the company affected. If the shareholder is
merely to be given a larger nominal claim, which does not in the least
affect the value of the assets which that claim concerns, and if the
relative amount of his claim is exactly the same with regard to the
other shareholders, it is clear that the rise in the value of the
shares is based entirely either on a psychological mistake on the part
of the public and its financial advisers, or on the fact that the
transaction called attention to the value of the shares which have
hitherto been undervalued in the market. Probably the movement arises
from both these causes. A large number of people think they are better
off if they have a larger nominal share, without considering that
all the other shareholders are at the same time having their claim
increased, that the assets to which they all have a claim are not
being increased, and that, consequently, if a sharing-out process were
to take place they would all be exactly as they would have been if
no such capitalisation of reserves had been carried out. And if a
sufficient number of people think that a share or any other commodity
is more valuable, it thereby becomes more valuable, because value is
nothing else than the amount, whether in money or other commodities,
at which a commodity can be disposed of.

But it is also true that there are, at all times, a very large number
of securities, especially in the industrial market, which would
stand higher if their earning power and position were more closely
scrutinised. This is very clearly seen to be the case from the
apparently extravagant prices at which insurance companies, for
example, sometimes buy the businesses of one another. They give a
price which is considerably above the market value of the concern as
represented by the price of its shares. Critics say that the terms are
extravagant, and yet the deal is found to be highly profitable to the
buying company. The profit of the deal, of course, may be increased by
the advantages of amalgamation, but quite apart from that it is clear
that the market price of securities very often undervalues, as it
also, perhaps, still oftener overvalues, the real position of the
companies on whose earning powers they represent claims. In any case,
there is the fact that these capitalisations of reserve funds, which
make no real difference to the actual position of the company, are
universally regarded, in the language of the Stock Exchange, as "bull
points." It is assumed, of course, that the directors would not carry
out such an operation unless they saw their way to a higher earning
power in the future as a justification for the larger capital. In this
expectation the directors might be right or wrong, and, even if they
are right, that prospect of higher earning power, if market prices
could be relied upon to express the true position of a company, would
have been "in the price."

There is another kind of Bonus share, which is not exactly a Bonus
share, but carries a bonus with it. This comes into being when the
directors of a company sell new shares to existing shareholders at a
price below the terms which they might have obtained if they made a
new issue to the general public. The classical example of this system
is the Aerated Bread Company, that concern to which City clerks and
journalists and others owe so much as pioneers of cheap and simple
catering. It will be remembered that in the palmy days of this
company, before it had been severely cut into by competition, its L1
shares used to stand in the neighbourhood of L15. The directors used
then to make issues of new shares to existing shareholders at their
face value, that is to say, at L1 per share, although it was obvious
that if they had made a public issue inviting all and sundry to
subscribe they could have sold their new issues at or above L14
per share. This system put an enormous bonus in the pockets of the
existing shareholders at the expense of the company and its future
prospects. The directors practically gave to the existing shareholders
a present of L130,000 if they sold them 10,000 new shares for L10,000,
which they and the public would have readily subscribed for at
L140,000. There was nothing wicked about the process, but it was
extremely short-sighted. If the company had retained the monopoly
which its pioneer work as a cheap caterer for a long time secured
it, it might have kept its prosperity unimpaired even by this
short-sighted finance. As it was, attracted several competitors, some
of which were extremely well managed and financed, and although it
still does a most useful work for the community, its earning power has
suffered considerably. But this is only an extreme example of a system
which is reasonable enough if it is not carried too far. The Canadian
Pacific Railway, for instance, has for many years adopted a very
moderate use of this system, making new issues to its shareholders on
terms rather cheaper than it could have obtained by a public issue,
but not giving away enough to impair its future seriously in order
to make presents to the existing stockholders by this means. By the
continued making of small presents to their constituents the directors
of the company have obtained the support of a very loyal body of
stockholders, who feel that they are being well treated but not
pampered. This system of granting a small bonus to existing
shareholders on occasions when the company has to issue new capital is
one which is quite unobjectionable as long as it is not abused. If,
owing to the use of it, the directors are encouraged to finance
themselves badly, that is to say, to pay out of new capital for
improvements and extensions which a more prudent policy would have
financed out of earnings, just because they find that these issues
carrying a small bonus makes them popular with the stockholders, then
the system is being abused. Otherwise there seems no reason to object
to a measure which keeps the shareholders happy and does not do any
harm to the concern so long as it is worked in moderation.

Finally, there is a Bonus share or stock which does not represent
accumulation out of vast profits or issues of new shares at a premium,
and does not involve a bonus by the sale to existing shareholders at
a price below the terms which could be got in the market, but is at
first sight pure water, representing merely possibilities, perhapses,
and potentialities. This kind of Bonus share is chiefly known on the
other side of the Atlantic, and is usually damned with bell, book and
candle by purists among English financial critics. We say on this side
of the water that every pound of an English well-financed company
represents a pound which has actually been spent and put into tangible
assets which help the company to earn profits. This boast is by no
means true, since nearly all industrial companies come into being with
something paid for in the shape of goodwill, which is of enormous
importance, but can hardly be called a tangible asset; and even in the
case of our railway companies, many millions of original capital went
into Parliamentary and legal expenses, which have been, in one sense,
dead capital ever since, though without this expenditure the railways
could never have got to work. The American system of Common shares,
representing what appears to be water, is only a modification of what
every company has to do, in one form or another, on this side or
anywhere in the world. Wherever an existing business is bought out
something has to be given over and above the old iron value of the
concern for the value of the connection and other intangible assets.
Wherever an entirely new industry is started it has to meet certain
initial expenses. It has to placate, to use the unpleasant American
word, various interests in order to get to work, or it has to lay out
money, in building up a concern by advertising or otherwise. It is
impossible that every penny which is put into it will go into actual
buildings, plant, machinery, and stock-in-trade.

In America the system has been preferred by which the actual tangible
assets of a new concern are financed wholly or largely by issues of
bonds or Preferred stock, and the Common stock is given away to those
interested in the promotion, for them either to hold or to use in
order to secure the co-operation of those who may be useful, or modify
the opposition of those who may be dangerous. The net result of it is
that the Common stock is represented in fact by goodwill or the power
to get to work. If the company prospers, then it is the business of
those who hold these Common shares to see that assets are accumulated
out of profits, to be held against their Common stock, so squeezing
the water out of it and making it good. The system thus possesses this
very considerable advantage, that those who promote a company are
interested in its future welfare, and watch over it and guide it
through its subsequent existence, putting energy and good management
at its disposal in order that the paper which they hold may be
represented, not by water, but by real assets, and so may bring them a
tangible reward. It has thus in some ways a great advantage over the
English system, by which the company promoter is too often concerned
merely in the immediate success of the promotion. He is, as one of the
greatest of them described himself, a mere midwife, who brings the
interesting infant into the world, pats its little head, says good-bye
to it, and leaves it to take care of itself throughout its troubled
existence. By the American system the promoter is not a midwife but a
doctor who assists at the birth of the infant, and also watches over
its youth and makes every effort to guide its toddling footsteps in
such a way that it may grow into lusty manhood. It is not until he has
done so that he is enabled, by the sale of the shares which were given
to him at the beginning, to realise the full profit which he expected.
The profits realised by this method are in many cases enormous. On
the other hand, the amount of work that is put in to secure them is
infinitely greater than happens in the case of the English midwife
promoter; and if the enterprise is a failure, then the promoter goes
without his profits.

The system, like everything else, is liable to abuse, if a rascally
board of directors, in a hurry to unload their holding of Common stock
on an unsuspecting public, makes the position and prospects of the
company look better than they are by unscrupulous bookkeeping and
extravagant distribution of profits, earned or unearned. These things
happen in a world in which the ignorance of the public about money
matters is a constant invitation to those who are skilled in them to
relieve the public of money which it would probably mis-spend; but,
if well and honestly worked, the system is by no means inherently
unsound, as some English critics too often assume, and it has been
shown that it carries with it a very great and substantial advantage
in the hands of honest people who wish to conduct the business of
company promotion on progressive lines.

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