Speech

THE EQUITY CAPITAL SITUATION A personal statement by Thomas B. McCabe, Chairman of the Board of Governors of the Federal Reserve System, prepared at the re- quest of a Subcommittee of the Committee on Banking and Currency of the United States Senate Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis THE EQUITY CAPITAL SITUATION1 Until recently there has never been a general apathy may go much deeper. Clearly its persistence unwillingness on the part of investors in this coun- is to be viewed with concern. try to take reasonable risks with their savings. At As everyone recognizes, the supply of equity or times we have experienced an actual shortage of ownership capital is of vital importance to a savings, but rarely a significant lack of interest in dynamic, expanding economy. By equity capital risking those that were available if there was a I mean those funds supplied to a business which prospect of sizable return. Such risk-taking had do not involve any fixed lien or debt obligation long been an American tradition. It resulted in and on which no fixed return is guaranteed. Equity the rapid development of our resources, expanding capital is essential to a business because it permits production, and a steadily rising standard of living. growth and risk-taking without fear that a tempo- At times the desire for speculative gains became rary period of poor earnings will mean hardship. so great that serious social problems arose, as, for The use of equity rather than borrowed capital by instance, in the case of the common stock boom of industry renders the etonomy less vulnerable to the twenties, and it was necessary to adopt measures debt liquidation. Moreover, enterprises which to protect the economy from such over-exuberance. maintain high equity ratios are better able to get During the last two years we have been faced credit if it is needed under any economic conditions. with the opposite situation. In spite of a large flow Thus the sources, availability, and flow of equity of savings, the market for common stocks has been capital are of primary importance as they relate sluggish in its response to what historically were to the national objective of economic stability at stimulating circumstances of inflation and high high levels of production and employment. earnings. Stock prices have continued low in terms Stock financing by business corporations has been of dividends as well as in terms of earnings. As particularly low since the fall of 1946. New com- the following table shows, common share values, mon stock issues have averaged only about 10 per measured in relation either to cash dividends or to cent of total new corporate security issues. In earnings, have undergone a radical change since earlier periods of expanding economic activity the prewar: ratio averaged approximately 15 per cent. Since the fall of 1946 businesses have obtained funds for INTMRI-ST RATFS, AND BOND AND COMMON STOCK YIELDS capital outlays primarily from bank and insurance company loans, and new bond issues and retained 1949* 1948 1939 1929 Rates on commercial loans earnings, rather than from sales of stock on the of banks, per cent 2.7 2.6 2.8 5.8 market. In the interests of economic stability it is Bond yields (Aaa), per cent. 2.7 2.8 3.0 4.7 Industrial common stocks:1 always better if both large and small business enter- Yield, per cent 7.1 5.9 3.9 3.8 prises finance more of their investment expenditures Price/earnings ratio... 7 .0** 6.8 15 .7 16.4 with equity and less with borrowed capital. 1 From Moodv's Investors Service and based on 125 stocks. I should like to discuss three major aspects of the * First half. First quarter. equity capital situation as follows: (1) Why are individuals not buying more shares When the apathy to risk-taking reflected in these in business enterprises? figures first became apparent it was ascribed to a (2) Why are business enterprises not obtaining natural "burnt fingers" reaction to the 1929-32 more funds through stock sales? stock market collapse. Later a plausible reason (3) What, in my judgment, can be done about seemed to be investors' fears of a serious postwar the situation. depression. However, by now it appears that this WHY ARE INDIVIDUALS NOT BUYING MORE SHARES 1 A personal statement by Thomas B. McCabe, Chairman of the Board of Governors of the Federal Reserve System, IN BUSINESS ENTERPRISES? prepared at the request of a Subcommittee of the Committee Desire for Security. There is no single reason on Banking and Currency of the United States Senate. Submitted August 5, 1949. why investors do not buy equity shares in business. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis THE EQUITY CAPITAL SITUATION We knov/ that the volume of individual savings part, investment in common stock by these institu- today is tremendous, and it is not therefore a short- tions is prohibited or closely restricted by State or age of available funds that prevents people from Federal statute. For example, the State of New buying stock. I am firmly convinced that an im- York, home of many large life insurance companies, portant reason for people not buying common while permitting life insurance companies to pur- stocks is the increased emphasis which they place chase preferred and guaranteed stocks that meet upon security and safety of their savings rather certain tests, prohibits them from purchasing com- than upon prospects of gain. Security rather than mon stocks. The fact that the dollar volume of opportunity has recently become more and more funds flowing through recogfiized savings institu- a part of our national philosophy. The disappear- tions is now greater than ever before has been a ance of the frontier and the end of geographic major influence in the recent large supply of debt expansion, the unsettled state of international affairs relative to stock money available to business enter- since the turn of the century, and the dark memo- prise. ries of financial collapse and depression in the early Increased Taxes. The increased rates of taxation thirties have caused people to seek security in in- imposed to finance the Government's heavy expen- vestment as well as in Government intervention to ditures of recent years is .another factor that has mitigate economic and social disparities and in- affected the flow of indivicfual savings into business stability. equities. High taxation at prevailing levels of The desire of individuals for safety in investments national income, however, seems to be affecting the has been revealed in the Surveys of Consumer incentives to invest much more than the avail- Finances conducted in postwar years for the Board ability of funds. The dollar volume of individual of Governors of the Federal Reserve System by the saving and the volume of such saving in the hands Survey Research Center of the University of Michi- of individuals with relatively large incomes are now gan. These surveys suggest that an overwhelming much greater than they ever have been. In addi- majority of the population as a whole save pri- tion, the proportion of incomes that people save marily for security reasons, such as for a rainy day, has been considerably greater since the end of the old age, and emergencies. In the survey conducted war than it was in prior prosperous years. In 1947, early in 1948, covering all groups in the community, the 10 per cent of individuals with highest income 62 per cent of those interviewed were opposed to (roughly $6,000 upwards) were still responsible for holding common stock in business enterprises. somewhat over half of the total volume of saving Twenty-six per cent felt that such securities were and the dollar volume of saving by these individuals not safe, while 30 per cent were not familiar with was far above that of earlier prosperous years. stock as an investment opportunity. In interpreting However, since the highest rates of the progressive these results it should be remembered, of course, income tax apply to this group, their incentive to that ownership of common stock has never per- invest in risk assets that may yield high returns is meated all groups in the community. outweighed by the advantage of tax-exempt invest- The emphasis on safety is reflected in the large ments. volume of individual savings currently being held Tax-Exempt Investments. The investment of in the form of Government bonds; of deposits, upper income savings in State and local govern- shares, and reserves in such noncommercial bank ment securities and insurance policies has been and financial institutions as life insurance com- accelerated by the tax-free status of such securities panies, savings and loan associations, and savings and, for practical purposes, of all life insurance banks; as well as of reserves in private and Govern- company investment income. The technical prob- ment pension and trust funds. A large proportion lems involved in applying individual income taxes of individual savings is channeled into these types to State and local security holdings and life insur- of investment. In 1948, for example, the flow of ance investment income are numerous and difficult individual savings into life insurance companies, of solution. There is no question, however, that savings and loan associations, and mutual savings the current tax-free status of these forms of income banks alone totaled almost 6 billion dollars. The has drawn funds of many wealthy individuals away flow of funds over the past fifteen years into these from investments in the common stock of business channels exceeded 48 billion dollars. For the most enterprises. 2 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis THE EQUITY CAPITAL SITUATION Small Cash Dividends Relative to Earnings. 1948, a year of abnormally high profits in relation Some investors are not buying more stock because to capital investment, business corporations as a they observe that many companies are retaining group retained over half of their profits after in- a large proportion of their earnings rather than come taxes as compared with less than a quarter paying dividends. The new stock money that in 1929. Inventory profits, however, represented a businesses might obtain if they paid out higher much larger proportion of earnings in 1948 than in dividends would have to be balanced, of course, 1929. Inasmuch as these inventory profits were the against the smaller volume of retained earnings result of price increases and might be offset in directly available for investment expenditures. whole or in part by subsequent inventory losses More thought and study might very well be given resulting from price declines, they were considered to the relative advantages to the nation of the in many cases to be unavailable for distribution as form that equity financing takes, that is, equity cash dividends. In addition, depreciation charges financing through the use of retained earnings as based on original cost are, because of postwar price compared with proceeds from stock sales. One increases, insufficient to provide for replacement of aspect of the problem is the extent to which the fixed plant and equipment at current prices. former method substitutes decisions of a board for As was mentioned earlier, these decisions of cor- those of the free market in allocating capital among porate managements to4 retain a larger proportion industries and firms. of earnings have probably had some effect on the hac\ of Knowledge. Despite the general trend failure of stock prices to «rise. Had dividend dis- to safety and security there are many who are bursements been larger, undoubtedly stock prices willing to take the risks and invest their funds would have been more attractive and more new in expectation of gain. Among these are a new stock issues would have been sold. group of people with savings, including farmers, Study of stock market behavior over the period skilled laborers, proprietors of small businesses and 1895-1946 indicates the prices of stocks have fluctu- professional men. Many of these potential invest- ated more closely in relation to dividends than to ors, however, lack knowledge about stock invest- earnings. This suggests that investors attach more ment. significance to dividends derived from stock owner- ship than to reported earnings. In the recent in- WHY ARE BUSINESS ENTERPRISES NOT OBTAINING flationary period investors have been especially un- MORE FUNDS THROUGH STOCK SALES? certain as to whether undistributed earnings would There have been powerful inducements for busi- eventually result in higher dividends and capital ness enterprises to finance their recent expenditures gain. in ways other than through stock sales. Tax Advantage of Debt Financing. The tax High Cost of Equity Capital. Perhaps the most structure has also affected the businessman's choice important of such inducements has been the low as between debt and equity financing. In the case cost of debt money both absolutely and relative to of corporate enterprise, interest on debt is a busi- the dividend disbursements prevailing on common ness expense and therefore a deduction in deter- stocks. Interest rates on bank loans and long-term mining earnings subject to taxes. After these earn- bond money, as is indicated in the above table, are ings have been reduced by the full amount of the currently much below those of previous years while component income tax, any dividends paid from yields on common stocks are exceptionally high. the remainder to individuals are included in their This reflects in part the unwillingness of the public taxable income. These aspects of the tax structure to buy stocks, as previously mentioned. provide a strong inducement for corporations to Availability of Retained Earnings. An especially finance their expenditures with debt rather than attractive source of equity funds has been undis- equity capital. The fact that interest payments are, tributed profits. This form of equity capital has and dividend payments are not, deductible from been a very important source of business funds corporate income in computing taxes means that since the end of the war. Undistributed profits can the spread between the cost of stock and bond in a sense be considered free of carrying charge, financing after allowing for the tax advantages of for their volume is determined by management de- bond financing is appreciably greater, as the follow- cisions concerning dividend disbursements. In ing illustration shows: 3 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis THE EQUITY CAPITAL SITUATION COST OF $5,000,000 OF NEW EQUITY VS. DEBT CAPITAL the tax system tends to be neglected and postponed Capital Structure (after in times of receding business as well as in times of flotation) Company A Company B prosperity. We should, however, realize that basic Bonds—3% coupon*.... $ 0 $5,000,000 inequities may exist, and decide upon a long-term Common stock 9,500,000 4,500,000 Surplus 500,000 500,000 corrective program. The indicated changes can be made as the opportunity occurs. Among the many Total Capital $10,000,000 $10,000,000 suggestions that have been made, the ones discussed Earnings for current year below seem to me the most important. Before taxes and fixed There is no doubt that some additional invest- charges $1,000,000 $1,000,000 Less: Bond interest 0 150,000 ments in corporate equities would result from a re- duction of income tax rates, particularly those ap- Before Federal income taxes 1,000,000 850,000 plicable to the higher brackets. It is difficult to tell Less income taxes (38%). 380,000 323.000 how much additional investment would be induced by a given lowering of tax rates. Since the aggre- After Federal income taxes 620,000 527,000 gate amount of income in the high tax brackets is Less Dividends on com- relatively not large, only a .small volume of funds mon stock at 7%*.... 665,000 315,000 out of current income woul3 be directly made avail- Balance transferred to able for new investment by a reduction in the per- surplus $—45,000 $212,000 sonal income tax rate in those brackets. However, the indirect effects in attracting previously accumu- Charges applicable to new capital lated wealth that is now held in forms other than Interest on bonds $ 0 $150,000 equity investment, might be significant. Additional income tax. . 57,000 Some attention should also be given to the prob- Dividends on additional stock 350,000 lem of tax exemption of individual income derived from State and local government securities and the $407,000 $150,000 tax status of life insurance company investment. As a % of new capital Revision of this type of exemption might divert raised 8.14% 3.00% some individual savings from such securities, an- * Current yield, as per table, page 1. nuities, and insurance to listed stocks or small busi- ness enterprises. MY SUGGESTIONS AS TO WHAT CAN BE DONE ABOUT There is another type of adjustment of the per- THE SITUATION sonal income tax structure that should be con- I should like to make certain suggestions which sidered in connection with the equity capital situ- I think will help solve this problem of the im- ation, that is, more liberal provisions for carrying pediments to businesses which might wish to sell, forward and backward losses growing out of busi- and the reluctance of investors who might be in- ness operations. Such a change in the tax structure duced to buy, common stock. As such, these sug- would encourage direct investment by owners of gestions do not necessarily represent the views of small unincorporated enterprises and partnerships. the Board of Governors. Another feature of our income tax structure to Taxation. My first suggestion is that Congress consider is the double taxation of corporate divi- initiate a thorough review of the tax situation from dends. There is little reason on equity grounds to the point of view of its effect, frequently inad- tax both the corporation and the individual in- vertent, upon the availability of equity capital. Un- vestor on the same income. However, there is the fortunately there never seems to be a convenient practical problem of levying a tax on that part of time for such a basic review of the tax structure. corporate income not paid out in dividends and Last year, when we had a substantial surplus, we therefore not received and taxed as personal in- elected to reduce taxes without revamping the tax come. One solution to this problem that has been structure. Now with deficit financing facing us, proposed is to continue a moderate corporate in- we naturally do not want to do anything that will come tax and permit corporations to deduct from cause even a temporary loss of revenue. Therefore, their taxable income the dividends they pay to a fundamental study that would lead to reform of stockholders. An alternative solution, one which 4 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis THE EQUITY CAPITAL SITUATION was previously advanced by the Magill Committee, rightly established many years ago as safeguards is that of allowing individual taxpayers credit for needed at that time, may, in the light of changed taxes paid by the corporation in computing their savings and investment patterns, now be out of tax liability. date. I recommend that the life insurance com- If the basis of corporate income taxes were to be panies, in cooperation with the proper State author- changed in the manner suggested Government ities, explore fully the opportunities for investing in revenues from this source would undoubtedly de- common stock with the aim of modifying these cline somewhat, though not by an equivalent restrictions. amount. The Congress would of course have to Two of the most common arguments against devise alternative taxes to offset their decline in relaxing the legal restrictions on the investment op- revenue, but the potentialities for stimulating pro- portunities of life insurance companies and fidu- ductive investment of equity capital are sufficiently ciaries are: promising to warrant such action. (1) The risks of equity investments. Attention might also be directed toward a revision (2) Possibility of a concentration of industrial of the tax laws which would permit more rapid control in large life insurance companies. depreciation of plant and equipment. Allowing business concerns to amortize the cost of additions I agree that there is ascertain element of risk in- and betterments over a relatively short period of volved in the ownership of equity shares. Yet time, and to deduct these depreciation charges in there is little ground in past experience to support computing their taxable net income, would provide the broad premise that many permitted bond in- a stimulus to business investment at this time. vestments involve less risk than carefully selected Moreover, by permitting larger tax-free recovery, common stock. In general I feel that informed through increased depreciation charges, of funds and flexible investment policy together with sound invested in plant and equipment, the short-run con- judgment are much to be perferred to rigid legal traction of internal sources of funds that character- restrictions. The experience of endowment funds izes a downward drift in business activity would be of educational institutions, as well as of the fire lessened. insurance industry, which operate under more A final feature of the income tax problem is the liberal investment regulations, has demonstrated treatment of capital gains and losses. The volatility that diversified investment in common stocks along of capital gains over a period of time deserves more with other types of securities can produce better consideration than it has received. From an invest- than average return. ment point of view some of the objections to the In order to prevent domination by the life insur- capital gains tax might be met if a method were ance companies of individual companies or indus- devised enabling individuals to average their capital tries, or unwarranted risks of investment loss gains and losses over a number of years in order through common stock ownership, such investment to determine their taxable income. However, I should be carefully prescribed by appropriate legis- mention this only in passing, as it is a complicated lation. Some such formula as the following might question and one which would require careful be employed, e.g., investment of any one life insur- study. ance company in the common stock of a business enterprise might be limited to one per cent of the LIFE INSURANCE AND FIDUCIARY INVESTMENTS outstanding voting shares or $1,000,000, whichever is larger. My second major suggestion for alleviating the equity capital problem would be that consideration EDUCATION AND MERCHANDISING be given to a liberalization of the investment oppor- tunities open to fiduciary institutions, particularly I would like to urge those engaged in marketing the life insurance companies. In view of the large securities to give extraordinary consideration to volume of individual savings flowing into private ways and means of informing the public more fully pension and insurance reserves, the legal restric- about the investment opportunities in stock owner- tions on insurance companies and other fiduciaries ship. It should be recalled that 30 per cent of the which prohibit them from investing in corporate individuals interviewed in the 1948 Consumer stocks should be reviewed. These restrictions, Finances Survey conducted for the Board of Gover- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis THE EQUITY CAPITAL SITUATION nors of the Federal Reserve System said they were This and other measures of developing good public against holding common stocks because they were relations in the areas in which the company's plants not familiar with them. Moreover, some of the are located often results in a high percentage of largest gains in income since the prewar period stock ownership in those areas. have been among groups like farmers, skilled NEW FINANCING AGENCIES laborers, proprietors of small businesses and some professional people whose knowledge of common There might still remain a long-run equity stocks is very limited. These facts pose an educa- capital problem for business even if legislative tional and merchandising challenge to those en- changes in regard to taxation and investment out- gaged in marketing securities. lets for fiduciary institutions were feasible and if There are, of course, many problems involved distributors of common stock and businesses them- in the merchandising of risk investments to the selves did a more aggressive job of informing the general public. We do not want the overselling public about the advantages of stock ownership. of stocks to receivers of small incomes that char- Many individual concerns, particularly small ones, acterized the years of the late twenties. There are do not at present have convenient access to the many small income recipients who should not as- savings potentially available for investment in sume the risks of business ownership. But it equities and others have rfo access to such funds at seems clear that certain merchandising adjustments all. In the long-run, there may be a need in this can and should be made. There should be an country for new types of financing agencies to meet adjustment to a changing market and more ade- this problem, particularly for the channeling of quate attention given to the majority of upper- equity capital to small and medium-sized enter- middle-income savers who invest, rather than focus prises. At least three types of financing agencies on the minority who trade in equity securities. have been suggested and deserve further consider- ation: I doubt if the great majority of small investors are familiar with investment trust shares. Invest- (1) Private financing companies; ment trusts have diversified holdings of preferred (2) Special community funds and development and common stocks and other securities, and thus corporations; and can offer the small saver diversification of risk (3) Capital banks. together with the higher income to be derived from equity shares. There has been a great in- Examples of the first two types of financing crease in the amount of new money placed in invest- agencies are already functioning. An illustration ment companies since the passage of the Investment of the type of private financing company I have Company Act of 1940. During the four years in mind, which I shall not mention by name, is 1945-48 sales of new open-end investment company a corporation which obtains money from insurance shares totaled almost 700 million dollars. Although companies, trust funds, research and educational investment companv funds are rarelv used to buy foundations, established investment companies, and new issues of securities, purchase of existing issues individuals, and invests such funds in equities of supplies sellers with funds for the purchase of new new and established business concerns that have issues and by helping to maintain a strong market some product or process to be developed that is of may encourage the sale of new stock issues. scientific importance. Thus, the corporation pro- Considerably more attention could be given by vides a channel whereby equity risks can be pooled corporations themselves to cultivation of the mar- and financed, in part at least, by previously un- ket for future equity financing. Certain ones have available funds of fiduciary institutions. gone to great lengths to prepare their future market Community development corporations are usually by giving the general public, particularly their privately sponsored and obtain their funds from stockholders, more information about their oper- leading citizens and established business enter- ations, their financial position and their earnings. prises in the community. Their primary purpose is Some companies have also cultivated equity owner- to bring enterprises that need capital into contact ship by their employees. Such ownership can im- with a pool of funds composed of small amounts of prove working relationships and enhance com- money that might separately not be available for munity goodwill toward the company as well. investment. These plans have the advantage of 6 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis THE EQUITY CAPITAL SITUATION diversifying risks and yet at the same time leaving earnings of enterprise. Thereby, resources origi- the financing decisions with local individuals who nally acquired with borrowed capital are gradu- are familiar with the capabilities of the business ally refinanced out of equity capital. Over the past men in their communities. Among the commu- two decades, there have been important technical nities with prewar plans that are still operating developments along these lines in the credit field. are Baltimore, Maryland; Louisville, Kentucky; and The five to fifteen year term loan extended by Easton, Pennsylvania. More recent plans aimed at many larger banks and most insurance companies, aiding the reconversion or relocation of business with repayments budgeted in accordance with ex- concerns after the war have been developed at pected earnings, is an illustration of this type of Albert Lea, Minnesota and Ashtabula, Ohio. credit. Another example is market borrowing The capital bank proposal has been advanced by through the convertible debenture. This type of many individuals and organizations in the past and obligation offers important incentives to manage- most recently by the Committee for Economic De- ment to retain earnings in order to expand oper- velopment. The general purpose of the proposal is ations and build up profits so that holders will be to add to our present banking structure a set of induced to convert their bonds into the company's new banks to provide long-term loan and equity common stock. capital to business, particularly to small enterprises. As you will gather, I am a confirmed optimist regarding the future of America. I firmly believe CONCLUDING REMARKS that the basic characteristics of our economy are Thus far I have treated debt and equity financing expansion and growth. Economic expansion today largely as alternative means of raising capital for presents a strikingly different challenge from that a business enterprise. This emphasis may create a of a hundred years ago. Then, the frontier of de- somewhat distorted impression of the part which velopment was the opening up of our great western each plays. Debt and equity are actually comple- resources. The geographic frontier is gone, but we mentary ways of financing business though they still have a frontier of development. That frontier must be properly balanced in order to achieve a is technology—the technology of producing more sound financial structure. and better goods with the resources we know are There is another aspect of the relationship to available and the technology of distributing those which attention should be directed. We generally goods on a mass basis for the constant improvement assume that debt expansion increases the financial of the standard of living of all. To realize our resources of a business, and that debt repayment potential sustained expansion, we need to be con- reduces those resources. This is a correct view cerned with assuring a steady and adequate flow in the short-run, but over the longer-run, debt of savings into equity ownership. I sincerely be- financing may be a means of building up equity. lieve that if we are in earnest, ways and means can I have reference to debt incurred on a basis that be found for accomplishing this purpose that are calls for its gradual repayment out of the retained fair and equitable to everyone concerned. 7 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Thomas B. McCabe (1949, August 4). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_19490805_mccabe

@misc{wtfs_speech_19490805_mccabe,
  author = {Thomas B. McCabe},
  title = {Speech},
  year = {1949},
  month = {Aug},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_19490805_mccabe},
  note = {Retrieved via When the Fed Speaks corpus}
}