Showing papers in "Journal of Finance in 1962"

The influence of growth duration on share prices

Abstract: THE SPECTACULAR INVESTMENT performance of "growth stocks" in recent years has focused attention on the problem of evaluating the securities of fast-growing companies. Unfortunately, methods for placing valuations on such securities are not yet adequately developed, and investors make their buy-and-sell decisions as best they can. That a company's high rate of "growth" may come to an end is an important, but little-emphasized, investment consideration in the evaluation of growth stocks. To call attention to this point, we present in this paper an exploratory analysis of the relationship between price-earnings ratio, rate of growth, and the duration of growth. In omitting risk from the present analysis, we are explicitly neglecting the fact that investments in growth stocks are often riskier than in non-growth stocks. Consistent with this, the capitalization rates for both kinds of securities are assumed to be the same, and hence any differences in their price-earnings ratios are attributable to differences in their growth of earnings. The obvious investment success of growth stocks has led investors to seek out these securities for purchase, with the result that their prices have been driven up so that growth stocks now generally carry high price-earnings ratios. But just how high it is wise for investors to drive price-earnings ratios is not clear. If a growth stock is evaluated by discounting future growing dividends back to the present, the paradoxical result is obtained that an infinite price-earnings ratio is justified for a stock whose dividends per share are expected to grow at a (per cent per annum) rate that is higher than the discount rate. This clearly untenable result comes from the implicit assumption of an indefinite continuation of exponential growth and may be

Federal expenditure policy for economic growth

Abstract: MY ASSIGNMENT FOR this session is indeed a broad one. Fortunately, economists have been discussing the relation between government spending and economic growth for many years; I need only cite the interesting set of papers on this subject in the joint Economic Committee Compendium, Federal Expenditure Policy for Economic Growth and Stability. One would also be hard put to find a better statement on this problem than the Committee for Economic Development's policy statement of 1959, The Budget and Economic Growth. So, I shall just raise a few fundamental questions and put the problem into a current perspective.

Interdependence of utility rate‐base type, permitted rate of return, and utility earnings*

Abstract: As IS WELL KNOWN, regulatory agencies determine the dollar earnings of public utilities by fixing in rate decisions the rate base of the utilities and the rate of return that the utilities can earn on that rate base. Some regulatory agencies use original cost as their criterion in determining the rate base, others use reproduction cost as their criterion, and still others use a value, which for purposes of this paper will be called "fair value," somewhere between original cost and reproduction cost as their criterion.1 Since the reproduction cost of public utility assets has exceeded the original cost of these assets during the postwar period of increasing factor prices, the question naturally emerges of whether agencies using the original-cost ratebase criterion have tended to compensate for the lower rate base by allowing higher rates of return. This paper suggests an answer to this question, at least for the 15 Bell operating telephone companies in the country which operate within a single regulatory jurisdiction.2 The first part of the paper shows that in the case of these 15 telephone companies, those in original-cost rate-base jurisdictions have been permitted the highest rates of return on their rate bases and those in reproduction-cost jurisdictions have been permitted the

A proposal for precise definitions of “trading on the equity” and “leverage”: comment

Abstract: IN A RECENT ISSUE of this Journal, Professor Pearson Hunt suggested precise definitions for "trading on the equity" and "leverage."' While this objective is laudable, the article contains certain statements which appear to impede its achievement. In particular, the following remarks on the Hunt article will argue that (1) the measurement of trading on the equity is inappropriate; (2) the analysis employing the trading on the equity measurement is inadequate and misleading; and (3) the verbal and symbolic formulations of the leverage measurement are in minor disagreement; also the symbolic statement of this measure is not so general as it should be. The criticisms which follow, while representing substantial disagreement with Hunt on certain points, are intended to improve, not negate, his efforts to remedy terminological confusion. The reader will observe agreement concerning the definition, though not the measurement, of trading on the equity and agreement on the general, though not detailed, concept of leverage. 1. Hunt's measure of trading on the equity is inappropriate because it attempts to measure an effect, and a very incomprehensive one, rather than the act being defined. Hunt's definition and measurement are as follows: "It is proposed that trading on the equity be defined as: The use of fixed (or limited) charge securities in the capitalization of a company, measured by the ratio of (1) the rate of return on the existing common-stock equity to (2) the rate of return on the entire capitalization as it would have been if there were only common stock outstanding."' It is important to note that "trading on the equity" is an expression which designates an act (the use of ... .) which, in the context of Hunt's article and many others on business finance, is assigned the role of a causative factor. Measuring the act of trading on the equity by one of its effects blurs a necessary distinction. There is a direct way of measuring the act which is no more susceptible to error and subjectivity than measurement of the effect.

Are compensating balance requirements irrational

Abstract: IN A RECENT ARTICLE in this Journal, Douglas Hellweg argues that "by eliminating compensatory balance requirements, a bank can enlarge its own earnings while at the same time reducing the effective rate of interest paid by the borrower."' These requirements are therefore, or so Hellweg argues, irrational, and it is a puzzle that they ever became so firmly imbedded in banking practice.2 Hellweg illustrates his case somewhat as follows: Consider a thousand dollar loan with a contract interest rate of 4 per cent and a 20 per cent compensatory balance requirement. Since the borrower has the use of only $800, he pays an effective rate of 5 per cent. If, instead, the bank advanced $800 at a 5 per cent contract rate but with no required balance, the borrower would be just as well off. The bank, however, would be better off because it would not have to hold required reserves against deposits represented by the compensating balance. Thus, in the first case above, where a compensatory balance is required, the lender's income is $40 (0.04 X $1,000), but $40 of reserves is tied up (assuming a reserve ratio of 20 per cent). If the bank advances $800 at 5 per cent with no balance required, its income is $40 (0.05 X $800) plus the return it can obtain on the $40 of required reserves released through the reduction of deposits by $200. The additional income can be shared with the borrower in the form of a lower contract rate, so that both parties can be better off without the compensating balance requirement. The burden of this note is that Hellweg's argument applies to a special case; this case exists and requires explanation, but it does not describe compensating balance relationships generally.

Terms on conventional mortgage loans on existing houses

Abstract: ECONOMISTS GENERALLY ASSUME at least two things about the structure of interest rates on mortgage loans. The first is that, because of borrower mobility, both stated interest rates and effective interest rates (that is, stated interest rates plus loan costs) tend to be uniform on comparable mortgage loans within a given market area. The second is that interest rates vary as other terms of the mortgage loan contract vary; particularly, it is widely assumed that, since default risk tends to increase as loan to value ratios (LVRs) increase, interest rates also vary directly with LVRs. Both these hypotheses about the mortgage market are, of course, reasonable, but there have been few systematic efforts to substantiate them. Most of the existing data on the relation between interest rates and LVRs are fragmentary, while there are almost no available data at all on the extent of variability of interest rates on comparable loans in a given market area.' The major objective of this paper is to present data that, at least to some extent, test these two hypotheses for a particular market at a particular time. These data show both stated and effective interest

Interest rates, contract terms, and the allocation of mortgage funds

Abstract: THIS PAPER IS concerned with the role of interest rates, down-payments, and contract maturities in the allocation of mortgage funds among borrowers. It has been widely observed that decreases in interest rates on mortgage and other consumer loans' are often accompanied by decreases in average down-payments and increases in average contract maturities.2 The most popular explanation for this association is one variant of the credit-rationing hypothesis that might best be called the "multiple-term hypothesis." Lenders, so this argument goes, do not ration funds solely on the basis of price-the interest rate-but also on the basis of other conditions of the loan, requiring higher down-payments or shorter maturities than (some) borrowers would prefer to arrange at the quoted interest rate. When either the demand for loans falls or supply increases, lenders may reduce rates charged but also allow borrowers more generous terms in the form of lower downpayments or longer maturities.8 Likewise, according to this argu-

The investment decision under uncertainty: portfolio selection*

Abstract: THIS THESIS IS designed primarily to test the usefulness of a formal theoretical model in explaining the investment decision under uncertainty. It is largely empirical and is analytical rather than normative in character. The model.-Conceptually, the present approach may be classified under any (or all) of three common headings: expected utility maximization, certainty equivalence, or mathematical programing. Formally, the model requires the maximization of a quadratic objective function, y iIAiA 2;2i ijyj

Investment experience with less popular common stocks

Abstract: (CAVEAT EMPTOR-The editors feel that the article following, by Dr. Scott Bauman of the University of Toledo, is a valuable contribution. We discussed with the author the possibility that the eight years reviewed do not represent a complete investment cycle without the experience of 1962-63. By mutual agreement it was decided not to delay publication until the additional data became available and could be processed. If there is sufficient interest among the members of the Federation, Dr. Bauman will prepare a sequel for later presentation in the Financial Analysts Journal.)

Aspects of federal reserve policy, 1951–59 facts and controversies†

Abstract: SOME CRITICS OF MONETARY policy recently have gone so far as to argue that monetary policy is inherently defective and should be replaced by more reliance on direct control of various types of economic activity. This study examines the possibility that some of the alleged deficiencies of monetary policy in the 1951-59 period stem from the way in which monetary policy was applied by the Federal Reserve rather than from any inherent defect. The Federal Reserve's choice and use of monetary instruments and its general conception of the proper scope of monetary management are analyzed to determine how successful its approach was in influencing monetary magnitudes and the financial markets, for it is through these that the "real" economic decisions of the nation are affected. Part I sets out the background in which the 1951-59 policies of the Federal Reserve were formulated and compares Robert V. Roosa's view-sometimes called the "New York Reserve Bank view" -of monetary management with the view which apparently governed the actual conduct of Federal Reserve policy. Part II focuses on the Federal Reserve's use of monetary policy instruments during the 1951-59 period. Most attention is given to the policy of confining open-market operations to "bills only" because this aroused the most controversy and also because open-market operations are widely considered to be the most important monetary policy instrument. There is also extended discussion of discount policy, changes in reserve requirements, and selective controls on consumer and real estate mortgage credit. The following conclusions are drawn: (1) Continuous adherence to the "bills only" policy was and is undesirable. (2) The discount mechanism should be used primarily as a "defensive" weapon of monetary policy. (3) Moderate increases in reserve requirements might be a useful tool of credit restraint, to achieve a quicker, more pervasive impact on bank reserve positions and the money supply. (4) Selective controls on consumer and mortgage credit might prove useful supplements to general credit

Some investment aspects of accumulation through equities

Abstract: THE TERMS OF reference for this paper relate to systematic plans for saving or accumulation through common stocks. Such plans might include (a) a pension plan concentrating on equities, such as the CREF arrangement for college professors; (b) the very similar mechanics of the newly developing variable annuities; (c) systematic purchases of mutual-fund or closed-end investment company shares; and (d) an individual dollar-averaging plan, such as the monthly-purchase program of the New York Stock Exchange. The chairman has asked me to consider investment aspects of such plans in longer perspective and to give my views on the following questions: What results can be expected from them in the future as compared with the results either of the shorter-term pasti.e., since 1949-or of the longer-term past, going back into the last century and farther? How good will common stocks be as an inflation hedge in the future? Can dollar-averaging be counted on infallibly to produce satisfactory results? More specifically, can the much better performance of common stocks as against bonds be counted on to repeat itself in the next fifteen years? I shall leave the chances and the effects of atomic war out of the following discussion, except for some observations regarding the indefinite continuance of the Cold War. Which of the two past periods will the future stock market resemble more closely-that of 1949-61 or that of, say, 1871-1961? The latter comprises the 90 years for which we have commonstock indexes of earnings, dividends, and prices, as compiled first by the Cowles Commission and then continued by Standard & Poor's. In discussing equity experience in terms of the future behavior of these indexes, we are assuming that the various equity-accumulation plans within our purview are likely to show results, in the aggregate, approximating those of the S-P Composite or 500-Stock Index. It would seem easy enough to equal these average results; all that is needed is a representative diversification "across the board" and without that selectivity which is a watchword of today. But, para-

Is the portfolio control of financial institutions justified

Abstract: WHILE MOST firms are allowed to select their assets freely, financial intermediaries are severely limited in their asset choices. I shall attempt here to see whether one can justify this disparate treatment and whether I can reconcile my intuitive feelings in favor of portfolio control with my libertarian conscience. Let us therefore see whether a justification for asset control can be provided by the reasons usually given for interfering with the free play of market forces. The most important of these are (1) absence of sufficient competition,' (2) consumer ignorance of the nature of the product, (3) economic instability, inflation, and underemployment, (4) external economies and diseconomies, and (5) "wrong" choices by the consumer.2

Should the treasury auction long‐term securities?*

Abstract: COMPARED WITH many other national economic goals, reducing the debt management costs of the Treasury is an objective of secondary importance Moreover, such measures as increasing reserve requirements for commercial banks, imposing liquid-asset requirements on non-bank financial intermediaries, and modifying the selection of debt maturities would probably do far more to reduce the Treasury's interest costs than any change in its specific marketing techniques (or mix of techniques)' Nevertheless, an examination of alternative debt-marketing techniques may be worthwhile, since (a) even a relatively small reduction in the Treasury's interest payments is probably desirable2 and (b) more significant interest-minimizing actions, such as those just mentioned, may be politically unacceptable or administratively impractical This paper considers one modest, but frequently suggested, debt-management proposal-that the Treasury experiment with sealed-bid auctions to sell marketable securities maturing in more than one year The Treasury's current practice is to sell all its coupon issues

Optimum rate on time deposits

Abstract: THE ACTION OF THE Federal Reserve Board in raising the ceiling on time deposit rates reopens the debate about higher rates on time deposits at commercial banks.' Profitable loan and investment outlets, more efficient use of reserves, and the possibility of attracting new funds, either domestic or foreign, argue for higher rates. High marginal costs argue against an increase. The debate, at both national and local bank levels, is hampered by the absence of quantitative information and is clouded by confusion about the potential sources of bank funds. This article attempts to provide a quantitative basis for the discussion and to examine some of the implications of an increase in time deposit rates for credit markets. Since the variables are numerous and the functional relationships have not been empirically tested, the results are stated as a range of possibilities rather than as a single statistical solution. The probable range that can be developed from existing knowledge, however, is narrow enough to be meaningful for most discussions. An optimum rate implies a specific point of view and definite goals. This article approaches the problem from the bankers' point of view and assumes the objective to be the profitability of the banking system. This approach was prompted by the suspicion that the best interest of the banking system might not be served by higher rates on time deposits. Although the optimum rate for the banking system may not correspond to the socially most desirable rate, an understanding of the bankers' position provides the basis for an exam-