ENVESTING IN FARM AND NfiNFARM EQLHTIES Thesis for the Degree of M. S. MICHIGAN STATE UNIVERSETY William EMdge Kost 1957 [£15515 ‘ Q LIBRAR} Michigan 3” Univcr ty ABSTRACT INVESTING IN FARM AND NONFARM EQUITIES by William Elvidge Kost This thesis studies in depth two equity investments: farm real estate and common stock. The vantage point for this study will be that of an indi— vidual with funds available for a general investment portfolio. Thus, these two equity investments are viewed more as a means of longer run, general investment rather than that of providing one's primary occupation. Since particular investments fulfill different investor objectives they fit into different portions of a total personal investment program. Because we are considering only a specific portion of this total investment program the degree of simi- larity between farm real estate and common stocks must be high before their rates of return can be directly compared. The first half of this study shows that these two investments have many similar characteristics. There are only three major differences: differences in (1) relative marketability, (2) degree of ownership and (3) investor attitudes toward them. With these exceptions they are similar in their invest- ment advantages and disadvantages as well as in the manner in William Elvidge Kost which they are valued. The second half of the study compares the rates of return on these investments. Three rates of return were calculated for each for the period 1950-1963. Farm real estate rates of return are based on aggregate data for the United States while rates of return for common stock are based on data from a ran- dom sample of one hundred common stocks listed on the New York Stock Exchange. The total rate of return is composed of two separate components: an income rate of return and a price rate of return. The income rate of return is the ratio of net earnings to the value of the investment. For common stocks this means that net corporate earnings are used instead of dividends. This is necessary to make the common stock income rate of return comparable to that for farm real estate. The average income rate of return for farm real estate over the fourteen year period is 4.41 percent and 9.31 percent for common stock. A U-test showed that the income rate of return for common stock is significantly higher than that for farm real estate. The price rate of return is a measure of the change in the purchasing power of the investment. It is computed by dividing a change in the value of an investment into two com- ponent parts: that change in value due to a change in the William Elvidge Kost quantity of the investment and that portion due to a change in the price of the investment. The price component adjusted for changes in the purchasing power of money and divided by the value of the investment is the price rate of return. The average price rate of return for farm real estate and common stock is 4.85 and 8.64 percent respectively. A U-test showed that there is no significant difference between the two. The total rate of return is the sum of the income and price rates of return. The average total rate of return for common stock is 17.94 percent and 9.26 percent for farm real estate. A U—test showed that the common stock total rate of return is significantly larger than that of farm real estate. These three rates of return are presented separately so that investors may compare the relative merits of income and capital gains. In summary, the rates of return for common stock for the 1950—1963 period are larger than comparable rates of return for farm real estate. However, common stock returns showed larger fluctuations than returns from farm real estate. Elimination of biases in the data would narrow the spread between the farm real estate and common stock rates of return. INVESTING IN FARM AND NONFARM EQUITIES by William Elvidge Kost A THESIS Submitted to Michigan State University in partial fulfillment of the requirements for the degree of Master of Science Department of Agricultural Economics 1967 ACKNOWLEDGMENTS It is literally impossible to acknowledge individually all those who have been kind enough to read portions of this thesis and/or listen to my discourses, sometimes at length, on the topic at one stage or another. They have all contributed many helpful suggestions. Therefore, so as not to slight a single individual, I offer a collective "thanks" to all. A special acknowledgment is due Dr. David H. Boyne, my major professor, who supervised and encouraged me throughout my graduate program, and Dr. L. L. Boger, Chairman of the Depart- ment of Agricultural Economics, Michigan State University, for the financial assistance that made this study and my graduate work possible. Thanks must also be given to the secretarial staff, especially Nelda Wardell, who have helped in countless ways. It is perhaps needless to note that in the final analysis I alone am responsible for the content and organization of this thesis and stand ready to face up to or dodge, as the case may be, any criticisms resulting therefrom. ii TABLE OF CONTENTS ACKNOWLEDGMENTS. . . . . . . . . . . . . . . . . . . LIST OF TABLES . . . . . . . . . . . . . . . . . . . LIST OF FIGURES. . . . . . . . . . . . . . . . . . . Chapter I II III IV VI INTRODUCTION . . . . . . . . . . . . . . . INVESTING. . . . . . . . . . . . . . . . . INVESTING IN FARM REAL ESTATE. . . . . . . Advantages of a farm real estate investment. . . . . . . . ... . . . . Disadvantages of a farm real estate investment. . . . . . . . . . . . . . Valuation of farm real estate . . . . . INVESTING IN COMMON STOCK. . . . . . . . . Advantages of a common stock investment. . . . . . . . . . . . . . Disadvantages of a common stock investment. . . . . . . . . . . . . . Valuation of common stock . . . . . . . THEORETICAL FRAMEWORK FOR COMPARING INVEST- MENTS IN FARM AND NONFARM EQUITIES . . . . A COMPARISON OF COMMON STOCK AND FARM REAL ESTATE INVESTMENTS . . . . . . . Comparable rates of return for common stock and farm real estate. . . . . . Disaggregation of common stock rates of return . . . . . . . . . . . Comparison with the Fisher and Lorie rates of return . . . . . . . . Biases in the calculated rates of return . . . . . . . . . . . . . . iii Page ii vi l6 16 23 27 38 41 43 45 50 63 63 73 82 82 Chapter VII SUMMARY AND CONCLUSIONS. . BIBLIOGRAPHY . . . . . . . . . . . . APPENDIX I II III Construction of the Constant Dollar Value Series for Farm Real Estate. Construction of the Constant Dollar Value Series for Common Stock. Corporations Included in the Random Sample of Common Stocks. iv Page 87 96 100 103 104 LIST OF TABLES Table Page 3-1 Summation Method Used by the Federal Housing Administration in Determining Capitaliza- tion Rates for Residential Income PrOperties. . . . . . . . . . . . . . . . 32 3-2 Computation of a Capitalization Rate by the Band-of-Investment Method--An Example . . 33 4—1 Outline for Common Stock Investment Analysis 47 6-1 Income Rates of Return for Common Stock and Farm Real Estate, 1950-1963 . . . . . 65 6-2 Price Rates of Return for Common Stock and Farm Real Estate, 1950-1963 . . . . . 68 6-3 Total Rates of Return for Common Stock and Farm Real Estate, 1950—1963 . . . . . 71 6-4 A Summary of the Rates of Return for Common Stock and Farm Real Estate, 1950-1963 . . 74 6—5 Income Rates of Return for the Four Classes of Common Stock, 1950-1963. . . . . . . . 75 6-6 Price Rates of Return for the Four Classes of Common Stock, 1950-1963. . . . . . . . 77 6—7 Total Rates of Return for the Four Classes of Common Stock, 1950-1963. . . . . . . . 79 6-8 A Summary of the Rates of Return for the Four Classes of Stock, 1950-1963. . . . . 81 6—9 A Comparison with the Fisher and Lorie Total Rates of Return, 1950-1960. . . . . 83 LIST OF FIGURES Figure Page 5-1 Price and Quantity Components of a Change in Value . . . . . . . . . . . . . 54 6—1 Income Rates of Return for Common Stock and Farm Real Estate, 1950-1963 . . . . . 66 6-2 Price Rates of Return for Common Stock and Farm Real Estate, 1950-1963 . . . . . 69 6-3 Total Rates of Return for Common Stock and Farm Real Estate, 1950-1963 . . . . . 72 6—4 Income Rates of Return for the Four Classes of Common Stock, 1950-1963. . . . . . . . 76 6-5 Price Rates of Return for the Four Classes of Common Stock, 1950-1963. . . . . . . . 78 6-6 Total Rates of Return for the Four Classes of Common Stock, 1950—1963. . . . . . . . 80 vi CHAPTER I INTRODUCTION The purpose of this thesis is to study in depth two classes of equity investments: farm real estate and common stock. Every investment that an individual makes should fit a niche in his overall personal investment program. Differ- ent investments fulfill different needs. The vantage point for this study will be that of an individual with funds available for a general investment portfolio. Thus, these two types of equity investments are viewed more as a means of longer run, general investment rather than that of pro- viding one's primary occupation. Common stocks obviously fill this criterion. Some may consider an investment in farm real estate, in most cases, to be an investment in an occupation. However, for the 1950-1964 period an average of thirty-eight percent of United States farm real estate was tenant Operated. This shows that a significant portion of farm real estate is considered an investment, rather than an occupation, by its owner. Since particular investments fulfill different investor 1 2 objectives they therefore fit into different portions of a total personal investment program. Because we are here con- sidering only a specific portion of this total investment program it is important to investigate the similarities and differences of these two classes of equity investment. Are farm real estate and common stock close substitutes in an investment portfolio? If they are highly similar on such characteristics as risk, management, taxation, marketability, etc., then the rate of return becomes a key variable in selecting the class in which to invest. The aim of the next three chapters is to make a detailed comparison of all factors except the rates of return for the two investments. The con- clusion for this part of the study is that farm real estate and common stock are highly similar. Chapter II attempts to answer the question of why one should invest, how a personal investment program should be formulated and what some of the broad criteria are by which one may judge any investment. A discussion of the advantages, disadvantages and valuation methods for both farm real estate and common stock, based on the general investment criteria presented in the second chapter, is presented in Chapters III and IV respectively. On the basis of the discussion in these three chapters farm real estate and common stock may be compared on the basis of their relative rates of return. They have very similar characteristics and fulfill the same functions in an individual's personal investment program. Thus, the next two chapters consider the rates of return for these two equities for the period 1950-1963. Chapter V presents the basic model by which comparable rates of return will be calculated and Chapter VI presents the empirical results of the study. The final chapter consists of a brief summary of the first six chapters as well as the conclusions reached therein. CHAPTER II INVESTING Why should an individual invest his money? Before attempting to answer this question let's ask another: why should an individual save his money? There are many reasons why he may wish to save. He might wish to prepare for future family needs, such as buying a home or educating his children. A fund may also be set aside to provide aid in case of the death of the income pro— ducer. He may wish to use his savings to provide a supple— mentary or a retirement income for himself and his family. Savings can also be used to create an estate for future generations. It is now pertinent to ask why one should invest his money. In the broadest and commonly accepted sense an in- vestment is any asset held for the purpose of conserving capital and/or earning an income. Therefore, investing can be looked upon as the process of putting savings to work in order to meet personal saving objectives. This definition does not differentiate between safe and hazardous invest— ments, tangible and intangible investments, nor between 4 5 personally and institutionally managed ones. This defini- tion recognizes that savings accounts, life insurance, mortgages, bonds, stocks, real estate and other earning assets all fulfill the same basic function of employing their owner's savings. Investment in a more limited sense is sometimes used to suggest a commitment that is relatively free from risk with emphasis on protection of principal and real income producing ability. No sharp line separates this definition of investment from speculation and speculation from gambling. The distinction between the three is a matter of degree. Speculation means the deliberate assumption of risk in a venture in the hOpe of obtaining high income yields or, more commonly, large capital gains. Speculation involves choosing ventures with care, balancing the risks involved against the expected Opportunities for capital gains. To the best of his ability the speculator is making calculated risks. The difference between investment and speculation is the degree of risk involved. Speculating heavily on the basis of "market tips" and accepting risk with no desire to identify, appraise and balance the risk with the estimated gains is gambling. Thus, the degree of risk and ones atti— tude toward a venture determines whether it is classified as an investment, a speculation or a gamble. 6 An investor is faced with two problems -- what to buy and when to buy. What to buy is determined by what types of investments are apprOpriate for his personal saving objec- tives and the amount of risk he is willing to assume. He must decide what Specific investment will satisfy his re- quirements. Every individual should establish a personal invest- ment program. Anyone who decides to institute an investment policy for himself will soon realize that his plan must have a definite purpose. It must be formulated to meet certain needs and objectives. To determine these the individual must examine his own future. The organization of a personal portfolio can be broken down into five parts. These parts might reasonably be considered in the following order. First, one would want a certain amount of working capital set aside to meet regularly occurring home and business ex- penses. This could conceivably be in the form of cash or a checking account. Next, one should consider an adequate insurance protection plan on the head of the household to help assure family security in the case of death or dis- ability of the breadwinner. Third on the list should be a highly liquid emergency fund. This fund would probably be used and replaced many times by the family. Therefore, it should be in a convenient form and be readily available 7 without delay, inconvenience or heavy costs. This emergency fund might take the form of a savings account, insurance reserves or government savings bonds. The next portion of the personal portfolio should consist of investments in a home and a personal business if necessary. The last portion of the portfolio should consist of a general fund which would receive all sums not accounted for above. The objective of this portion of the plan might possibly be to provide retire- ment or supplementary income or provide money for some other distant future purpose. In planning a personal investment program one should consider his family and financial situation. What are the ages and health of the individuals that are to be the pri- mary beneficiaries of the portfolio? How many dependents, current and future, need to be considered? What about the ages and health of these dependents? How much is currently available for the portfolio? What is the current debt situation? What is the occupation of the breadwinner and how much income does he eXpect to receive from his occupa— tion and from other sources? What is the extent of the individual's training and experience in investment and financial matters? What are the investment goals -- a large estate, early retirement, travel, a home, . . . ? What is the investor's disposition? Is he a risk avertor or a risk acceptor? Answers to the above and similar questions will help in determining an investment philOSOphy which will be con— sistent with the investor's savings objectives, his circum- stances and his temperament. They provide a basis for deci- sions involving safety, growth of principal, current income and the preservation of the purchasing power of the investment. An individual will not have a single savings objective but after careful thought will have a list of objectives and will then be able to weight his investment decisions accordingly. In choosing specific investments the investor will need definite ideas about certain features that his portfolio should have. All investments involve an element of risk. In fact the problem of investment is in large part that of deciding on a policy toward risk. The investor must decide upon the degree of risk he is willing and able to assume and then appraise the degree and types of risk present in the indi- vidual investments. Four somewhat overlapping classes of risk are considered. The first type of risk is the financial or business risk. Every business or prOperty is subject to this risk. The earning power or usefulness of an investment may diminish because of changes in competition, demand, costs, government 9 action, management errors or any other adverse event. In- vestments are all vulnerable to financial risk to a greater or lesser degree. For example, there is very little finan- cial risk involved in United States government bonds While common stock and real estate are more subject to it. Interest rate risk applies eSpecially to fixed income securities of long or indefinite maturity; such as bonds, mortgages and preferred stocks; but it may also apply in a smaller degree to variable income securities such as common stocks and real estate. Interest rate risk refers to the fact that income securities increase in value when the inter- est rate on new security issues declines and decrease in value when interest rates on new issues rise. Thus, a security that is subject to little or no financial risk may be subject to a great deal of interest rate risk. Selection of short term fixed income securities would minimize the effect of interest rate changes on the investment because the money would be released for reinvestment sooner to take advantage of the new market interest rates. This policy may not be completely satisfactory since the cost of constant reinvestment would be high and the interest rates on short- term investments may average lower than long—term rates due to the increased uncertainty of recovering the principal in the longer run. It could be argued that the investor may 10 hold the security till maturity and complete the contract as he originally planned, but this policy would still subject him to either a capital loss or an income below the going rate for a long period of time. This is theoretically balanced by the chance of gain in the case of falling in— stead of rising interest rates but it still should be taken into consideration when investigating investments subject to this risk. Another type of risk that investments are subject to is the purchasing power risk. Purchasing power risk is due to changes in the purchasing power of the monetary unit or in the general price level. This will affect both the principal in and the income derived from an investment. Fixed income securities are especially susceptible to pur- chasing power risk. Receipt of dollars is certain, but the value of those dollars is uncertain. Market prices of investments may fluctuate substan- tially even though their earning power remains constant. Market risk is the risk of investing when the market price is high relative to the earning power of the investment or selling when it is underpriced. There are many reasons why prices fluctuate. Commonly investments vary in price because of changing investor's opinions about the future desirability of the investment; or as Lord Keynes once said, differences 11 in, ". . .the average man's Opinion of what the average man's Opinion will be."1 Adverse fluctuations in the market price of an investment is not as undesirable as adverse changes in earning power as long as one does not have to sell or borrow on it; though given enough time changes in earning power are reflected in changes in market prices. The only investments that are completely immune to market risk are those which are always available in cash, such as a savings account. Since risk is a part of all investments the investor may wish to minimize his risk by following a policy of diversification in his portfolio. Diversification means dividing the portfolio into segments on the basis of industry, financial type, maturity, location, management and so forth. If this is accomplished, losses due to adverse effects in any particular segment of the economy or country will tend to be minimized. Diversification, however, can be wasteful if carried too far. Too many different securities can re- quire too much time to manage prOperly and become uneconom- ical because of excessive commission and other transaction charges. Directly related to risk is the rate of return or yield on the investment. Yield may be defined as the ratio lBernhard, Arnold, The Evaluation of Common Stock, Simon and Schuster, New York, New York, 1959, p. 36. 12 of current net income to the current price of the invest- ment. The yield on an investment can be looked upon as the sum of the rate of compensation for the use of money in- vested plus the rates of compensation for risks and other imperfections of the investment. For those who must depend on their investment for most Of their income, the yield will be one of the most important characteristics of the invest- ment. They will be interested in as high a yield as possible on their capital. Also they will want as little year-to— year variation in the yield as feasible. Another feature one should consider in planning his portfolio is safety. Depending on the objectives, one may be interested in safety of principal and/or safety of income. In both cases there are two types of safety: "dollar" safety and ”purchasing power” safety. In the first case, one would be maintaining the nominal value of the investment or having a steady and safe flow of nominal income from it. This safety objective would be subject to the purchasing power risk. An example here might be a savings account where the original sum invested would be relatively safe and the income from this account would be stable as well as safe. The other case would be that of minimizing the pur- chasing power risk in order to maintain the real value of the principal or the income. For this one might consider 13 certain "blue chip" common stocks. These represent tangible goods and their price and earning power in dollars would be eXpected to vary prOportionally with all commodities and with the purchasing power of money. In some cases, capital appreciation or growth may be a more important feature than current yield. One who is actively employed may be more interested in building up the value of his assets for the distant future than he is of earning an income from them now. The marketability of an investment is also an impor- tant feature. Marketability refers to the degree of readi- ness with which an investment may be converted into cash. It is especially important for an investment to be highly marketable if it suffers from major price fluctuations. Also, to be marketable the investment should be capable of being purchased or sold with little expense and trouble. If an investor thinks that in the future he may have a temporary need for money, but does not want to sell his investment asset and buy it back later, he should consider those investments that have a high value as collateral for a loan. An investment that has a relatively stable value will usually be taken by a lender as security for a loan. The more stable and the more marketable the investment is the more you can borrow relative to the value of the investment. 14 Investment policy is also affected by the tax policies of the federal and state governments. As elsewhere, the in— vestor should be interested in the net returns from his in- vestment and must therefore take into consideration any changes in net returns due to differences in tax structures for different investments. The investor must consider the advantages and disadvantages of income tax, capital gains tax, estate and inheritance tax and prOperty tax policies in making his investment decisions. One must also consider the minimum sum that is required to make a Specific investment. Even though an investment meets all of the requirements of an investor, the minimum denomination may be so high that the specific investment is out of his relevant range of investment possibilities. The existence of risks in all investments makes "buying good things and then forgetting them" impossible. Constant supervision is necessary for all investments in order to receive good returns and/or prevent losses. The degree of supervision required by an investment varies. Some require constant attention while others require only cursory treat- ment. Some investments require more than just watching securities. Active control of the investment may be re— quired by the investor instead of the passive kind that is associated with the management of most securities. Supervision 15 and control of an investment requires time. Investments here have been discussed in terms of investing for a general portfolio fund and not as a full—time profession. Thus, other things equal, an investment that is relatively free from care is preferred to one that is not. Don't hire yourself to do a job that someone else wouldn't hire you to do is an old saying that has some rele— vance for an investor. In planning an investment program one must ask himself if he is proficient enough to go it alone. If not, he should obtain the best advice he can from outside sources. But, one must not forget that this outside investment help and advice is secured only at a cost and should be obtained only as long as it is profitable to do so. So far we have discussed personal portfolio investment objectives and the general criteria one must consider in making investment decisions. An investor's most important task is to develop investment goals that are consistent with his investment philOSOphy, temperament and personality and then stick to these goals. CHAPTER III INVESTING IN FARM REAL ESTATE What is meant by farm real estate? Farm real estate here will be defined to include land, tenements and other buildings, other improvements, patent rights and heredita- ments used for agricultural purposes. Thus, an investment in farm real estate would be an investment in what is com— monly defined as a "farm" for farming purposes. Advantages of a farm real estate investment Farm real estate as a field of investment offers several distinct advantages to certain investors. Farm real estate is an earning asset. Investment in it will return a current flow of income and/or a capital gain. Since returns are dependent upon earnings, an invest- ment in farm real estate is not subject to a large amount of interest rate risk. Therefore, when the farm business earnings are increasing, the investor will not be forced to settle for a fixed income stream —— fixed at a relatively low level -- but will be able to reap some of the benefits from the larger earnings through larger returns to the farm real estate. 16 17 Since it is an earning asset, where current returns are dependent upon current earnings, the value of farm real estate can be expected to increase as the general price level increases. That is, farm real estate provides a good hedge against inflation and therefore is not subject to pur- chasing power risk. Another incentive for investing in farm real estate is provided by the United States tax structure. One tax advan- tage an owner of farm real estate may claim is that of a depreciation deduction for that portion of farm real estate that is depreciable prOperty. The purpose of this deprecia- tion deduction is to let the investor recover his investment in depreciable prOperty over the useful life of such prOperty. It permits the investor a reasonable allowance for the ex— haustion, wear and tear, and obsolescence of property held for the production of income. This will reduce the investor's taxable income. A second advantage the investor in farm real estate finds in the tax structure is the investment credit pro- vision (instituted in 1962). Under this clause certain new or used depreciable property, acquired for use in the farm business, can be used to reduce the investor's income tax liability by a certain percentage of the value of the quali- fied investment for the year the asset is acquired. Both 18 the depreciation allowance and the investment credit provi- sion allow the investor to reduce his income tax liability. A third method by which an investor in farm real estate might decrease his income tax liability is through a carry— back adjustment for net Operating losses. If in a calendar year, ". . . the total of your losses from Operation of your farm, sale or other disposition of depreciable prOperty or other prOperty used in your trade or business, casualty, or sale or exchange of stock of certain small business corpo- rations, exceeds your income from all other sources, . . .,"l then this net Operating loss may be carried back three years to offset the net income for that year. If any excess net Operating loss still remains, it may be utilized to offset the net income earned two, then one year prior to the current calendar year. If any excess still remains it may be carried forward, for five years, as a debit against future income until it is absorbed. Another incentive to invest in farm real estate is provided by the current capital gain and loss provisions of the income tax law. Under these provisions gains and losses from the disposal of assets used in the farm business and held for six months or more are treated as gains and losses lFarmer's Tax Guidele964 Edition, United States Treasury Department, Internal Revenue Service, Publication NO. 225, p. 31. 19 from sales of capital assets.2 The income from the capital appreciation of the farm real estate is thus eligible to be taxed at a much lower tax rate than is income derived from current Operating profits. Not only is the income from capital appreciation taxed at a lower rate, but it is not taxed until such time that the actual gain is realized by the sale of the capital asset. Farm real estate will assimilate large inputs of capi- tal. It will therefore provide investors in the higher in- come brackets an Opportunity to transform some current Operating income into income from capital gains. The farming enterprise can, in this manner, be Operated so as to show a net accounting loss, thereby lowering the investor's income tax bracket as well as transferring part of his "real" current income to capital gains income which will be taxed at a later date as well as at a lower rate. In this case, it could be possible that the investor in farm real estate, who is in a high income tax bracket may find it to his advantage to invest in his farm real estate beyond the high profit point to capital in the farming enterprise or to sell his farm real estate at a price that would represent an out— right loss to an individual whose only income is derived 2In the case of livestock, they must be held for twelve months or more before qualifying. 20 from the farming enterprise or one who has a much lower in- come. The point at which the investor stOps investing in his farm real estate will be a function of his "true” mar- ginal income tax rate for his income from all sources. The effects of the capital gains tax may be mitigated by retaining ownership of the asset until the death of the original buyer. When the asset is transferred to the in- vestor's heir a new cost base is acquired. This base is determined by the market value of the farm real estate at the time of death of the original owner. The new owner or owners may sell the farm real estate subject to little or no capital gains tax, or this inheritance process may be continued for another generation. It is true that inheritance taxes will still have to be paid as they would in any case. But appraisal practices of farm real estate for inheritance tax purposes are differ- ent than for other assets. An estate consisting of nego—. tiable securities will, in most cases, be valued at current market prices as of the date of death; while an estate con- sisting of farm real estate will seldom be appraised for inheritance tax purposes at current market prices. This gain through relatively lower inheritance taxes, however, may be partly Offset if the heirs decide to sell the farm real estate, as the base for computing the amount of capital 21 gain will therefore be lower. But even in this case there will tend to be a relatively lower total tax liability. To a certain extent, farm real estate has maintained its popularity due to the fact that the owner could easily see and inspect his investment as well as exert direct per- sonal control over it. The ordinary investor in equity securities does not have a direct voice in or control of the management of the enterprise in which he has invested. He has only a limited indirect influence upon management. Investing in farm real estate has been discussed, so far, in terms of it entering into the general investment fund portion of an individual's total investment program. By investing in farm real estate the investor may also meet another of his personal portfolio Objectives. As well as providing a place for his excess funds an investment in farm real estate may provide him with a home. It may also contribute to family living by providing unlimited access to natural resources and recreational facilities such as hunting and fishing. In certain instances an investment in farm real estate could also provide a form of occupa— tional insurance. Farm real estate, more so than any other type of in- vestment, has affiliated with it strong elements of tradi- tion, as well as social beliefs and values, as to its innate 22 virtues. To many peOple farm real estate has a special appeal. It is tangible and exists forever. The owner can, possibly with rapture, observe his property, walk on it and feel its substance; while if he owns intangibles he can find comfort only in a mental image, a fragile, tenuous paper ex- tending by law his rights to the actions and prOperties of others. These agricultural fundamentalistic views regarding farm real estate vary in degree and over time among differ- ent individuals. Einaudi sums up some attitudes that are as applicable to certain individuals in the United States now as they were to some Italians in 1934: The land is not sold by comparing the mar- ginal yield obtained from it with that which could be obtained by reinvesting the proceeds of the sale. Perhaps the only case which has some affinity with sales for 'economic reasons' is that of the peasant who owns a little bit of land -- and who sells it in order to buy a larger farm. But to sell for the sake of sell— ing, for the sake of a good bargain, so as to have a nice little sum of money in the bank, no, never. Such an idea never crosses the peasant's mind. . . Land for sale does not appear on the market until one or the other of the events. . .described occurs; economic con- vulsions, as in the post-war years; the ruin of a peasant family due to idleness, or in the case of gentry, gambling, bad behavior or slow exhaustion and financial difficulties long disguised by the creation of debt. Apart from such circumstances, the axiom governing the normal economic conduct of a landowner is that land is 223 for sale. This is not an economic axiom; it is born of instinct and is incompre- hensible to the townsman. Those in whom that 23 instinct works buy but do not sell. To sell is an illicit, immoral act, which their moral code forbids." For some peOple, the belief that land is basic to our economy and the pride of ownership received from the posses- sion of farm real estate provides reason enough to invest here over other alternative investments. Another advantage that one might attribute to invest- ing in farm real estate concerns the effects of government farm programs in agriculture. Most of these programs have had as their goal stabilizing and/or increasing farm incomes. This might provide an incentive for investing in agriculture. However, the fact that most farm programs are "temporary" in nature might have a tendency to offset any advantages attri- buted to them. Disadvantages of a farm real estate investment Some possible advantages of and reasons for investing in farm real estate have been cited. But investment in farm real estate is not one-sided. For some individuals this investment has certain distinct disadvantages. One of the advantages attributed to farm real estate above was that it was an asset where returns were dependent 3Scofield, William H., "Prevailing Land Market Forces," Journal of Farm Economics, Vol. 39, December 1957, p. 1509. 24 upon earnings. As an investment it may be subject to little interest rate risk but it is susceptible to financial or business risk. It was also stated that an advantage of farm real estate was that it acted as a hedge against inflation. While the value of farm real estate increases with increases in the general price level it must not be forgotten that the reverse is also true. In periods of deflation the value of farm real estate will decrease, unlike that of fixed value investments. The same argument applies to the income pro- duced by farm real estate as well as to the value of the investment. A second disadvantage associated with investments in farm real estate lies in the relatively large minimum invest— ment that is required to obtain an economically viable unit. This large initial outlay almost eliminates those investors who have only a small amount to invest. A small investor may still invest in farm real estate by taking advantage of the liberal credit facilities available to purchasers of farm real estate. However, to do this, it will mean tying up future investment funds. Because future investment funds are tied to a specific investment, the buyer will not be able to follow a comprehensive diversification policy with respect to his general investment portfolio. 25 Another disadvantage is due to some typical character— istics of the farm real estate market. Farm real estate is not a standardized product. It is a heterogeneous product, not easily graded or described in common terms. Since farm real estate is an immobile asset, its market value must be determined on the basis of its use only at its present fixed location. Because of this, farm real estate transactions occur in many local markets instead of a single national market or a few closely integrated markets, with no stand- ardization, with lack of market organization and limited communication of information. With this dependence upon local supply and demand con- ditions the number of transactions is often so low that an objectively observed level of farm real estate prices cannot be reported. This is due, in part, to the absence of specu- lators in the market, in the sense of being ready to clear the market of all offerings. These characteristics plus the general inexperience of the average buyer and seller, due to their infrequent participation in the market, cause farm real estate to lack marketability. This uncertainty and slowness of the farm real estate market implies the presence of a relatively large amount of market risk. Another possible reason that may cause the marketability of farm real estate to be lower involves the problem and expense 26 of obtaining a merchantable title. The investor in farm real estate must also consider the fact that he has Operating and maintenance expense obli— gations to meet. Farm real estate also has some general prOperty taxes which are fixed expense that must be paid every year whether a net income was produced or not. These are reoccurring expenses and, in a sense, represent "out-of- pocket" costs. This is especially true when the farm incurs a net Operating loss. Even in the case Of a net Operating profit the timing of the inpayments and outpayments may be such that the investor incurs a "short-run" loss. Thus, an investor in farm real estate is forced to have a relatively larger fund of working capital than would be necessary else— where. In discussing the tax advantages of farm real estate above, the benefits of a depreciation expense allowance were examined. While this improves the current income picture, it must not be forgotten that, at the same time, it implies a decreased value of the original investment. This is true of all equity investments. Another advantage previously discussed concerned the possibility of exercising complete ownership control over the farm real estate investment. Managing and supervising the farming enterprise requires relatively more time than 27 for more intangible investments. It also entails a certain degree of more specialized knowledge and experience. This personal responsibility and time involved may be a disadvan- tage, although not a major one, for some investors. By utilizing the facilities available in many commercial bank farm departments or professional farm management services the investor can negate this disadvantage at a relatively modest cost. A final disadvantage attributable to farm real estate concerns its value as collateral for loans. Farm real estate is not as satisfactory as common stock, especially from the viewpoint of divisibility. The relative illiquidity of farm real estate also greatly affects loans made upon it. Valuation of farm real estate Some pros and cons of farm real estate investment have been discussed. The most relevant question to ask now is -- "What is farm real estate worth?” No one actually knows the answer. The best reply is the old standby —— ”That depends." To have worth a thing must have utility. Therefore, the worth of a thing is a subjective concept that is determined in the mind of each individual. Value, on the other hand, is a general overall quality of worth that exists in a thing measured in terms of money. There are then two kinds of 28 value: subjective value and market value. Subjective value is a measure of the worth of a thing, in dollars, determined by an individual. While it is subjective in the sense that it is determined by an individual, it can be determined by this individual in a systematic, objective manner. Market value, on the other hand, measures the worth of a thing, in dollars, in the marketplace; it is a group determination of worth. The investor is interested in both the subjective value and the market value of farm real estate. The subjective value tells the investor how much he is willing to pay for the farm real estate while the market value tells him how much he has to pay before ownership will be transferred to him. This relationship between subjective value and market value determines whether the investor purchases the farm real estate or not. If the subjective value is greater than or equal to the market value he will buy the farm real estate. If the market value is greater than the subjective value he will not buy it; it will ”not be worth what it sold for" to this investor. In an attempt to answer the above question, two sys- tematic farm real estate appraisal methods will be discussed: income capitalization and market comparison.4 In the final 4For a detailed discussion of rural appraisal see Murray, William G., Farm Appraisal and Valuation, Iowa State University Press, Ames, Iowa, 1961. 29 analysis the answer will still be the same -- "That depends." The solution will be heavily dependent upon the assumptions made during the appraisal process and these assumptions are a function of the individual's subjective knowledge and expectations. Income Capitalization Approach. Traditional economic theory says that the value of any durable productive asset is the discounted present value of the future stream of earnings from its most productive use. This income capitali- zation approach is usually emphasized in most farm real estate appraisals because of the large weight placed on the future income producing ability of the individual prOperty. For most prOperties, earnings constitute a basic value which is attainable and subject to calculation. Earnings, therefore, provide a positive foundation on which farm real estate can be judged. An appraisal, using the income capitalization approach, can be made by determining four estimates or expressions of Opinion; the annual gross revenue that the farm real estate will produce, its annual total cost, the prOper capitaliza- tion rate and the adjustments necessary to account for all those factors that are not fully reflected in earnings. The first step in the income capitalization approach is the estimation of the future net earnings from the farm 30 real estates most productive use. These net earnings are the annual flows of economic rent that the piece of farm real estate can reasonably be expected to earn in the future. There are two methods of obtaining the farm real estate's economic rent after gross revenues are determined: the landlord-tenant method or the owner—Operator method. The estimates made by the first method represent the net income received by the landlord for the use of his farm real estate while those from the latter depict the amount that the owner has left as a return on his farm real estate after all expenses have been deducted. Either method may be used to determined the economic rent regardless of the plan to be followed on the farm. Both methods have their disadvantages. The owner—Operator method is subject to the problem of allo- cating net profit from farming to the various factors of production. The landlord—tenant method involves the issue of rental share determination. The landlord-tenant method is generally preferred because the owner-Operator expense deductions are harder to estimate than rental shares. This, in part, is due to the existence of a market in which rental contracts are determined by landlords and tenants. Now that the economic rent or net income attributed to farm real estate has been determined, the next step in the income capitalization approach is to choose the apprOpriate 31 capitalization rate. The capitalization rate depicts that rate of return which the investor is willing to accept on his investment. The actual rate of return that investors are willing to accept may vary greatly between individuals and between investments. So like the estimated net income attributed to farm real estate the capitalization rate has an element of personal or individual subjectivity in it. There are three systematic methods of estimating the appropriate capitalization rate. The first is the comparison method. This is an Opportunity cost concept. It is based on the relationship existing between the annual net incomes and the current market values of comparable investments. That is, if the next best alternative investment is currently earning a six percent rate of return then the capitalization rate for farm real estate should be six percent. A second approach to determining capitalization rates is the summation method. By this method a capitalization rate is constructed from independent estimates of rates for the various factors considered in the capitalization process. A separate capitalization rate is estimated for the various risk features of an investment and these separate rates are summed to give a capitalization rate for the investment as a complete unit. Each time the investor takes on an addi- tional risk the capitalization rate will increase. An 32 example of determining capitalization rates by the summation method is presented in Table 3-1. Table 3-1: Summation Method Used by the Federal Housing Administration in Determining Capitalization Rates for Residential Income PrOpertiesl Rates for Five Grades . . Rate of PrOperties Ranging For Risk Features from Poor to Excellent Property Risk Considered l 2 3 4 5 Safety of principal 3.50 3.25 3.00 2.75 2.50 Certainty of return 2.00 1.75 1.50 1.25 1.00 Regularity of return 1.75 1.50 1.25 1.00 0.75 Liquidity 1.50 1.25 1.00 0.75 0.50 Burden of management 1.25 1.00 0.75 0.50 0.25 Total capitalization rate lBarlowe, Raleigh, Land Resource Economics, Prentice- Hall, Inc., Englewood Cliffs, New Jersey, 1958, p. 192. The third method of determining capitalization rates is the band-Of—investment theory. In this case the capi- talization rate is computed as the weighted average of the market interest rates that apply to various segments or "bands" of the investment. An example of a capitalization 33 rate computed by the band-of-investment method is given in Table 3-2. When the investment is wholly financed through the owner's equity the band—of-investment method is identical to the comparison method. Table 3-2: Computation of a Capitalization Rate by the Band—of-Investment Method —- An Example Financing Market Type of Covered by Interest Weight Financing Each Type Rate (2) x (3) (l) (2) (3) (4) First mortgage 0.50 6.00% 3.00 Second mortgage 0.20 8.00 1.60 Short-term loan 0.10 6.00 0.60 Owner's equity 0.20 10.00 2.00 Total Capitalization Rate 7.20% Now that estimates of annual net income and capitali- zation rates are determined, they can, with the apprOpriate capitalization formula, be used to find the current value of drainvestment.5 As stated before the current value of an 5For an extended discussion of capitalization for- mulas see Heady, Earl 0., Economics of Agricultural Produc- tion and Resource Use, Prentice-Hall, Inc., Englewood Cliffs, New Jersey, 1952, Chapter 13. 34 investment is the discounted present value of all its future income streams. This concept is based on the theory of time preference -— income today is worth more than income tomorrow. Capitalization formulas are all based on the principle of compound interest. The present value of income received in a future period is Y n V = n ..,. (l + In) (3'1) where V equals the discounted present value of the invest- ment, Yn equals the net income received from the investment in period n, rn equals the capitalization rate applicable to period n and n equals the number of periods between the present and the time when the income is received. If income is expected to come in each period for a definite length of time the formula Y Y Y V = l + 2 + . . . + n (l + r1) (1 + r2)2 (1 + rn)n n Y. - Z l i (3-2) can be used. This equation is a sum of equations (3-1) for the periods one to n. This is the general form of the capi- talization formula. 35 After the discounted present value of the future income stream from farm real estate has been calculated it must be adjusted to account for those factors which are not fully reflected in net income. Some factors that should be con- sidered in adjusting the discounted present value are (l) the quality of roads and transportation facilities available; (2) the educational, cultural and religious facilities avail- able in the local community; (3) the location in the com- munity and neighborhood; (4) the natural resources, recrea— tional and scenic features; (5) the housing, landscaping and other farmstead improvements; (6) the public utilities available; (7) the distance from urban areas; (8) the pos— sibility of the farm real estate being subject to restricted use or having Oil, mineral and/or other rights reserved; and (9) the possibility that the prOperty is included in special improvement districts; such as drainage projects, levee and flood protection districts and irrigation projects; and is, therefore, subject to special bonded indebtedness. Farm real estate value to an investor stems from two sources. The first, the future income stream, has already been discussed. A second important determinant Of farm real estate is through future changes in real estate price that are not or not completely supported by future income changes. These capital gains or losses change the investors' real 36 wealth position. These future real wealth changes should be capitalized separately from the future income streams. They should be capitalized independently so that the investor may express his differing preferences for these two types of "income”. He can do this by capitalizing these two "income" streams with different capitalization rates. After the discounted present value Of the farm real estate has been adjusted for the above factors, the investor will have, what he considers to be, the best estimate of the subjective value of the farm prOperty. Market Comparison Approach. A second real estate ap- praisal method that is frequently used is the market com— parison approach. With this approach the prospective in- vestor would examine market conditions and price relation- ships associated with the sale of comparable farm prOperties. He would then value the prospective piece of farm real estate in terms of the price he feels it would bring on the current real estate market. A disadvantage of this method is that farm real estate prOperties are not homogeneous and the volume of transactions is too small to accurately determine the condition of the market. The major disadvantage of the market comparison method of appraisal is that it bases the estimate of the subjective value upon market value of prOperty. What the market 37 comparison approach really determines is an estimate of the market value of farm real estate. This is not what an in— vestor wants to determine. If an investor had perfect know- ledge and estimated the value of a piece of farm real estate by the market comparison approach, the estimate would always equal the market value of that property. While an estimate of the market value may be of some assistance, the subjective value is relatively more important. It is through the sub- jective value that the investor determines whether the property is a "good buy" or not by comparing it with the seller's price. A final question needs to be answered. Where can the investor obtain the relevant information necessary to make a decision about an investment in farm real estate? A large percentage of the information necessary for evaluation of a specific piece of farm prOperty may be obtained from its present owner and/or Operator. Other important sources Of information are county agents and state university college of agriculture extension services. Tax records and lending agencies may also supply certain relevant data. CHAPTER IV INVESTING IN COMMON STOCK Common stock represents ownership equity in private business corporations. It consists of the residual owner- ship and control of the corporation and entitles the stock- holders to all assets and earnings of the business after all other limited claims have been satisfied. Thus, the common stockholder occupies a directly comparable position to that of the owner of farm real estate or any other equity asset. While the stockholder exerts direct ownership control he only has an indirect influence on the management of the cor- poration through the election of corporate Officers. The most fundamental right of the common stockholder is to share in the net earnings of the corporation. His principal immediate benefit derived from this stream of net earnings is through the distribution of dividends. Neither the specific dollar amount of dividends nor the prOportion of net earnings distributed as dividends is Specified in the common stock contract. This decision is left entirely with the corporate management, which may be almost completely independent and separate of the majority of the stockholders. 38 39 Dividends generally mean a cash payment to stockholders out of the present or past earnings of the corporation. Divi- dend policy varies considerably but common stock dividends are usually based on one of the following plans: (1) stabi- lized regular dividends, (2) regular dividends at rates occasionally revised as earnings vary, (3) regular dividends at a minimum rate with occasional extra dividends as justi- fied and, (4) the time and amount Of each dividend based on the current situation. Dividends may not be cash, but, on occasion, may con- sist of distributions of stocks, bonds or various kinds of prOperty. Stock dividends are prOportionate payments to stockholders of additional amounts of common stock. Stock dividends increase the number of shares owned by each stock- holder but do not change his total nor his prOportionate investment in the corporation. They then represent the reinvestment of corporate profits through the capitalization of a portion of the earnings. Thus, stock dividends are similar to stock Splits. A stock split can be defined as a reduction in the par value or stated value of a corporation's common stock. This gives the common stockholder a larger number of the new shares, having the same aggregate value, in exchange for their old shares. Thus, both stock dividends and stock splits increase the number of shares outstanding 40 without changing the total capital position of the corpora- tion. The result is to reduce the value per share of the stock which will tend to make the Shares more marketable. PrOperty dividends, other than stock dividends, usually consist of (1) those paid in preferred stock or bonds of the paying corporation, (2) those paid in securities of other corporations and,(3) those paid in goods and services. PrOperty dividends, however, are uncommon except in the case of the liquidation or voluntary reorganization of a corpora- tion. The income tax position of the shareholder may be quite complex in this case. In general, securities received through voluntary reorganization or liquidation, like stock dividends and stock splits, are not considered as taxable income but as a return of the stockholder's investment in the stock of the corporation. However, to the extent that such a distribution exceeds the stockholder's original invest— ment in the stock it must be considered as a capital gain. Most other property dividends, however, are considered as taxable income. All earnings that are not paid out in dividends are either reinvested in the corporation or used to reduce any outstanding senior capital claims. Therefore, retained earnings increase the asset position and/or strengthen the financial position of the corporation. This implies that 41 retained earnings will make the corporation more profitable in the future and less susceptible to unfavorable future develOpments than it would have been had there been no retained earnings. Advantages of a common stock investment Like farm real estate, common stock offers several distinct advantages to the investor. Common stocks are earning assets and are, therefore, subject to little interest rate risk. Because they are earning assets where the stock- holder's returns are a function of corporate earnings, common stocks provide a good hedge against inflation. Common stocks offer the investor few direct tax advan- tages. However, the tax advantages attributed to farm real estate in the previous chapter are available to the corpora- tion directly. These tax advantages will tend to improve the asset position of the corporation which will in turn lead to increased common stock values and/or dividends. Thus, the stockholders benefit indirectly from a favorable corporate tax structure. Common stocks offer few direct tax advantages to the stockholder that are not available from other types of equity investments. A minor direct tax advantage deals with the ease with which individuals can keep tax records on their 42 investment in common stock. A summary of data necessary for tax purposes is usually made available to the stockholder by the corporation. Not only are tax data made available to stockholders but general information on the business affairs of the corporation also is readily attainable. Stock exchanges generally require publication of financial statements and annual reports. These, along with the wealth of information in financial journals and newspapers, supply adequate information to keep the stockholder well informed pertaining to his common stock investment. Another advantage claimed for common stock is that the investor need not be burdened with the time—consuming job of managing the affairs of the corporation. The stock- holder can receive the benefits of an equity investment and still, by delegating his management responsibilities, apply his full time and energies to his primary occupation. A related advantage concerns the limited liability aspects of common stock. If the corporation becomes bank- rupt a stockholder only loses his original investment in the corporation. Almost no corporations have the legal power to assess stockholders for added capital, even in the case of insolvency. This also means there are no out— of—pocket expenses associated with a common stock investment. Due to the existence of Stock exchanges in all major 43 financial centers, common stocks are readily marketable. Common stocks can be bought or sold at a moments notice on any business day. There is always a ready market for common stock. Since the majority of common shares sell for less than one hundred dollars, an investment in common stock is within the range of investment possibilities for the investor with limited funds. Thus, common stocks can be purchased in blocks to suit the needs of the individual investor. Because of this it is also much easier for an investor to follow a policy of diversification in the equity portion of his port- folio. He can spread his investment over several different industries within the economy as well as over several com— panies within any particular industry. Disadvantages of a common stock investment Common stocks also have some disadvantages, many of which are common to all equity investments. Because they are equity investments common stocks are subject to business risk. Thus, even though common stock- holders gain during periods of business expansion, they can also lose in the reverse case. This also means that during periods of deflation the value of their investment will decline. The Opposite is true, however, for any fixed income asset, such as a bond. This tends to offset some 44 of the advantages of any equity investment, especially in periods of deflation. One of the advantages of common stocks stated above concerned their marketability. Because there is a ready speculative market in common stocks their market prices are subject to unpredictable fluctuations. J. P. Morgan described this phenomenon when once asked what the stock market was going to do. He said that it was his considered judgment that the stock market would fluctuate. Thus, even though common stock can be sold at any time, there is no assurance that any share can be resold at what was paid for it. These relatively wide day to day fluctuations may eliminate common stock from consideration for certain individuals. Another advantage mentioned above dealt with the limited amount of management responsibility required on the part of the investor. In most cases the Shareholder has no responsibilities in the management of the corporation. In fact the corporation management may consist of a completely separate group from that of the average Shareholder. If a shareholder or part owner of a corporation feels that the firm is being mismanaged, there is little, if anything, he can do to remedy the situation as long as he is in the minority. The only way he can Show his dissatisfaction is by selling his stock in the firm. If his view is shared by 45 the market this alternative may not be very advantageous to him as the market price of the stock will then be depressed. Valuation of common stock Common stocks differ in their investment characteristics as widely as do the companies that they represent. Because they are such a heterogeneous commodity they are hard to evaluate in the aggregate. Common stocks can be classified into different functional groups -- each satisfying different portfolio objectives. Income stocks are those of companies in reasonably stable industries whose earnings and dividends per share follow a relatively stable trend and that have little long-term growth prospects. Growth stocks are those of companies whose sales are increasing at a rate greater than that of the national economy and whose earnings per Share, but not necessarily dividends, increase at a rate greater than the average for all corporations. Even though some common stocks appear suitable for income purposes and some for long—term growth prospects, it is highly unlikely that the same common stock is desirable for both income and growth. It is possible, however, that a given group of com- mon stocks can be chosen to meet any combination of invest- ment goals. Because common stocks differ and the investor's 46 Objectives vary greatly it is impossible to define a sys- tematic appraisal approach to use in determining what common stocks to buy and what the subjective value of these stocks is. Clendenin, however, suggests an outline for investment analysis which will help organize the ordinarily available dafia on common stocks. This outline is presented in Table 4—1. Part I indicates that the investor should formulate his investment philOSOphy and then, on the basis of this philOSOphy, decide on what general type of common stocks will best fit these goals. On the basis of his philOSOphy the investor can make a first approximation of some accept- able industries and corporations within these industries. This first approximation selection can be refined on the basis of some easily attainable preliminary data, as is out- lined in part II. The stocks remaining can be analyzed in more detail as is suggested in parts II through VI. 0n the basis of the predictions made in part VI an income capitalization approach can be used to determine the subjective value of these stocks. This approach is analogous to that discussed in the preceding chapter. Capitalization rates can be determined in a like manner and the same cap- italization formulas can be used. Both the expected future stream of dividends and the eXpected future change in price of the common stocks can be capitalized with separate Table 4—1: I. II. III. IV° 47 Outline for Common Stock Investment Analysis Determination of type of investment desired A. B. C. Basic A. B. C. D. E. F. G. General type Acceptable industries Quality and characteristics (preliminary) indications Earnings per share Dividends Price-earning ratio Leverage Book value Market price Reputation Industry analysis A. B. C. D. E. F. G. Permanence of the industry Growth of the industry Stability of sales and earnings Competitive conditions Labor relations Governmental attitudes Immediate outlook for sales and earnings Analysis of the firm A. B. C. D. E. F. G. H. I. J. K. L. Size, leadership, dominance Growth Prestige, established position Brands, patents, good will Diversification Assets and Operating situation Sales outlook Costs, overhead, profit margins Earnings estimates Stability of sales and earnings Working capital position Dividend estimates p. lClendenin, John C., Introduction to Investments, McGraw-Hill Book Company, Inc., New York, New York, 1960, 319-20. 48 Table 4-1: (continued) M. Capital structure N. Management 0. Stockholder position V. The individual security A. Its legal rights B. Its market position 1. Number of holders 2. Popularity of type 3. Eligibility 4. Additional issues or secondary Offerings 5. Market history C. Financial position in capital structure, improving or weakening VI. Conclusions A. Future earnings B. Future payments C. Quality and characteristics D. Future price 49 capitalization rates. By using two separate capitalization rates the investor can differentiate between the relative importance of the two components of total subjective value. This estimate of subjective value can then be compared with the easily attainable market value to determine whether these remaining common stocks are or are not good investments. The discussion above is in more general terms than that concerning the valuation of farm real estate in the previous chapter. This is because common stocks represent many more industry types than do farm real estate. Were we to consider farm real estate in terms of the outline pre- sented in Table 4-1 we would only be concerned with parts IV, V and VI. In this case the industry is already determined: agriculture. More specifically the farm real estate portion of agriculture. After this industry has been chosen an analysis of individual farms (firms) can be conducted follow- ing this latter portion of the outline. This discussion does not mean that the investor should disregard the large volume of interpretative reports from stock brokers and financial services and conduct all his own analytical work from primary data. It would be uneco- nomical to do this. The investor should collect data from all sources and compare his individually reached conclusions with those reached by the experts. CHAPTER V THEORETICAL FRAMEWORK FOR COMPARING INVESTMENTS IN FARM AND NONFARM EQUITIES In the previous chapters some advantages, disadvan- tages, and methods of determining values for the two types of equity investment have been suggested. There has been considerable discussion in recent years concerning the in- come position of the agricultural sector of the economy. Investment analysts are almost unanimously pessimistic con- cerning investing in real estate--especially farm real estate. This attitude is exemplified by Jordan and Dougall: "Aside from the investment in his home, however, the average investor is advised to utilize other media for the placement of that portion of his funds that may apprOpriately be de- voted to equities."l To advocate investing in equities other than farm real estate it must be shown that the total rate of return on farm real estate is significantly lower than that of other types of equity investment. Is this so? The following two 1Jordan, David F. and Herbert E. Dougall; Investments, Prentice-Hall, Inc., Englewood Cliffs, New Jersey, 1959, p. 587. 50 51 chapters will be devoted to answering this question. This chapter will present the theoretical framework used in this study to determined the total rates of return for the two types of equity investment and Chapter VI will present the empirical results of the study. The total rate of return on an investment is composed of two components: an income rate of return and a price rate of return. The income rate of return is the same as the yield of an investment, as was discussed in the second chapter, and is the rate of return that is generally con— sidered in the standard accounting process. The income rate of return is defined as yt = , (5-1) where ry equals the income rate of return in period t, Yt t equals the income received in period t and V equals the t value of the investment in period t. Both Yt and Vt are in current dollar terms. In the case of farm real estate Yt equals the net rent to landlords in period t and Vt equals the value of farm real estate owned by landlords in period t. For common stock Yt and Vt’ respectively, equal net profits for the year and the market value of the common stock in period t. Retained earnings must be included to 52 make the common stockholder's income comparable to net rent to landlords. A landlord must take money out of his net rent if he wants to have any added investment in his farm real estate but this is already done by a corporation before an investor obtains his cash dividend. Stock dividends and splits are not included in Yt because if the common stock investor were allowed to sell them to obtain current income it would mean a change in the investor's prOportionate share of the corporation. The effect of stock dividends and splits will Show up in the real wealth component through changes in future price expectations. The price rate of return represents that portion of the change in value of an investment that changes the in- vestors' real wealth position. It reflects changes in the purchasing power of price sensitive assets. This real wealth gain or loss is considered by accountants to be an unrealized gain or loss. The real wealth gain or loss is not accounted for until the asset under consideration is actually sold. This concept of realized and unrealized real wealth gains and losses emphasizes cash receipts and expenditures rather than the concept of accrual accounting. This price rate of return is included in the total rate of return because, as one writer puts it, ". . . this interpre- tation accords well with common sense: for the gain or loss 53 results from holding money claims during a period of changing prices, not from disposing of the money claims at some par- ticular level of prices." In determining the price rate of return the total change in the value of the investment between two periods must be decomposed into corresponding price and quantity components. This is done as follows: v — v = p — P t+l t t+l Qt+1 tot = Pt (Qt+1 ‘ Qt) + Qt (Pt+l ' Pt) + (Pt+l - Pt) (Qt+l - Qt) . (5-2) where Pt equals the price per unit in period t and Qt equals the physical quantity of the asset in period t. This change in value can also be represented graphically, as in Figure is the area OP b Q 5-1. V is the area OPtth and Vt+l t+l t+l. t The change in value between t and t+l equals the difference between these two rectangles. This change in value can be 2Coughlan, John W.; "Applicability of the Realization Principle to Money Claims in Common Dollar Accounting," The Accounting Review, January 1955, p. 113. 3The procedure for determining the price rate of return that follows is similar to that develOped by Boyne in Michigan State University Technical Bulletin 294, "Changes in the Real Wealth Position of Farm Operators, 1940-1960." 54 Figure 5-1: Price and Quantity Components of a Change in Value Price Pt+1 a b Pt d C 0 Qt Qt+l Quantity 55 b k . t th t. 3 _ p - ro en in o ree por ions Pt (Qt+1 Qt) Qt (Pt+1 Pt) and (Pt+1 - Pt) (Qt+1 - Qt) respectively represented by areas QtQt+lCd' PtPt+lad and abcd. The price component of a change in value is defined as the portion of the change in the value of the asset that is due to a change in price. Similarly the quantity component of a change in value is defined as that portion of the change in value that is due to a change in quantity. Thus, the price component includes the term Qt (P — Pt) and the t+1 quantity component includes the term Pt (Q - Q Since t+1 t)' the price component plus the quantity component must equal the change in value the term (Pt - Pt)(Q - Qt) must +1 t+1 be allocated between these two components. It is neither wholly a price component nor a quantity component Since it consists of both a change in price and a change in quantity. By assuming that the rate of change of price and quantity is constant, but not necessarily equal, between period t and t+1 this remaining term of equation (5-2) can be dis- tributed equally between the price component and the quantity component.4 Thus: (Price component)t = Qt (Pt+l - Pt) ( 5-3) + g (Pt+1 ' Pt)(Qt+l ' Qt) 4For a proof of this see Boyne, Ibid., p. 70—71. 56 and (Quantity component)t = Pt (Qt+1 - Qt) (5_4) 3’ — _ + 2 (P Pt)(Qt+l Qt). t+1 In terms Of Figure 5—1, the price component is represented by P P abd and the quantity component by QtQ bd° t t+1 t+1C Only the price component can be utilized in obtaining the price rate of return. If the quantity component is included it essentially allows the investor to count any increased investment as part of his real wealth gain. Therefore, including the quantity component would cause the price rate of return to be overstated. The price component defined above cannot be calculated unless certain assumptions can be made about the physical quantities of the two assets. How can these quantities be measured? If it is assumed that the number of acres and the number of common shares are good measures of the respec- tive quantities, then equation (5-3) can be used to compute the price components. This is not a realistic assumption. It would not allow for farm real estate changing from one land use class to another or for the real assets of a cor- poration increasing without a corresponding increase in the number of common shares. Changes in the quality of an investment are not necessarily reflected as corresponding 57 changes in quantity. However, the price components can be calculated by using two types of data for each type of investment: a current dollar value series and a constant dollar value series. Since price is constant in the constant dollar value series, it is in reality a measure of the quantity of the investment in dollar terms. In order to calculate the price components by this method, they must be computed as a residual so the problem of defining a base period quantity can be eliminated. Thus, the price component is defined here as the total change in value less the quantity component. First, two price components are defined: one including and one excluding the term (Pt+1 - Pt) (Qt+l - Qt)' These two price components are: ' 'k = _ _ _ (Price component) t (Vt+l Vt) Pt (Qt+1 Qt) = (Vt+l - Vt) - Pt Qt Qt+l - Qt Qt - (Vt+l ‘ Vt) ‘ Vt [ngt+1 ' Pth l Pth = (Vt+l ' Vt) ' Vt vt+1 _ 1 Vt (5-5) 58 and (Price component) ** = V _ _ _ t ( t+1 Vt) [Ptmt+1 Qt) + - — (Pm Pt) (Qt+1 09] = V _ _ - ( t+1 Vt) Pt+1 (Qt+l Qt) ' (V V ) P 7 - t+1 t ' t+th+l Qt+1 ’ Qt Qt+1 , = (Vt+l - Vt) - Vt+1 Pth+l — Pth Pth+1 Vt+1 (5-6) where Pb equals the price in the base period and Vtequals the constant dollar value for period t. The method of con— structing these constant dollar value series is presented in Appendices I and II. The price component of equation (5-3) can now be de- fined as the average of the above two price components: . _ * (Price component)t - .% [(Price component) t + (Price component)**] . (5-7) t In determining the price rate of return for farm real estate Vt does not represent the value of farm real estate owned by 59 landlords as was the case while computing the income rate of return. It represents the value of all farm real estate. It will be assumed that the price rate of return for land- lords is the same as that for all farm real estate owners. As before, Vt for common stock represents the market value of the common stock in period t. The price component, the change in value due to a price change, must then be adjusted for changes in the pur— chasing power Of money. To do this, the percentage change in the Consumer Price Index is multiplied by the value of the asset at the beginning of each period. This is CPI - CPI CPI l t t+1 Vt = Vt *F—-—- — l , (5-8) CPIt CPIt where CPIt equals the Consumer Price Index for period t. This gives the amount by which the current dollar value of the investment must change to maintain its original pur- chasing power. Thus, the real wealth change in the value of the invest— ment is defined as (Real wealth change)t = (Price component)t FCPI j t+1 - Vt --———- — l . CPIt (5-9) 60 This real wealth change is that portion of the change in value that is attributed to changes in investors' expecta- tions of future income streams, future discount rates and future changes in prices. By adjusting the price component for changes in purchasing power the investment is forced to become a 100 percent hedge against inflation. The price rate of return is then defined as rpt = (Real wealth change)t Vt (5-10) where r equals the price rate of return for period t. t The investment's total rate of return can now be com- puted: rt = r + r (5-11) where rt equals the total rate of return for the investment in period t. The income rate of return and the price rate of return, and, therefore, the total rate of return, are calculated on the basis of current market values for the underlying assets. The total rate of return as defined in equation (5-11) is based on the assumption that one dollar received in cur- rent income is equivalent to a real wealth gain of one dollar. As was discussed in the previous chapters, this was not necessarily the case. How an individual ranks current 61 income gains or losses with real wealth gains or losses depends upon his investment goals and Objectives. A more general formulation for an investment's total rate of return is rt = rYt +ert ' (5_12) where >\is the relative importance of income in the form of real wealth gains or losses compared to current income gains or losses. Thus will be a subjectively determined parameter and may be different for every investor. In this study it will be assumed that ).= l and equation (5-11) will be used. In general, however, ).may be either greater than or less than one depending on the relative weight one attaches to the two Sources of income. Computation of the rates of return on farm real estate is based on United States Department of Agriculture Census of Agriculture aggregate data. The rates of return for common stock are based on data obtained from Moody's Investors Service, Incorporated. The common stock data are for a random sample of one hundred common stocks listed on the New York Stock Exchange. This constitutes a 7.9 percent sample of all common stocks listed on the Exchange. A list of the one hundred stocks in the sample is in Appendix III.5 5Using Moody's classification, this sample is com- posed of 76 industrial, 11 public utility, 8 transportation and 5 bank and finance common stocks. 62 Because aggregate United States data are used, just one rate of return for farm real estate for each year will be obtained. However, for common stock a rate of return will be available for each of the one hundred stocks. The aggregate rates of return for common stock will be calculated as a Simple average of the one hundred individual common stock rates of return. This is akin to the investor allo- cating an equal amount to each common stock in the sample. These aggregate rates of return are those that would be available to an investor who randomly selected stocks from the New York Stock Exchange. An alternative method of aggregation would be on the basis of the prOportion of the current value of the common stock of each corporation to the current value of the complete sample of common stocks. This method would indicate the rate of return apprOpriate for all the investors of the sample common stocks viewed as a group. The former aggregation method is used in this study because this is the same method that is used by Fisher and Lorie and there will thus be a check on the validity of this study's results.6 6Fisher, L. and J. H. Lorie, "Rates of Return on Investments in Common Stocks," The Journal of Business, Vol. XXXVII, No. 1, January 1964. CHAPTER VI A COMPARISON OF COMMON STOCK AND FARM REAL ESTATE INVESTMENTS The previous chapter presented the theoretical frame- work by which comparable rates of return for common stock and farm real estate were calculated. This chapter will be concerned with a comparison of the calculated rates of return for the period 1950-1963.1 Comparable rates of return for common stock and farm real estate The mean, used in this study to represent the aggregate rates of return for common stock, was compared with the median to determine its value as a measure of central tendency. In the three cases; for the income rate of return, the price rate of return and the total rate of return; the null hypo— thesis that both samples come from the same pOpulation, or from equal pOpulations, was accepted at the .01 level rather than the alternative hypothesis that the two samples come 1Only the final results are presented here. Raw data and intermediate calculations can be Obtained from the author for farm real estate and for each of the corpora— tions in the random sample. 63 64 from different or unequal pOpulations. A nonparametric test, the U-test, was used. This test is also known as the Mann—Whitney test or the Wilcoxon test.2 This result implies that the mean is not biased as a measure of central tend- ency by either extremely high or extremely low rates of return. Income rates of return. Table 6-1 and Figure 6-1 pre- sent the results for the income rates of return for 1950- 1963. Both the mean and median rates of return for common stock are shown. The mean income rate of return for the fourteen year period for common stock is 9.31 percent and is 4.41 percent for farm real estate. Not only is this mean income rate of return higher for common stock but it is higher in each of the fourteen years. A nonparametric, U—test was conducted and the alternative hypothesis that the mean (rather than the median) income rates of return for common stock were greater than the income rates of return for farm real estate was accepted at the .05 level rather than the null hypothesis that the rates of return were the same for the two investments. Both income rates of return are stable when compared to the price and total 2Freund, John E., Mathematical Statistics, Prentice- Hall, Inc., Englewood Cliffs, New Jersey, 1962, p. 290— 294. 65 Table 6-1: Income Rates of Return for Common Stock and Farm Real Estate, 1950-1963 Common Stock Farm Real Year Median Mean Estate 1950 14.46% 17.67% 6.44% 1951 11.82 13.24 6.23 1952 10.54 12.33 5.63 1953 11.23 13.29 4.87 1954 9.58 8.78 4.86 1955 9.07 8.81 4.37 1956 8.78 8.07 4.44 1957 9.04 9.63 3.86 1958 7.15 7.44 4.12 1959 6.67 7.09 3.32 1960 6.97 5.56 3.23 1961 5.22 4.90 3.44 1962 6.55 6.59 3.52 1963 6.94 6.96 3.34 Mean 9.31 4.41 66 MOON mm. mm. Ho. 00. mm. mm. mm. om. mm. vm. mm. mm. Hm. om. _ _ _ _ _ _ _ _ _ _ _ _ _ _ 10.- lml o , ill!!! (I!!! ill .\a Ml. illlllltlllllllllu Im 41\ oo/“ZOLO I! [Ano’o . .|./.. LS ./ \\ \\ II ”I. /. 13 / low .lmm Lom mumuwm Hmmm Eumm .Imm . . .. . .Acmflpmzv xooum GOEEOO II II II. Acmmzv xooum COEEOU .mog .me mmmfilomma .mumumm Hmmm Eumm mam Mooum GOEEOO Mom cusumm mo mmumm OEOOCH "Hum musmflm quaoxad 67 rates of return; however the income rate of return for com— mon stock varies more than that of farm real estate. The standard deviation of the income rate of return for common stock is 3.59 and is only 0.95 for farm real estate. This greater stability for farm real estate may be due in part to the success of governmental income stabilization policies for agriculture. A least squares, trend line was computed for both rates of return. Both showed a negative trend in the income rate Of return: -0.76 percent and -0.24 percent per year for common stock and farm real estate respectively. Price rates of return. The results for the price rates of return for common stock and farm real estate for 1950-1963 are presented in Table 6-2 and Figure 6-2. The mean price rate of return for the whole period for common stock and farm real estate is 8.64 percent and 4.85 percent respectively. Again, a U-test was conducted and, at the .05 level, the null hypothesis that the rates of return from the two investments were the same was accepted against the alternative hypothesis that the common stock price rates of return were higher than those for farm real estate. The price rate of return for farm real estate was greater than the mean and median price rates of return for common stock in seven and nimeyears respectively out of the fourteen years studied. Both price rates of return Show more 68 Table 6-2: Price Rates of Return for Common Stock and Farm Real Estate, 1950-1963 Common Stock Farm Real Year Median Mean Estate 1950 1.53% 3.19% 13.53% 1951 - 2.38 - 1.23 9.42 1952 - 5.93 - 4.14 0.04 1953 13.10 16.03 2.55 1954 21.05 24.00 4.33 1955 — 0.90 9.53 3.98 1956 —10.19 - 7.67 6.92 1957 4.92 10.47 4.75 1958 19.44 34.72 7.29 1959 - 9.30 2.00 4.46 1960 18.88 35.53 0.88 1961 —10.38 -10.61 4.80 1962 1.47 2.41 4.22 1963 1.49 6.78 5.93 Mean 8.64 4.85 69 .mumumm Hmmm Eumm paw \ mumumm Hmmm Eumm . .. . ..ACMHOOZV Mooum COEEOU II .I. II Asmmzv xuoum COEEOU momalomma .IOm lmm .low .Lmv xooum coEEOO MOM Gunpom mo mmpmm OOHHm "mum wusmflm queoxed 70 variation than the income rates of return. The standard deviation for the common stock price rate of return is 14.45 and is 3.96 for the farm real estate price rate of return. Since the hypothesis was accepted that the mean price rates of return for the two investments were equal at the .05 level another U-test could be conducted to test the null hypothesis that the two price rates of return have the same, or identical, pOpulations against the alternative hypothesis that the variation for common stock is greater than that for farm real estate. The null hypothesis was accepted at the .05 level. As above, a least squares, trend line was fitted to the data. The regression showed a posi- tive trend in the price rate of return for common stock of 0.33 percent per year and a negative trend for farm real estate of —0.18 percent per year. Total rates of return. Total rate of return results are presented in Table 6—3 and Figure 6-3. For common stock the mean total rate of return for the 1950-1963 period is 17.94 percent and for farm real estate it is 9.26 percent. The U-test's null hypothesis that the two investments' total rates of return are the same was rejected at the .05 level against the alternative hypothesis that the total rates of return for common stock were greater than the total rates of return for farm real estate. The total rate of return 71 Table 6—3: Total Rates of Return for Common Stock and Farm Real Estate, 1950-1963 Common Stock Farm Real Year Median Mean Estate 1950 17.37% 20.64% 19.97% 1951 12.16 12.01 15.65 1952 7.66 8.06 5.59 1953 27.04 29.32 2.32 1954 30.26 32.79 9.19 1955 8.02 18.34 8.35 1956 - 1.43 0.41 11.36 1957 15.15 20.10 8.61 1958 29.16 42.19 11.41 1959 - 2.60 9.09 7.78 1960 25.04 41.09 4.11 1961 — 6.67 - 5.76 8.24 1962 6.48 9.09 7.74 1963 7.90 13.74 9.27 Mean 17.94 9.26 72 quaOJSd mm om wumuwm Hmwm Enmm mm ‘ . . .. . .Acmflpwzv MUOum COEEOU * \ .\ I! .I. :1 Acmwzv xOOum COEEOU Ov mv mead ommH .wumumm Hmwm Eumm tam Mooum COEEOO How cusuwm mo wmuwm Hmuoe "mum wusmflm 73 for farm real estate was greater than the mean total rate of return for common stock three years out of fourteen and greater than the median total rate of return for common stock eight years during the period. The standard devia- tion for the common stock total rate of return was 14.31 and 4.47 for the farm real estate total rate of return. Looking at Figure 6-2 and 6—3 it can be seen that the variations in the total rate of return are almost completely dominated by variations in the price rate of return. Again a least squares, trend line was estimated and both common stock and farm real estate showed a negative trend of -0.42 percent per year. However, the level of the common stock total rate Of return trend line is higher than that of farm real estate. A summary of the trend statistics for the different rates of return and different investments is presented in Table 6—4. Disaggregation of common stock rates of return The rates of return for common stock in this study are based on a random sample of one hundred stocks from the New York Stock Exchange. A question can be raised about these data. Is there a difference between the major classi- fications of the common stock? Since the rates of return were calculated for each individual common stock it was 74 Table 6-4: A Summary of the Rates of Return for Common Stock and Farm Real Estate, 1950-1963 Income Rate Price Rate Total Rate of Return of Return of Return Farm Farm Farm Common Real Common Real Common Real Stock Estate Stock Estate Stock Estate Mean 9.31 4.41 8.64 4.85 17.94 9.26 Standard Deviation 3.59 0.95 14.45 3.96 14.31 4.47 1 &. 15.01 6.21 6.17 6.20 21.09 12.41 *1 [3 - 0.76 -0.24 0.33 -0.18 - 0.42 - 0.42 1Estimates of the parameters of the trend equation, r = m6. NS. 46. oo. mm. mm. _ _ queoxad Om. _ . _ _ IIIONII f lioal o IJOH IJON ILom I.o x x w X X . . x x niom . . x x O 0 x X . . x x x x x x x x coawmpuommsmue I oo o x . u M x Suflflflpp oflansm . o x x I ..I. II HOHMDmSOGH , Jon 0 0 xx .. xx . o .. . .mosmcflm w xsmm no & l om ... x momfilomma .xuoum COEEOO mo mmmmmao Hsom wnu How susumm mo mmumm Hmuoa .mno musmflm 81 Table 6-8: A Summary of the Rates of Return for the Four Classes of Stock, 1950—1963 Income Rate Price Rate Total Rate of Return of Return of Return Mean Bank and Finance 6.66 11.03 17.70 Industrial 9.13 8.36 17.68 Public Utility 8.10 7.74 15.84 Transportation 14.98 8.30 23.29 Standard Deviation Bank and Finance 1.65 23.25 25.92 Industrial 3.77 15.62 15.03 Public Utility 1.35 9.27 11.15 Transportation 8.06 24.90 25.80 5<1 Bank and Finance 9.13 12.16 21.37 Industrial 14.91 5.51 20.23 Public Utility 10.35 12.02 23.19 Transportation 27.73 0.95 28.69 31 . Bank and Finance - 0.33 - 0.15 - 0.49 Industrial - 0.77 0.38 - 0.34 Public Utility — 0.30 — 0.57 — 0.98 Transportation — 1.70 0.98 - 0.72 1Estimates of the parameters of the trend equation, r = 0<+lbt, where r equals the apprOpriate rate of return and t equals the year (1950 = 1, 1951 = 2, . . .). 82 return on transportation common stocks was the largest of the four classifications and the rate of return on bank and finance common stocks was the lowest. There was no signifi— cant difference between the income rate of return for public utility and industrial common stock. There was no significant difference between the four classifications for either the price rates of return or the total rates of return. Comparison with the Fisher and Lorie rates of return It was mentioned above that the rates of return for common stock calculated in this study could be compared with those computed by Fisher and Lorie. A comparison Of the rates of return computed in both studies is presented in Table 6-9. Only the total rates of return are presented as these are the only rates of return that are comparable A U- test was conducted and the null hypothesis that the two rates of return are the same was rejected at the .05 level against the alternative hypothesis that this study's total rates of return are larger than Fisher and Lorie's. A possible reason for this is suggested in below. Biases in the calculated rates Of return Certain biases may be present in all of the rates of return calculated in this study. These rates of return are 83 Table 6—9: A Comparison with the Fisher and Lorie Total Rates of Return on Common Stock, 1950-1960 Total Rate of Return Year Kost'sl Fisher and Lorie's2 1950 - 1952 13.57% 12.5% 1950 - 1954 20.56 17.9 1950 — 1956 17.37 17.0 1950 — 1958 20.43 16.5 1950 - 1960 21.28 14.8 1955 - 1956 9.38 6.4 1955 - 1957 12.95 - 3.7 1955 - 1958 20.26 13.0 1955 - 1959 18.03 14.0 1955 - 1960 21.87 11.2 1The rates of return presented here are the means of the yearly rates of return for the apprOpriate time period. 2Fisher, Lawrence and James H. Lorie; "Rates of Return on Investments in Common Stocks," The Journal of Business, Vol. XXXVII, No. 1, January 1964. The rates of return presented here are rates of return on investment in common stocks listed on the New York Stock Exchange with reinvestment of dividends. The figures are percent per annum compounded annually rates for tax exempt, cash-tO-portfolio portfolio. 84 not net rates of return. They do not reflect any commission charges nor any tax deductions on the investment income. The only way that taxes and commission charges could have been considered was to follow a cash—flow type analysis for differing income classes as was done by Fisher and Lorie in their study. This could be a partial explanation of why the total rate of return calculated in this study was greater than that calculated by Fisher and Lorie. The common stock rates of return may also Show an up- ward bias that is not present in the farm real estate rates of return. Farm real estate rates of return are based on aggregate United States data while common stock rates of return are not based on data from the whole population of common stocks. Common stock rates of return are based on a random sample of stocks taken from a larger, nonrandom sample of common stocks. The sample consists of only common stocks listed on the New York Stock Exchange. The New York Stock Exchange tends to have the common stocks of the larger, older and stronger corporations. Because the stocks in this study are listed on a stock exchange they must also meet the requirements of the Securities Exchange Commission. To the extent that these corporations have higher rates of return the rates of return computed in this study are biased upward. This is not a serious bias, however, as the average common 85 stock investor will seldom consider unlisted common stocks. Therefore, while this study's rates of return may not reflect the average for the whole pOpulation, they may reflect the most relevant portion of the population for the average investor. For the same reason there will be a downward bias in the farm real estate rates of return. The rates of return for farm real estate are based on data from all farm real estate. This includes the best to the most marginal agri- cultural lands. To the extent that the inclusion of all the marginal, low return farms lowers the increases in the value of farms and the net rents the farm real estate returns are underestimated. Above it was said that the "listed bias" for stocks was not a serious bias because the listed common stocks reflected the most relevant portion of the population. In the case Of farm real estate the relevant portion for the investor in farm real estate should not be the whole pOpu- lation but that portion of farm real estate equivalent to the listed common stocks: the "better" farms. A fourth possible bias may exist in the common stock rates of return——a "success" bias. The random sample of common stocks was chosen from those common stocks listed on the New York Stock Exchange in 1964. Therefore, no corporation that went bankrupt in the 1950-1964 period was 86 included in this sample—-on1y successful corporations were included in the random sample. This does not mean that new corporations were excluded however. In fact several new or newly listed corporations were included in the one hundred common stocks chosen. Will this "success" bias alter the results? This will depend on the number of corporations listed on the New York Stock Exchange going bankrupt during the period of this study. This has been negligible in the past fifteen years. A final point should be mentioned concerning the common stock data. No adjustments were made in the data to account for different accounting practices used by different corpo- rations. Data were taken from the corporate accounting statements without alterations. Any attempt to render the corporate data more comparable would have involved many subjective decisions and was beyond the SCOpe of this study. CHAPTER VII SUMMARY AND CONCLUSIONS Advantages and disadvantages of farm real estate and common stock were discussed in Chapters III and IV. Since they are both equity investments, these two classes of investments have many similar characteristics. Both are earning assets and are subject to business, market and pur- chasing power risk. There are only three major differences between these two investments. The first concerns the relative market- ability Of the two. Farm real estate is an immobile and unstandardized product and is therefore traded in relatively unorganized, low volume, local markets. On the other hand,' common stocks, which are more standardized, are sold on large, well organized, national, or at least regional, markets in large numbers. This difference in marketability affects relative price fluctuations and collateral values of the two assets. The two investments are also differentiated by the differing degree of ownership. Farm real estate is generally wholly owned by an investor while the investor in common 87 88 stock is normally a fractional owner. This, in large part, is due to industry being organized in a corporate form which, in turn, is due to the relatively large amount of capital necessary to organize and Operate a business in the nonfarm sector of the economy over that needed for a farm business. This capital can be raised easier by allowing multiple ownership and the most efficient method for achieving this is the corporate form of business. A by—product of this form of organization is the limited liability aspect of com— mon stock. Theoretically this form of organization can also be utilized for farm real estate investments; however, it has seldom been done. Also, a corporation may be wholly owned by a single investor and any farm real estate advant- ages due to full ownership would then accrue to the common stockholder. This difference determines the investor's diversification policy and the size of his minimum investment. Finally, investors' attitudes toward these two types of investment differ. There still exists, in many minds, an agricultural fundamentalistic image for farm real estate. In fact most individuals have a fairly distinct bias either for or against farm real estate. In general, a comparable influence doesn't exist for common stock. The investment decision process is divided into two parts: the formulation of investment goals and the analysis 89 and selection of the equity asset portion of the investor's portfolio. The investor must have goals that are compatible with his investment philosophy,temperamau:and personality. On the basis of these goals the investor must decide on an investment policy ranging between the extremes of current income only and only growth or capital gains. Both investments should be evaluated in terms of their discounted present value. This capitalization process should be conducted separately for the expected future stream of income and for the expected future real wealth changes. These are computed separately to allow the investor to adjust for his differing preferences for these two features of both investments. These discounted present values determine the invest- ments' subjective value. This subjective value tells the investor what the investment is "worth" to him. He then must compare this with the market value of that same invest“ ment, what must be paid to have the ownership transferred to him, to determine whether this asset should be added to his portfolio. The investor may follow a model of satisficing behavior, rather than one of maximizing behavior, in determining which specific farm or stock to add to his portfolio. To follow a maximizing policy the investor would invest, ceteris paribus, 90 when the difference between the subjective value and the market value is maximized. This would necessitate analyzing all relevant alternatives which, because of uncertainty and the costs of information and learning, may be impractical. In- stead an investor that follows a satisficing model starts with a first approximation list of prospective investments and con- ducts more extensive analysis to determine their subjective values. Investment alternatives are analyzed until an invest- ment is found in which the difference between the subjective value and the market value is positive. The investor has then found an asset that to him "is worth more than it is selling for" and will, therefore, invest in it. Because of the added costs involved in attempting to find better investments he will stOp searching and be "satisfied" with this investment. Now that the investment characteristics and investing policies for the two types of equities have been discussed, a final question remains to be answered. Is there a Signifi- cant difference in the rates of return for the two equity classes? In order to answer this question three rates of return were calculated for farm real estate and common stock for the period 1950—1963. The total rate of return was composed of two separate components: an income rate of return and a price rate of return. 91 The income rate of return for farm real estate and com- mon stock is the ratio of net earnings to the value of the investment. For common stocks this means that net corporate earnings are used instead of dividends. This is necessary to make the common stock income rate of return comparable to that for farm real estate. The average income rate of return for farm real estate over the fourteen year period is 4.41 per— cent and 9.31 percent for common stock. A U—test Showed that the income rate of return for common stock was Significantly higher than that for farm real estate. In fact the income rate of return for common stock was larger than that for farm real estate in each of the fourteen years. Both income rates of return showed a negative trend over the period with the largest negative trend for common stock. Common stock income rates of return also showed a larger variation than farm real estate. The price rate of return is a measure of the change in the real wealth or purchasing power of the investment. It is computed by dividing a change in the value of an invest- ment into its two component parts: that change in value that is due to a change in the quantity of the investment and that portion that is due to a change in the price of the investment. This price component, adjusted for changes in the purchasing power of money, divided by the value of the investment is the 92 price rate of return for the investment. Adjusting the price component for changes in the purchasing power of money yields price rates of return that an investor who does pgp'have money illusion would consider relevant. If investors did have money illusion this adjustment would not have been made and the com— puted price rates of return would have been larger than reported in this study. The average price rate of return for farm real estate and common stock was 4.85 percent and 8.64 percent respec- tively. A U—test showed that there was no significant differ- ence between the rates of return for the two equity classes. The variation in price rates of return was larger than that for the income rates of return, but there was no significant difference in the standard deviations of the two price rate of return series. A slight negative trend was apparent for the farm real estate price rate of return and a small positive trend was found for common stock. The total rate of return calculated in this study was the sum of the corresponding income and price rates of return. The average total rate of return for common stock was 17.94 percent and 9.26 percent for farm real estate. A U—test showed that the common stock total rate of return was sig- nificantly larger than that of farm real estate. Both total rates Of return showed identical trends but common stock had a larger variation around this trend line. 93 These three rates of return are presented separately so that investors may compare the relative merits of income and capital gains. On the basis of tax considerations alone an equal return in the form of price rate of return has more utility than that same return in terms of income rate of return. This is due to differences in the income and capital gains tax rates. On this basis peOple in different income classes will place differing relative importances on the two types of re— turns. Above, however, it was assumed that one dollar received in current income is equivalent to a one dollar real wealth gain. In summary, the rates of return for common stock are larger than comparable rates of return for farm real estate. However, common stock returns have larger fluctuations or greater risk than returns from farm real estate. Also the discussion in the previous chapter would indicate that the spread between the farm real estate and the common stock rates of return is not as great as calculated. These results are for the 1950-1963 period and are not meant to be predictions for the future. Results in the future will depend on future economic conditions. Will the rational investor then consider farm real estate investments when they yield a lower rate of return? Again the answer is "that depends." There are two situations 94 in which the investor may be willing to accept a lower net return on his investment. The first concerns the degree of leverage one can achieve with the two classes Of equities. If the investor is not allowed to invest borrowed money, the investor would not invest in farm real estate given this study's results. However, since an investor's leverage factor may be greater for farm real estate, he may be willing to accept a lower rate of return on the value of the total in- vestment in order to obtain a higher rate of return on his invested capital. Secondly, the investor may invest in the lower yielding farm real estate if there are nonmonetary considerations. As discussed before, he may allow noneconomic factors to influence his investment decisions. BIBLIOGRAPHY 95 BIBLIOGRAPHY Babson, Thomas E. and David L. Babson, Investing for a Successful Future, The Macmillan Company, New York, New York, 1959. Barlowe, Raleigh, Land Resource Economics, Prentice-Hall, Inc., Englewood Cliffs, New Jersey, 1958. Bellemore, Douglas H., Investments. Simmons-Broadman Publish- ing Corporation, New York, New York, 1960. Bernhard, Arnold, The Evaluation of Common Stock, Simon and Schuster, New York, New York, 1959. Bonbright, James C., The Valuation of Property, McGraw-Hill Company, Inc., New York, New York, 1937. Boyne, David H., "Changes in the Real Wealth Position of Farm Operators, 1940—1960," Technical Bulletin 294, Michigan State University Agricultural Experiment Station, Department of Agricultural Economics, 1964. Burlingham, Lloyd, ”What's Land Worth?" International Har- vester Farm Magazine, Vol. 48, No. 1, Winter, 1965. Burtchett, Floyd F., Investments and Investment Policy, Longmans, Green and Co., New York, New York, 1939. Carpenter, H. G., This is Investment Management, Scarborough Press, Scarborough, New York, 1955. Clendenin, John C., Introduction to Investments, McGraw—Hill Book Company, Inc., New York, New York, 1960. COOper, Robert U., Investments for Professional People, The Macmillan Company, New York, New York, 1959. Coughlan, John W., "Applicability of the Realization Principle to Money Claims in Common Dollar Accounting," The Accounting Review, January, 1955. Crouse, Earl J. and Charles H. Everett, RuralpAppraisals, Prentice—Hall, Inc., Englewood Cliffs, New Jersey, 1956. 96 97 Fisher, L. and J. H. Lorie, "Rates of Return on Investments in Common Stocks," The Journal of Business, Vol. XXXVII, No. 1, January, 1964. Freund, John E., Mathematical Statistics, Prentice-Hall, Inc., Englewood Cliffs, New Jersey, 1962. Hayes, Douglas H., Investments: Analysis and Management, The Macmillan Company, New York, New York, 1961. Heady, Earl 0., Economics of Agricultural Production and Resource Use, Prentice-Hall, Inc., Englewood Cliffs, New Jersey, 1952. Hoagland, Henry E., Real Estate Principles, McGraw—Hill Book Company, Inc., New York, New York, 1955. ”How to Handle Your Money Now," U.S. News & World Report, Vol. 52, April 2, 1962. Jordan, David F. and Herbert E. Dougall, Investments, Prentice-Hall, Inc., Englewood Cliffs, New Jersey, 1959. Larsen, Arne, Worksheets on constant dollar value series for farm real estate. Murray, William G., Agricultural Finance, The Iowa State College Press, Ames, Iowa, 1953. Murray, William G., Farm Appraisal and Valuation, Iowa State University Press, Ames, Iowa, 1961. Prime, John H., Investment Analysis, Prentice-Hall, Inc., Englewood Cliffs, New Jersey, 1959. Raup, Philip M., "Economic Development and Competition for Land Use in the United States," Journal of Farm Economics, Vol. 39, No. 37, December, 1957. Reporting the Financial Effects of Price—Level Changes, Accounting Research Study No. 6, American Institute of Certified Public Accountants, Inc., Accounting Research Division, 1963. Rossmiller, George E., Farm Real Estate Value Patterns in the United States, 1930-1962, Unpublished Ph.D. Thesis, Michigan State University, 1965. 98 Sauvain, Harry, Investment Management, Prentice-Hall, Inc., Englewood Cliffs, New Jersey, 1959. Scharlach, Wesley C. and G. Edward Schuh, "The Land Market as a Link Between the Rural and Urban Sectors of the Economy," Journal of Farm Economics, Vol. 44, December, 1962. Scofield, William H., "Land Prices and Farm Earnings," Farm Real Estate Market Develgpment, United States Department of Agriculture, Economic Research Service, October, 1964. Scofield, William H., "Prevailing Land Market Forces," Journal of Farm Economics, Vol. 39, NO. 37, December, 1957. United States Department of Agriculture, Agricultural Prices, United States Government Printing Office, Washington, D.C., May, 1965, Supplement NO. 1. United States Department of Agriculture, Agricultural Sta- tistics, United States Government Printing Office, Washington, D.C. United States Department of Agriculture, Farm Income Situation, Economic Research Service, July, 1965. United States Department of Agriculture, Prices Paid bprarmers for Commodities and Services, U.S., 1910-1960, Sta— tistical Reporting Service, Statistical Bulletin No. 319. United States Department of Commerce, Business Statistics, United States Government Printing Office, Washington, D.C.] 1963. United States Treasury Department, Farmers' Tax Guide, 1964 Edition, Internal Revenue Service, Publication No. 225. Wall Street Journal, The, Vol. XLV, No. 51, December 24, 1964. Weimer, Arthur M. and Homer Hoyt, Principles of Real Estate, The Ronald Press Company, New York, New York, 1954. Yarmon, Morton, Invest Smartly, Charles Scribner's Sons, New York, New York, 1961. APPENDICES 99 APPENDIX I CONSTRUCTION OF THE CONSTANT DOLLAR VALUE SERIES FOR FARM REAL ESTATE The constant dollar value series for farm real estate is composed of two parts: a constant dollar value series for farm land and a constant dollar value series for farm buildings. The constant dollar value series for farm land was com— puted for each census year for each state. The intercensus year values were estimated on the basis of a linear interpola- tion between the census years. Farm land was separated into five groups: (1) crOpland not irrigated, (2) cropland irrigated, (3) pasture irrigated, (4) pasture not irrigated and (5) other land. Relative price weights for the base period were computed in terms of the price of pasture not irrigated. The sum of these relative prices times the number of acres in each land group will thus give the number of pasture acre equivalents. These pasture acre equivalents represent the number of acres of farm land in a state in terms of the amount of acres of nonirrigated pasture land they represent. By converting to a common denominator, nonirrigated pasture acres, the problem of quality differences is circumvented. The pasture acre equivalents are computed as follows: 5 ”it = Z —J_Pi'b Qijt' (1-1) 1=1 P4jb 100 101 where i represents the farm land group defined above, j equals the state, t equals the census year and b equals the base year. Thus, th represents the number of pasture acre equivalents for state j in census year t; Pijb equals the average price per acre for the farm land group i in state j for the base. year b; and Qijt depicts the number of acres in farm land group i in state j and census year t. The price per pasture acre equivalent in the base period for each state can be defined as: where ij is the current dollar value of farm land in state j in the base year. Now utilizing this constant pasture acre equivalent base period price and the pasture acre equivalents, the constant dollar value of farm land for each state for the census years can be determined: th ’ ijth - (1—3) After the constant dollar value series for farm land for each state and each year is determined it can be summed over all states to determine the constant dollar value series for the United States: 48 ._ L t o 31 3t t‘l n . (I-4) The constant dollar value series for farm buildings is 102 built on a perpetual inventory type construction. To the value of the farm buildings in the base year is added the sum of the deflated net investment in farm buildings for the inter- vening years. This gives the constant dollar value series for farm buildings in period t: ‘ St: Ik B = + —— - _ t 13b . (I 5) k=1 BMPIk where Bb equals the value of farm buildings in the base period, Ik represents the annual net investment in farm buildings in current dollars in period k and BMPIk represents the Building Materials Price Index for period k (k=1...t). The constant dollar value series for period t for farm real estate can now be defined as: Vt: '1'. + E. (I-6) lNet investment in farm buildings is defined as the gross capital expenditures on farm Operator's dwellings, service buildings and other structures less depreciation of these structures and an allowance for accidental damage and the Buildings Materials Price Index is the mean of the House Building Materials Price Index and the Service Buildings and Other Structures Materials Price Index. APPENDIX II CONSTRUCTION OF THE CONSTANT DOLLAR VALUE SERIES FOR COMMON STOCK The constant dollar value series for common stock is a type of perpetual inventory series. It will be assumed that the value of the outstanding common stock in the first year of this study is a good estimate of the "real”value of the investment in the corporation in that year. To convert this value to constant dollar terms it will be deflated by the Wholesale Price Index for that year. The constant dollar value of the common stock investment in any succeeding year will be this deflated value Of the outstanding common stock in the first year plus the sum of the deflated changes in retained earnings for the corporation for the intervening years. That is: ._ V R Vt = l + k p (II-1) WPIl = WPIk where-Vt equals the constant dollar value of common stock in period t, V equals the current dollar value of the oustanding 1 common stock in period one, WPIk represents the Wholesale Price Index for period k and Rk equals the retained earnings Of the corporation for period k(k=1 . . . t-l). 103 10. 11. 12. 13. 14. 15. 16. 17. 18. APPENDIX III CORPORATIONS INCLUDED IN THE RANDOM SAMPLE OF COMMON STOCKSl Aeroquip Corporation (Aeroquip) American Investment Co. (Am Inves) American Machine & Foundry Company (Am M Fd) American Sugar Company (Am Sugar) Ametek, Incorporated (Ametek) AMP Incorporated (AMP Inc.) Arvin Industries, Inc. (Arvin Ind) Associated Spring Corp. (Assd Sprg) Atlantic City Electric Co. (At City El) Avco Corporation (Avco Corp) Baxter Laboratories, Inc. (Bax Lab) Boeing Company (Boeing) Briggs Manufacturing Co. (Briggs Mfg.) Bulova Watch Co., Inc. (Bulova) Carrier Corporation (Carrier) Chemway Corp. (Chemway) Chicago Great Western Railway Co. (Chi Gt Wn) Chris—Craft Industries, Inc. (Chris Crft) 1The symbols in the brackets are the corporation abbreviations used in The Wall Street Journal. 104 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 105 The Columbia Gas System, Inc. (Col Gas) Commercial Credit CO. (Coml Cre) Continental Air Lines, Inc. (Cont Air) Continental Motors Corporation (Cont Mot) Controls Co. of America (Controls) Deere & Company (Deere) Duffy—Mott Co., Inc. (Duffy Mott) Food Giant Markets, Inc. (Fd Gt Mkt) General Electric Company (Gen Elec) Gerber Products Co. (Gerber Pd) Globe-Union Inc. (Globe Un) Goodyear Tire & Rubber Company (Goodyr) The Great Atlantic & Pacific Tea Company, Inc. (Gt A & P) Hallicrafters Co. (Hallicraft) Hayes Industries, Inc. (Hayes In) Helene Curtis Industries, Inc. (Hel Curt) Helme Products, Inc. (Helme Prod) Heublein, Inc. (Heublein) Holt, Rinehart & Winston, Inc. (Holt R & W) Hudson Bay Mining and Smelting Co., Limited (Hudsn Bay) Interstate Department Stores, Inc. (Inters DS) Jewel Tea Co., Inc. (Jewel T) The Kendall Company (Kendall) Kinney Service Corp. (Kinney S) 43. 44. 45. 46. 47. 48. 49. 50. 51. 52. 53. 54. 55. 56. 57. 58. 59. 60. 61. 62. 63. 64. 65. 66. 106 Livingston Oil Co. (Livings O) Loral Electronics Corp. (Loral Corp) Marshall Field & Company (Marsh Fd) Masonite Corp. (Masonite) The Maytag Company (Maytag) McCrory Corporation (McCrory) McDonnell Aircraft Corporation (McDon Air) McIntyre Porcupine Mines, Limited (McIntyre P) Arthur G. McKee & Co. (McKee) McNeil Corp. (McNeil) Minnesota Power & Light Company (Minn P L) Mueller Brass Co. (Mueller) National Airlines, Incorporated (Nat Airl) National Aviation Corp. (N Aviat) National Fuel Gas Company (Nat Fuel) National Steel Corporation (Nat Steel) National Tea Co. (Nat Tea) Niagara Share Corp. (Niag Shr) New Jersey Zink Co. (N J Zink) New York Shipbuilding Corporation (N Y Shipbldg) North American Coal Corp. (N Am Coal) Norwich Pharmacal Co. (Norwch) Ohio Edison Company (Ohio Edis) Oklahoma Natural Gas Company (Ok N Gas) 67. 68. 69. 70. 71. 72. 73. 74. 75. 76. 77. 78. 79. 80. 81. 82. 83. 84. 85. 86. 87. 88. 89. 90. 107 Owens-Illinois, Inc. (Owens Ill) Oxford Paper CO. (Oxfd Pap) Pacific Petroleums Ltd. (Pac Petrol) Phillips-Van Heusen Corp. (Phil VH) Plough, Inc. (Plough) Puget Sound Power & Light Company (Pug SPL) Rayonier, Incorporated (Rayonier) Rheem Manufacturing CO. (Rheem Mf) Richfield Oil Corporation (Riche Oil) Rochester Gas & Electric Corporation (Roch GE) Ronson Corp. (Ronson) Ryan Aeronautical Co. (Ryan Aero) Ryder Systems, Inc. (Ryder Syst) Seaboard Air Line Railroad Company (Seab A1) Seagrave Corp. (Seagrave) Seeburg Corp. (Seeburg) Seiberling Rubber Co. (Seiber Rub) 800 Line Railroad Company (Soo Line) Southern Natural Gas Company (Sou Nat G) Southern Railway Company (South Ry) Standard Kollsman Industries Inc. (Std Kollsman) Standard Oil Company (New Jersey)(Std Oil NJ) Suburban Gas (Subur Gas) Sunbeam Corporation (Sunbeam) 91. 92. 93. 94. 95. 96. 97. 98. 99. 100. 108 Sunshine Mining Co. (Sunsh M) Texas Eastern Transmission Corporation (Tex East T) Trans—World Financial Co. (Tra W Fin) Udylite Corporation (Udylite) United Fruit Company (Un Fruit) United States Tobacco Company (US Tob) Universal Oil Products Co. (Univ Oil Prod) Waldorf Systems Inc. (Waldorf Syst) Washington Gas Light Company (Wash Gas) Wheeling Steel Corporation (Wheel Stl) ”'1 1111111111 ((11111 111111“