All Commentary
Sunday, April 1, 1962

The Role of the Securities Market

Mr. Reinach is President of Venture Options, Inc., a Put & Call writing company. This ar­ticle is an excerpt from his book, The Nature of Puts & Calls, New York: The Bookmailer, 1961. $2.00.

In order for man to raise his level of living, he must both save and use part of his savings to finance the accretion of business’ tools of production. To finance means to provide capital through lending or investing. When man finances the accretion of tools of produc­tion, he is supplying business with the means to produce more eco­nomically and more abundantly. A financier is a nourisher of busi­ness and thereby a stimulator of production.

Consuming never generates tools of production, nor does hoarding. This does not mean there should be a stigma attached to hoarding. Man hoards when he thinks hoard­ing will afford him greater satis­faction than consuming, lending, or investing.

Lending sometimes generates tools of production. Loans to indi­viduals are usually consumed. Loans to businesses usually gener­ate tools of production. Loans to governments occasionally generate tools of production. Deposits in banks or savings and loan associa­tions are actually loans to them. Loans to banks or savings and loan associations are in turn loaned by them to businesses, governments, and individuals and generate tools of production to the extent that these borrowers employ their loans for that purpose.

Investing almost always gener­ates tools of production. This does not mean that all investing is pro­ductive. In order for tools to be productive, they must produce what is in effective demand with sufficient economy to afford their investors or owners a profit, or promise of a future profit, to an extent that will encourage present investors or owners to remain as such, or to an extent that will en­courage new investors or owners to replace those who want out.

Financing New Business

When you invest your savings by beginning a business of your own, by purchasing a business al­ready in existence, by purchasing newly issued shares of stock of a corporate enterprise being started by others, or by purchasing newly issued shares of stock of a corpor­ate enterprise already in exist­ence, it is pretty easy to visualize the financing job your savings ac­complish. When you purchase the already outstanding shares of stock of a going company, how­ever, it becomes considerably more difficult to connect your savings with the new or improved tools of production your savings generate. You purchase 100 shares of Gen­eral Motors. Your savings do not go to the General Motors Corpora­tion. They simply go to some per­son who sold the 100 shares you bought.

What you may overlook, how­ever, can be perceived every busi­ness day in the financial sections of the country’s leading newspapers. Every day some American com­panies seek financing to improve their production facilities. In the Wall Street Journal of June 29, 1961, advertisements appeared concerning the financings of the following companies: The South­western States Telephone Com­pany, Northeastern Water Com­pany, United Aircraft Corpora­tion, Special Metals, Inc., Rockower Brothers, Inc., Empire Fund, Inc., Hunt Foods and Industries, Inc., and Morris Shell Homes, Inc. And there were undoubtedly other fi­nancings that day that were not advertised.

Let’s now return to the person who sells the 100 GM you pur­chase. Perhaps he sells his shares to purchase one of the new issues. In this event, your purchase is only one step away from being a direct financing. Or perhaps he sells his shares to invest in some already outstanding shares of a steel company, but the man who disposes of his steel shares does so to purchase one of the aforemen­tioned new issues. In this event, your purchase is two steps away from being a direct financing. Or perhaps ten or twelve transactions have to be traced to locate the fi­nancing that your routine pur­chase helps to make possible. This is usually the case, which is partly the reason that many investors do not appreciate the productive achievements their savings accom­plish when invested.

Now let’s suppose that the per­son who sells you his GM stock uses the proceeds for a vacation in Europe. In this event, your pur­chase replaces savings withdrawn from the capital equity market. If you refrain from investing your savings, and our traveler with­draws his savings from the mar­ket, funds to purchase the trav­eler’s stock will have to be diverted somewhere from direct financing, thus contributing to the delay or failure of some borderline proposi­tion.

The preceding paragraph should answer, by implication, most of the “What would happen if?” questions. The vital point to re­member is that an effect can be traced to every purchase or sale of stock. Your sale of stock or re­fusal to invest will not, of course, affect those financings which are eagerly sought, or even unexciting routine financings. But your sale of stock or refusal to invest must, if only nominally, adversely affect the financing of marginal enter­prises—the future General Motors and IBM’s.

Three Prime Functions

The role of the securities mar­ket should now begin to evidence itself. A securities market has three principal functions to which all others are subservient:

1.      Initially, a securities market is created to help finance growing, or sometimes new, corporations. A securities market finances di­rectly when its principals or mem­bers invest or lend their own funds. Because this source of funds is obviously limited, cus­tomers must inevitably be re­cruited to participate in financing operations.

2.      The second important func­tion of a securities market meshes with the first. A securities market, while providing industry with new capital, must simultaneously help investors and lenders to locate se­curities which meet their objec­tives.

3.      The third function of a se­curities market is as crucially im­portant as the first two, though rarely as appreciated. A securities market provides liquidity, to vary­ing degrees, for the securities traded within its domain. Full liquidity would mean ready sale­ability or purchasability of any reasonable quantity of a particular security at or near its latest cur­rent market price. Full liquidity is rarely achieved. All securities con­tain degrees of liquidity. Ameri­can Telephone and Telegraph en­joys a high degree of liquidity. Most over-the-counter stocks do not.

Liquidity is the most overlooked attribute of the market place. Where liquidity is present to a large degree, buyers and sellers do not materially suffer from the price differentials between the bid prices and the asked prices, and trade is accordingly brisk. Where liquidity is largely absent, buyers and sellers suffer from the price spreads, and trade is accordingly dull. The secondhand automobile market is quite liquid. Car owners of even modest means can enjoy the luxury of periodic taste changes. The secondhand furniture market lacks liquidity. Only the wealthy can afford the luxury of periodic furniture taste changes.

Because liquidity is important to investors who value the knowl­edge that they can easily dispose of their commitments at or near their latest current market prices, only those corporations whose is­sues have a satisfactory degree of liquidity can get added financing economically. The aggressive pur­chasing of a company’s already outstanding securities will signifi­cantly advertise the fact that new issues of that company will be well received. During the past decade, AT & T has encountered no diffi­culty attracting the capital it re­quired to bring telephones to vir­tually every family in the United States. During the past decade, AT & T has been aggressively traded and purchased.

Ultimately, liquidity is made possible by traders, speculators, scalpers, or whatever you wish to term them. A trader makes profits by correcting price distortions. The profit a trader makes precisely matches the quantitative extent of the net distortions he corrects. The more successful a trader is, the more future liquidity he will be able to provide for the markets in which he functions.