‘Enormous initial dividends were paid on these modern trust companies, with the result that in the nicely arranged match between founders and shareholders… the founders romped home while the shareholders were nowhere.’ The Bankers Magazine (1893)1
Investment trusts are pooled investment vehicles which aim to reduce risk by diversification. Like all investments, however, they are prone to periods of excess. The investment trust boom of 1888/9 shows how a low-risk sector of the stock market can be transformed into a high-risk one during buoyant market conditions, with important lessons for investors today.
The 1880s was a decade of economic expansion across the world, driven by low interest rates and technological change. The period saw important developments in the provision of electric power (thermal and hydroelectric), the first electric iron and electric lift. It provided drinkers their first glass of Coca-Cola and photographers their first Kodak box camera. It also saw the building of the first steel-skeleton skyscraper, as well as construction of the Eiffel Tower and Statue of Liberty.
During these years there were huge global capital flows with a substantial amount finding its way into Latin America, particularly Argentina, which was viewed as a high growth market at the time.
The London stock market also boomed. A popular area of the market was the investment trust sector, with a plethora of new trusts launched to meet investor demand for higher yielding investments.
Investment trusts were first established in the 1860s as vehicles for investment diversification. The first trust, Foreign & Colonial, was launched in 1868 to bring share ownership to a broader range of investors.2 Investment trusts were investment companies listed on the London Stock Exchange that invested in different assets (bonds and equities) across different markets and sectors.
The new issue boom in the trust sector between 1887 and 1890 involved the flotation of 72 trusts on the London Stock Exchange, with 15 launched in 1888 and 35 in 1889.3 Some of the new trusts listed at this time included Nitrate & General Trust and The Spanish Railways Investment Trust.
The boom involved the creation of a new kind of investment trust which sought to boost returns by earning fee income from underwriting new issues, investing in illiquid securities and specialising in emerging markets, including Latin America. In other words the flotation of new trusts was associated with taking on much higher risk.
One feature of trust flotation in the 1880s was the issuance of founder shares. These were shares given to individuals in return for underwriting new issues or covering preliminary expenses of the issue. They were often allocated to well-connected figures in financial circles who were willing to put their names to flotations to help publicise them. Founder shares could provide huge profits from the dividends paid on them. They also encouraged trust management to take on more risk to boost short-term earnings to fund the large payouts to founder shareholders.
An extreme example highlights how lucrative they might be. The Trustees, Executors and Security Insurance Corporation paid £100,000 in 1889 on 100 founder shares which had a nominal value of £10, but were only partly-paid at £3. In other words, for a payment of £3 the founder shareholders received dividends of £1,000 – the annual dividend yield on the partly-paid shares was 33,333%!4
Although the issue of founder shares was not illegal, it was morally questionable. Huge sums went to the well-connected, dwarfing the dividends of ordinary shareholders. In modern day parlance, standards of corporate governance had lapsed during the greed of the bubble. It was a classic example of the rich and well-connected benefitting from bubble conditions in financial markets.
All booms come to an end. In the late 1880s, a political revolution in Argentina pricked the bubble in global stock markets. Barings, the British bank, was heavily exposed to Latin American securities and faced a severe liquidity shock. Although Barings was ultimately bailed out by the Bank of England, its troubles triggered a crash in global stock markets. There was significant capital flight from high risk markets like Argentina. Among investment trusts, those invested in Latin America were hit first, although all trusts were impacted eventually, with share prices falling 60-70%.
The crash caused a shake-out in the trust sector. In the wake of the crisis, many trusts had to suspend their dividends, some were forced into liquidation and others into merger. Of the 100 investment trusts estimated to have been in existence in 1890, 30 had disappeared before the end of 1890s, and 50 had been liquidated or merged by the 1920s.5
Conservatively-managed trusts, such as the Alliance Trust, Foreign & Colonial and the Scottish Investment Trust, survived the debacle and are still around today. However, the crash of 1889 dented the reputation of the trust sector for many years. Low risk investments had turned out to be high risk ones and the wealthy had benefitted at the expense of the ordinary shareholder.
Lessons for investors
The investment trust bubble of 1888/9 was a classic example of an investment fad or fashion during bubble conditions. At Stewart Investors we seek to avoid such fads by our questioning culture. Analysts are expected to challenge portfolio managers about the companies they hold in their portfolios.
The tendency of bubble conditions to result in lax standards of corporate governance is highlighted by the journey of investment trusts from low-risk to high-risk investments. The lesson is that even so-called low-risk assets must be re-appraised constantly to ensure corporate governance standards are being maintained.
The debacle highlights the importance of investing in conservatively-run companies with strong management teams and independent boards which are not drawn into risk-loving behaviour typical of boom periods.
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