Developing the railways required a huge amount of capital investment, as the canals in Britain had done a generation before. Where would this money come from? Happily, the Industrial Revolution coincided with – and stimulated – the evolution of financial markets. Until that point, the options for investors consisted primarily of purchases of interest-bearing government securities. In an agrarian economy, few ‘growth’ investment opportunities existed. Such high risk/reward ventures as there were consisted mainly of funding or underwriting foreign trade ventures.
The Industrial Revolution brought a stream of new industries which required capital, and held out the prospect of huge increases in productivity. The individuals funding these new companies demanded a slice of the profits in return for the risks they were assuming. Increasingly, they were unwilling to accept simple interest-bearing securities with fixed semi-annual or annual payments. Naturally, as profits multiplied, equity funding grew in popularity. New companies were quick to take advantage, and established finance houses – which had grown through their relationship with government and their ability to place government debt – soon adapted to the new world. They, too, began to participate with great gusto in the funding of industrial companies. The famous finance houses of the Rothschilds and Baring Brothers were joined by financiers such as J. P. Morgan, who emerged from their association with the ‘new’ companies and industries.
This period also saw the emergence of a new breed of what we would now call ‘corporate raiders’, attracted by the ready profits to be made. In legal terms, the development of the joint stock company was a critical step: until that point, parliamentary approval was required for the constitution of a new company. Pure equity financing did not become widespread until the late 19th century. But even 200 years ago the investor who so chose could invest outside the UK. The financial press at the time devoted a large proportion of its column inches to international bond issues. The Napoleonic Wars had meanwhile left a heavy legacy of war debt to be financed.
In the mid-1820s, transport was the dominant class of investable securities. Canals, docks, bridges and roads made up more than half the quoted stock market universe in 1825. Of the rest, the most important sectors were gas and water utilities and mining companies. The latter showed that strong speculative demand was already present in the market. The relatively strong economic conditions created an ideal environment for raising capital for ventures that would otherwise have been deemed highly speculative. The mines were mainly in South America. The promoters argued that by bringing in British technical and management expertise, their fortunes could be resuscitated. Their argument was that previous failures had been the result of local political issues rather than commercial or technical failings.
In reality, the mining did not live up to expectations. Further capital was soon required from shareholders. The excitement that had driven up mining share prices evaporated just as quickly. As figure 1.1 shows, the index of mining share prices rose by almost 600% in less than 12 months, only to fall back just as rapidly. This rapid puncturing of a share price bubble is typical of what happens during a phase in which market valuations are driven more by themes and concept stocks than by profits, dividends and other fundamental considerations. It has been repeated many times since.
1.1 – Nothing new: the 1820s mining stock bubble
Performance of mining stocks relative to the stock market, 1824–1829
Source: D. G. Gayer, W. W. Rostow and A. J. Schwartz, The Growth and Fluctuation of the British Economy 1790–1850, (2 vols.), Oxford: Oxford University Press, 1953.
The heyday of canals
The Industrial Revolution mechanised the production of many bulk goods and textiles and created a requirement to shift these goods from central production points to market. Advances in engineering and construction techniques helped to make possible the construction of a myriad of canals upon which the goods could be shipped. With their viaducts, bridges and tunnels, the canals quickly captured most of the market for land-based transportation of goods. Their costs were barely one third of the main alternatives, horse-drawn containers and coastal ships. Passenger and mail traffic remained the preserve of the horse and carriage.
Between the late 18th century and 1824, more than 60 canal companies were created, raising more than £12 million of new capital, equivalent to some $12 billion in today’s money. Demand for canal shares was so great that capital was widely obtained from public subscription on an unprecedented scale. Many of the issues were substantially oversubscribed.
At first this enthusiasm appeared relatively well founded. Some historians have noted that many British canals provided substandard returns for investors. Over the full life of the canal system, this may have been true. However, before the railways emerged to take away their market, canals did provide strong absolute and relative share price performance. As with many infrastructure projects, the problem for canal investors was the continuing need for large capital outlays. To recoup such heavy upfront investment required an extended period of profitable operation. The arrival of the railways denied canal investors this necessary period of capital recovery and provides a timeless lesson for investors attracted by the lure of a new technology.
Any technology that necessitates heavy capital expenditure and requires returns to be earned over an extended period is always going to be a high-risk undertaking – unless, that is, there is some form of protection against competition. This protection may take the form of patent, copyright, legal prohibition or simply fundamental competitive advantage (such as a superior cost curve). There is an obvious parallel between what happened with the canals and the debate about the prospects for third-generation (3g) telecommunication licences at the time of the first edition of this book in 2001. In both cases, massive amounts of capital expenditure were committed but without any guarantee that the new technology would enjoy a sufficiently long period of dominance in which to earn back, let alone exceed, the capital cost.
The mid-1820s was the last period of investor enthusiasm for canals in Britain. This was a time of general enthusiasm for new issues. In 1824–25, more than £370m was invested in 600 new companies, a huge sum equivalent to $300bn today. To put it in context, this was roughly equivalent to the peak (year-2000) total annual global capital expenditure on telecommunications – including, wireless, optical cabling and broadband! Canals and railways accounted for 15% of this total, the single largest category of investment other than collective investment schemes. This was the high water mark for the canals – though, as figure 1.2 shows, it was not until the 1830s, when the railways began to undercut and displace them, that canal share prices began to be badly affected. The new railways could ship goods at prices at least one third lower than the canals, which were forced to drop their prices significantly in order to remain competitive.
The new production technology is adapted for transport
The very success of increased mechanised production that constituted the early part of the Industrial Revolution created with it a series of obstacles that needed to be overcome if the full benefits were to be realised. The new ‘mass’ production required large workforces and out of this need came the rapid expansion of urban centres. It also required the ability to shift goods from point of production to their waiting markets. The canal system had been developed in response to this need but it remained limited in its capability by the relative inflexibility of the system and the method of locomotion: the horse. The logical and obvious step for the Industrial Revolution was to take the technology used in the production of goods and adapt it for use in their transportation.
The markets had to be broadened and deepened by reducing the cost and increasing the speed with which products could be shipped. In this regard the origins of the railway lay in the improvement to the steam engine through the addition of a separate condenser by James Watt in 1769. This invention took steam technology to a new level by dramatically increasing its reliability, efficiency and capacity.
<
br /> The machines created by Watt and his partner Matthew Boulton were applied in many industries. In the coal industry they were used to pump out wastewater. In factories, they would drive the new machinery of the textile industry. Eventually they began to form the basis for new, improved forms of self-powered transport. In time, these new forms of transport would supplant the dominant position of the canals for freight transport in the UK. More importantly, it would bring the potential to open up whole new continents for economic development, through its ability to reduce the cost and time of transportation.
Reducing the time of transportation had at least one unintended side effect – the development of standard time. In Britain, because of its relatively small size, the difference between time in the east and the west was a matter of minutes rather than hours, but the differences were important nevertheless. For a railway they could be critical, given the difficulties in scheduling operations. Time differences which had previously carried little meaning before began to be significant. In 1845, the Liverpool and Manchester Railway petitioned Parliament to adopt London (i.e. Greenwich) time as the standard for the country. There was much resistance to the change but eventually the benefits led to its wholesale adoption aside from some recalcitrant outposts. (In North Wales, for example, one local railway company kept its clocks precisely 16½ minutes different from Greenwich time.)
James Watt, together with his chief engineer William Murdoch, was primarily interested in producing stationary steam engines. It was only as a sideline that they experimented with constructing a steam locomotive. A Cornishman by the name of Richard Trevithick broke new ground in transportation and on Christmas Eve 1801 completed the first successful preliminary test of a steam locomotive.
It is not often recounted that three days later the locomotive went out of control and needed to be stored. Nor is it normally recalled that its operators repaired to a local hostelry for food (and ale), leaving the locomotive unattended. The result? The boiler exploded, taking with it the surrounding buildings.
In fact, Watt had looked at the prospects for developing a high-pressure steam engine but had not pursued them due to concerns over safety. Nevertheless, Trevithick was undeterred by this setback and filed for a patent as he sought to develop a more compact powerful engine. More mishaps followed. In 1803 one of his high-pressure boilers again exploded, this time killing three people. The engine in question had been pumping water out of a corn mill and the boiler had been left unattended when the operator slipped away to fish for eels in a local pond. Even though the explosion was due to operator neglect, this did not inhibit rivals Boulton and Watt from using the tragedy to undermine the reputation of the high-pressure engines. Trevithick reacted by installing a number of safety features allowing steam to be released whenever the boiler pressure exceeded safe levels. In the early years, high-pressure boilers were typically used for a wide variety of tasks – pumping water, crushing rock, boring cannon, powering mills.
All, it seemed, except transportation. It was only later that the transport potential of a small powerful engine was recognised. One of the landmark developments was marked with a wager. Trevithick bet a neighbouring ironmaster 500 guineas ($50,000) that he could haul ten tons of iron ten miles on a tramway. In February 1804 he won the bet – with the first locomotive to run on tracks. The better-known steam engines such as Stephenson’s Rocket (which were later to become historical landmarks in the history of the locomotive industry) were derivatives of the basic principles embodied in Trevithick’s early work.
It is difficult to overstate the importance of the steam engine. It led to massive increases in productive potential in Europe’s largely agrarian economies. Factories were expanded and the development of towns and urban areas followed. Steam engines allowed the movement of such large bulky products as iron and coal to markets at competitive prices.
They were also critical, particularly in North America, in opening up new land for development. In Europe – and particularly the UK – the new railways essentially linked up existing urban centres. This meant their funding and viability could be estimated with a fair degree of assurance. For the emerging market of the USA, the position was entirely different. The railways were as much a tool of fostering development as they were a linkage between existing communities or industries. That difference is significant – because (at least in part) it explains the emergence in the US of the so-called ‘robber barons’.
Responding to the threat
The canal companies responded much the same way as the competitors they had earlier superseded. They cajoled Parliament to oppose and slow the establishment of the railways, while also seeking subsidies and the removal of restrictions on canal operation in order to aid their competitiveness. By the 1830s, however, declining profitability made it impossible for canal companies to raise new capital. The railways had become the investment of choice. Their superior economics effectively sounded the death knell for the canals. By the 1850s, canals had become of peripheral importance as an investment medium.
Before the railways, canal shares were steady performers in both relative and absolute terms, roughly doubling between 1811 and their peak nearly 15 years later. In some cases, canal shares also paid 10% annual dividends, meaning that the investor was receiving handsome total returns. After the market peak in the mid-1820s, however, their loss of competitiveness was reflected in the behaviour of their share prices. From that point on, as shown in figure 1.2, the shares consistently underperformed the market.
This demonstrates another timeless lesson that investors need to learn about new technologies. A theme that recurs throughout this research is that while identifying the winners from any new technology is often perilous and difficult, it is almost invariably simpler to identify who the ‘losers’ are going to be. The canals simply could not match the capacity and efficiency levels of the railways, and their eventual demise should have been evident to any perceptive investor by the 1830s.
1.2 – The technology losers: British canal shares 1811–1850
British canals stock price index relative to the UK stock market (ex-Mines)
Source: D. G. Gayer, W. W. Rostow and A. J. Schwartz, The Growth and Fluctuation of the British Economy 1790–1850, (2 vols.), Oxford: Oxford University Press, 1953.
Success not guaranteed
Initially, the success of the railway was through its industrial lines, particularly those linking coal-producing areas to existing transport links – or directly to end users. Transporting people was only a small proportion of traffic in the early years. Partly this was due to the very real threat of crashes, boiler explosions and fire from the gas lighting. (That said, these dangers were often exaggerated – particularly compared with the dangers of other available forms of transport.) There were some notable public relations setbacks; a spectacular example occurred during the opening of the Liverpool and Manchester Railway, when the ceremony was marred by the locomotive causing the death of a former cabinet minister.
However, despite early problems with safety, the advance of the railways proved inexorable. The simple economics of their ability to shift large volumes of both passengers and freight at speeds much faster than horse-drawn coach traffic, and much more cheaply than canals, made their expansion assured. Although coastal steamboats competed vigorously for passenger traffic, they were unable to keep pace with the railways’ improvements in speed and efficiency.
While the economic power of the railways was obvious, and the technology quickly proven, the introduction of railways in Britain was not a simple or smooth process. Like canals before them, land had to be purchased and existing buildings cleared to allow tracks to be laid between existing urban centres. Compulsory purchase of land has always raised public hackles, and the early locomotives were noisy and dangerous. At the same time, the vested interests of the canals were fighting a rearguard action.
It is ironic, then, that the first railways were built as feeder lines for the canal system. The Stockt
on and Darlington Railway was the first railway to use steam locomotion, but it was not set up as a direct competitor to existing canals. The first railway set up to compete directly with a canal was the Liverpool and Manchester in 1826. The same risk-seeking investors who funded the speculative bubble in South American mining ventures in 1824–25 also helped to provide capital for the new railways. In 1825–26, nearly as many railways were launched as had been brought into existence in the entire preceding 20 years.
An initial surge of new railway companies in the mid-1820s was followed over the next decade by a steady stream of new issues. With capital plentiful, for a time the problem was not one of funding but – as with the Internet bubble – of finding enough new companies for investors to put their money into. In 1836–37, with stock markets buoyant and railway share prices having doubled, 44 new companies were authorised by Parliament. These 44 companies raised more money in this one period than had been raised in total by the industry up to that point.
In the event, the enthusiasm was premature and in the years that followed, the index of railway share prices fell back. It was not until the early 1840s that it began to rise again and approach its previous peak. Between 1843 and 1845, the index of railway share prices doubled. Before 1843, the average annual investment in new railways, as represented by increases in authorised capital, was roughly £4m (the equivalent of $3bn today). In 1844 it was £20m, in 1845 nearly £60m and in 1846 it was £132m ($95bn). In 1846, a record 4,538 miles of new track was authorised.
Engines That Move Markets (2nd Ed) Page 3