In many cases, as with the railways, valuations at the peak of bubbles become so detached from reality that investors are in effect discounting the whole of tomorrow. Given that new technologies are prone to continuous change, and face in most cases the inevitability of intense business competition, identifying in advance the companies with the best prospects is difficult. It is certainly not as easy as identifying the losers. At a relatively early stage, it was evident that canals had lost their economic viability. They could not shift either their position on the cost curve or the curve itself sufficiently to counter the railways. The investment decision to exit an industry in secular decline in favour of other opportunities should have been relatively straightforward.
York and North Midland Railway
Should investors have seen through Hudson?
Virtually the entire asset base of Hudson’s railway company, the York and North Midland Railway, was funded out of shareholders’ capital, with almost no funding from retained profits. This looks unusual to modern eyes, but was less so in the context of the time. All promoters of new technologies know that raising capital depends heavily on creating a perception of success. In the case of the railways, this perception of success depended on the level of dividend payout being sustained. Any sign of weakening in dividends would have been taken as tantamount to an admission that operating profits were lower than investors had been led to believe. As the building of a railway network was a capital-intensive business, there would be legitimate questions even today about the correct level of depreciation to be charged.
At the time depreciation played no role in the financial reporting of companies. Financial reporting was a requirement of the listing particulars of the company and the parliamentary act that established it, but not a prescriptive legal requirement. In addition, there was no requirement for independent auditing. As a consequence, financial reporting was at the whim of the company. The distinction between capital and income was one which could be (and was) arbitrarily determined by the company itself. There was little barrier to dividends being paid out of capital masquerading as profits, so long as the balance sheet could sustain it.
For the outside investor, verifying the company’s financial results would have been impossible. Publicly available information was also relatively sparse. Nevertheless, there were sufficient warning signs to cause even a contemporary investor some concern. For example, the company claimed that its dividend, equivalent to over 10% of profits, was well covered by income. But the company accounts (reconstructed in the accompanying charts) showed an equity base that was growing alongside a return on assets of less than 5%, a combination that was only sustainable in the short run. Funding the expansion of the railway through new equity was also surprising, in the sense that equity capital was more expensive than debt.
1.9 – Hudson’s railway company: the York and North Midland
Source: Railway Chronicle. Railway Times.
Expansion should have been funded through retained profits, supplemented by debt, which in the early part of the period was available at a much lower cost than 10%. For the investor, the decision to fund growth entirely through issues of new equity would have demanded an explanation. Another anomaly which required explanation was the reported level of profit. The margins seemed to be very high, something that you would normally associate with monopoly pricing or a level of operating costs which was kept low through efficiency or capital underspend. That monopoly conditions were absent should have clearly pointed investors towards the questions of the cost and maintenance of the fixed asset base.
If the way in which Hudson massaged his profits to preserve his dividend capacity is clear enough now, even at the time the inconsistencies in the company’s financial statements and funding requirements should have created doubt in investors’ minds. This doubt would have been that net income was being overstated through artificially deflated expenses. At that point, the logical next question would have been to ask why such artifice was used. The obvious answer was that it was needed to sustain the dividend payout, on which in turn the capital to fund expansion depended. A modern parallel might be with the boom in conglomerates during the 1970s and 1980s. These companies were built on the back of continual acquisitions, which maintained growth in an accounting sense but rarely added much in the way of economic value.
So long as they could buy companies at an apparent lower valuation, in the short run their earnings continued to appear to grow (so much the better if they could also be run as cash cows). Unless the acquirer was able to make serious improvements to the business as well, the whole process was little more than a house of cards. For the York and North Midland Railway, the process was somewhat similar, though more short-lived because the favoured investment criterion of the day was dividend yield rather than price earnings multiple. The company faced a constant outflow of cash to pay dividends to shareholders. It needed a counterbalancing inflow from share issuance.
The game of equity funding the dividends continued for nearly ten years, during which the company expanded through acquisition, until the company could no longer make the arithmetic work any more. As the shareholder base grew, so did the dividend requirements. When profitability started to fall, the game could not continue. When interest rates rose and the economy slowed, the whole edifice came crashing to the ground. The case of the York and North Midland Railway underlines the need for a timeless analytical discipline: when in doubt, check the cash flow position. Profit can be misrepresented, but other than in cases of deliberate fraud, analysing cash balances and cash flows typically provides a better picture of the true underlying position.
The extent to which the railway mania had permeated society and the financial impact this had subsequently became the subject of a number of contemporary accounts, something which was to become a feature of future equity market bubbles (see figure 1.10).
“The extraordinary mania had seized on merchant and manufacturer with a power which defied control. It was condemned by parliament, and two-thirds of the members were dealers. It was condemned by the press, and editors were provisional committee men. It was condemned in the pulpit; and while a bishop was obliged to reprove his clergy, an archbishop was said to hold council with Mr. Hudson. The lord who derided it in the park, was beheld the next day in Throgmorton-street. The lady who ridiculed it in her boudoir, was seen the next hour at her broker’s.” (p.158)
“The subtle poison of avarice diffused itself through every class. It infected alike the courtly and exclusive occupant of the halls of the great and the homely inmate of the humble cottage. Duchesses were even known to soil their fingers with scrip, and old maids to inquire with trembling eagerness the price of stocks. Young ladies deserted the marriage list and the obituary for the share list, and startled their lovers with questions respecting the operations of bulls and bears.” (p.174)
“On Thursday, 16th October, 1845, the Bank of England raised the rate of interest; and the effect was immediate. On that day men looked darkly and doubtfully at each other; on Friday there was a considerable cessation of bargains, and on Saturday the alarm commenced. The news passed from the capital to every province in the empire, that there was a panic in the share market. From London to Liverpool and from Liverpool to Edinburgh the intelligence spread. Money was scarce; the price of stock and scrip lowered; the confidence of the people was broken, and the vision of a dark future on every face. Advertisements were suddenly withdrawn from the papers.” (p.191)
“Such were the effects of the last great money mania and its attendant panic. Many a futile effort to re-instate confidence was made by some, and many a bold attempt to regain the money they had lost was made by others. An undue depression was the natural result of the extreme excitement, and shares in lines which were not worse than they ever were, fell in price.” (p.253)
1.10 – Bubbles infect everyone: a contemporary account of the railway mania
Source: Francis (1968).
* * *
> 1 C. Cerf and N. S. Navasky, The Experts Speak: The Definitive Compendium of Authoritative Misinformation. New York: Villard, 1998, p.251.
2 J. Francis, A History of the English Railway: Its Social Relations and Revelations 1820–1845 (originally published 1851), New York: Augustus M. Kelley, Reprints of Economic Classics, 1968, p.135.
3 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, p.436.
chapter 2
Breaking Out
The story of the US railroads
“The New York railways have been worked with no common-sense and judicious object … They [the American railroads] have been regarded as mere links in a system which has reached to the extremity of Illinois, crossed the Mississippi, and penetrated into Missouri almost beyond the haunts of man, and one which will one day penetrate to the Pacific, and monopolise the carrying of tea from China. This is the rock upon which the American railways have struck … the more distant and worthless the traffic, the greater have been the sacrifices to encourage and secure it … What a different system from that which obtains in England, and how much less satisfactory to the share and bondholders!”
The Money Market Review, London, 30 June 1860
[between 1860 and 1865 the US rail stock index rose 150%]
Beginnings: boats, barges and horses
For the United States, the 1800s was a time of growing international trade, emigration from Europe and technology transfer from the developed economies to the New World. Some of the technology transfer simply took the form of the skills brought by the immigrant population. However, US entrepreneurs were also visiting Europe to see what new inventions and technologies could profitably be imported. In the case of the railroads, at first the Americans simply imported the steel and the locomotives.
Later, the skills and manufacturing techniques required to build a railway also began to cross the Atlantic, leading to the creation of an independent railroad industry. While America was a new country, it combined an established economic system on the eastern seaboard, resembling that of the ‘Old Country’, and the emerging potential of the new western frontier. Together these created a whole new set of operating conditions.
In the early 18th century, the transport of goods in America was a laborious and expensive process. Although a substantial network of rural roads existed, these were little more than cleared paths maintained by local communities, and could be navigated only with the forbearance of nature. The need for improvements stimulated the construction of privately and publicly financed tollroads and turnpikes. The British blockade of US ports during the War of 1812 helped to stimulate the construction of new roads, to provide new channels for the transport of goods. The real impetus only came after the end of the war, as economic conditions improved. The construction of turnpikes accelerated. By 1821, more than 6,000 miles of new roads had been authorised.
The turnpikes, though, were not a financial success. They were financed in the main by companies set up for the purpose, which raised funds from both public subscription and from governmental bodies. The economics of operation meant that many of them struggled to earn sufficient revenue to cover their maintenance costs, let alone provide a reasonable return on capital. The principal problem was that any meaningful charge for the bulk transportation of low-cost goods made using the road prohibitively expensive for the transporter. Equally important was how difficult it was to collect the charges. Users were quite willing to wait until nightfall before passing through the toll stations, or to circumnavigate them completely.
The toll roads’ financial failure can be measured by the fact that even in the most successful state for turnpikes, fewer than six out of a total of 230 paid satisfactory returns to investors.⁴ So far as canals were concerned, the development of an inland waterway system had lagged behind what had been witnessed in Britain. The principal reasons were the absence of capital to fund construction and a shortage of engineering skills to build them. Just as important was the lack of evidence from the few canals that had been built that they represented a viable financial proposition. It was against this background that the Erie Canal was built. The longest canal in America prior to the Erie had stretched a grand total of 28 miles. Authorised in 1817 by the New York legislature, the Erie Canal was to stretch over 350 miles, from Albany through wilderness to Buffalo on Lake Erie. Funded by the state, the Erie Canal proved a resounding success. Having cost roughly $7.5m ($1.3bn) to construct, it was soon earning tolls of $500,000–$750,000 a year (over $100m) and worrying about congestion on the waterway.
The success of the Erie Canal spurred a huge level of construction throughout America. No longer were investors or government bodies frightened by the financial consequences. Between 1816 and 1860, over $200m ($32bn) was poured into canal construction. Private investors were bolstered by the attitude of the states and the federal government, which were willing to subscribe to the new ventures and in some cases accounted for the majority of the invested funds. Unfortunately for all these investors, few canals ultimately proved profitable. The boom caused construction costs to rise, allowed some less-than-competent companies to be floated, and – most importantly – ignored the basic economics of many routes. The profitable canals enabled coal and other bulk goods to be transported quickly between supplier source and customer. They had the ability to carry relatively heavy tonnage, few locks, and efficient collection and distribution at either end. The railroad feeders at the ends of the canals were often unable to cope with the volume of goods, creating bottlenecks and delays.
No match for the railroads
All these were issues for the canals, but their demise was ultimately due to their inability to compete with the railroads. The year the Erie Canal was completed in America also saw the opening of the Stockton and Darlington Railway in Britain. While few canals were built in Britain after the 1830s, in America the major building took place during that decade and extended into the 1840s – by which time the economic superiority of the railroad should have been obvious. Perhaps the spirit of the time was such that the threat of the railroad was ignored – although it could not have been through ignorance. America had also embraced the railroad, to the extent that by 1840 there was more operational track in the US than there was in Europe.
In the period to 1850, roughly $372m (over $50bn) had been invested in the railroads, but in the seven years to 1857 a further $600m (over $80bn) was invested – a figure three times that which had been sunk into canals over their lifetime. The surge in capital for the US railroads involved funding from outside of America on an unprecedented scale, together with the creation of an industry which attracted many of the most famous (or notorious!) corporate figures of 19th-century America.
While the development of the American railroads followed a similar pattern to their counterparts in Britain, there were significant differences. Britain was in many ways the world’s economic superpower, and America was an emerging market. In Britain there was an established legal and governmental system; in America, the delineation of the legal province of the individual states and central government was in many cases unclear. In America, land on which to lay track was readily available; in Britain it often had to be secured against entrenched opposition. The final and most notable difference was that, as the major financial centre of the world, Britain was an exporter of capital – and, as a developing market, America was an importer.
The early American railroads were relatively short lines linking existing urban centres. As such, finding capital for them was not too difficult and was normally achieved within the locality being served. As the length of the railroads increased, so did the funding requirements. Frequently, the railroads would find the seed capital locally so that construction could begin, before going to Europe – and Britain in particular – for additional capital.
In the early years, British investors were unwilling to accept railroad stock d
irectly, preferring to purchase state bonds. In order to raise funds, the railroads exchanged bonds with the state and then sold the state bonds to British investors. The trade in these bonds was dominated at first by existing finance houses, most notably Baring Brothers and N. M. Rothschild & Sons. However, it was not long before the American importers such as George Peabody branched into the merchant banking and investment business, and his company was eventually passed to Junius Morgan. The other major form of funding came in the shape of barter payment for the iron rails being exported to America. These were almost entirely supplied from Britain until the 1840s, when the boom in British railway construction diverted supply to the home market and encouraged US domestic production. At one time, as much as half of the capital in American railroads owned by Britons was a consequence of funding the export of the rails themselves.
Engines That Move Markets (2nd Ed) Page 5