For the scion of the House of Morgan, the early funding of American expansion proved difficult. Although Peabody had established a thriving business, it was a period of great uncertainty. Lucrative returns had been earned selling American railroad stocks; demand for such stock soared after the food shortages brought on by the Crimean War. When the war ended and prices fell, however, Morgan found himself heavily overextended. He would have become insolvent if he had not been bailed out by the Bank of England through Barings. Morgan was later to catapult his company forward with a loan to the French government during the Franco-Prussian War. US companies such as Morgan, Cooke and Brown Brothers were now making inroads into the London market, hitherto the preserve of European financiers. This was important, as these groups were the ones to which many shareholders would turn during the increasingly difficult times that were to follow for British investors in American railroads.
The efficiency and capacity advantages which had been demonstrated in Britain’s railways were also evident in America. The buildup in canal freight that had accompanied the economic expansion of the American network was abruptly reversed as railroads encroached on the traffic. From the post-Civil War period onwards, the canals witnessed a steady decline in traffic.
2.1 – Winners for a while: canals in the US
Traffic on the New York State Canal, 1838–1918
Source: National Bureau of Economic Research (NBER): Macro History Database.
The process of capital raising and investment changed after the US Civil War, as investors increasingly sought participation in the growth of the railroads. The preference shifted away from bonds with fixed-interest payments towards common shares or bonds convertible into common shares. During the 1840s the US states had suspended interest payments, and some investors had long memories. This, together with recent failures in certain railroads, kept investors sufficiently wary that some form of interest payment was required, particularly during the construction phase. Hence convertible bonds became the favoured form of investment vehicle.
Equally, while the British investors were once more willing to invest in railroads and in US stock, they tended to concentrate on ‘lower risk’ enterprises. Typically, this meant railroads that had land mortgages and connected strategically important centres.⁵ The demand for convertible securities seemed to provide added security (by reason of the dividend payment), but this was to have an unintended side effect. It seemed ideal in principle that convertibles could be issued to finance construction and then, once the railroad was completed and the risk profile accordingly reduced, be converted into equity to give full participation in the growth. Later, however, unscrupulous operators were to discover that this provided the perfect backdoor route to issue new equity. It was a tool deployed to great effect by Jay Gould and his cohorts during the scandal of the battles over the Erie Railroad.
Vanderbilt and America’s steamboat wars
Economic development in America was accompanied by the emergence of a number of financial dynasties. (See figure 2.2.) Foremost among them were the Vanderbilts. Commodore Vanderbilt’s role in developing transportation in America, and the subsequent spread of his investments, was to make him an influential figure in many of the technologies which were to emerge through the 19th century. Cornelius Vanderbilt began his path to fame and fortune as a humble Staten Island ferryman. At the time, brand new technology of steam-powered navigation was beginning to emerge. In 1807 Robert Fulton operated a steamboat franchise granted by the state on New York’s Hudson River. Fulton had gained the exclusive rights from the state legislature to carry all steamboat cargo in and from New York for 30 years. Not surprisingly given such a monopoly, the trade was highly lucrative to Fulton and extremely attractive to others. Lured by the potential rewards, a man called Thomas Collins sought out assistance to attack the monopoly and enlisted Cornelius Vanderbilt to the cause.
An early treatise on emerging markets
In the early 1890s William Menzies, chairman of the Scottish American Investment Trust (SAINTS), gave a lecture to the Scottish Chartered Accountants Students Society. The lecture, entitled ‘America As Field of Investment’, was subsequently published in 1893. The lecture makes fascinating reading and in many ways is virtually identical to the types of discussions more recently heard on the world’s emerging markets. To give a flavour, some of the major points in the lecture are excerpted here:
The need for firsthand research
“You will be told that it possesses advantages superior to any other railroad in the United States, and that though possibly not yet built, it has a magnificent future before it. I was once offered the bonds of a railway company in the course of construction, which were recommended to me on the ground that the railway commenced nowhere and ended nowhere, and therefore was not bound to carry through traffic at unpaying rates.”
The need for fundamental financial analysis
“We in this country ought to have a dread of new enterprises until there are some results to show, and even when the results are shown it is important that an investigation should be made to see these are honest results. A new line often includes in its earnings for the first year or two a heavy freight upon the transportation of material for construction, and that, of course, ceases the moment the railway is made.”
The need for a sense of perspective and understanding the ranking of obligations
“Another point which it would be well to keep in view is, that if American securities do sometimes default, if they represent actual value they are pretty sure in the long-run to come right again … In selecting securities you ought to be careful to purchase only first mortgages, and so have what the Americans call a ‘front seat’ … If, therefore, American securities go into default, do not yield to panic and throw them away, but if you are advised they represent value, hold on to them, and they are pretty sure to come right.”
Morality is important
“From time to time popular crazes seize the public mind. Thus after the war a craze took the public of paying off the debt incurred after the war in greenbacks, which were then depreciated: this was happily averted and the United States maintained their credit… Whatever crazes prevail for a while evaporate and common-sense asserts supremacy in the long-run. The will of the people of America is a more autocratic power than that of the Czar of Russia … Among business men in the United States you will find men whose uprightness and integrity and code of honour is not surpassed by any business men of this country.”
2.2 – An early treatise on emerging markets
Source: William Menzies, chairman of the Scottish American Investment Trust (SAINTS), lecture to the Scottish Chartered Accountants Students Society. The lecture was entitled ‘America As Field of Investment.’
The battle was both fierce and prolonged, with Vanderbilt having to avoid not only his competitors but also the law, which Fulton invoked to enforce the monopoly agreement and protect his profits. The battle was not confined to the waters of the Hudson River. In many ways the battle for public opinion and the minds (or pockets) of the legislators was of even greater importance. In particular, the difference in attitude and legal structure between the individual states and the federal government left many unresolved anomalies. After a sustained campaign, the Supreme Court ruled in 1824 that the regulation of interstate commerce and trade was not the province of the states and struck out the monopoly agreement. With political and legal protection removed, the battle switched to economics. Competition intensified and the cost-cutting through technological improvement of the Collins-Vanderbilt axis left Fulton unable to compete.
One direct consequence of the Supreme Court’s ruling was that the cost of passenger transport between Albany and New York City more than halved following the verdict. Through the 1820s, with the market largely to themselves, Collins and Vanderbilt amassed profits of more than $40,000 ($7m) per annum. It did not take Vanderbilt long to use the capital, and the experience he had gained, to split from Collins a
nd go into business on his own. His initial tactics were broadly similar to those he had developed with Collins. They were to seek out a monopoly market, attack with low pricing, and either replace the monopoly (subsequently raising prices) or accept ‘greenmail’ to leave the market alone.
In the competition with America’s largest steamboat line, the Hudson River Steamboat Association, for example, he accepted a payment of $100,000 ($17m) and an annual payment of $5,000 ($850,000) for ten years. Unfortunately for the Hudson River group, the payment which removed Vanderbilt only made others salivate after the same result. The company had to make further payments to other notorious figures of the time, including Daniel Drew, and at least five other competitors. Vanderbilt’s simple target was the accumulation of wealth; it mattered not to him whether it accrued from greenmail or operational profits. The key to Vanderbilt’s success was his ability to use technology to remain the lowest-cost competitor (although this alone would probably not have been sufficient). He also had long since learned the importance of courting those in political positions of power who could assist his endeavours.
By the 1840s, steamboats had increased in size to become steamships. Demand for these vessels extended beyond the eastern seaboard to transatlantic routes. Again, at first the business was dominated by political patronage. The first steamship operator was Samuel Cunard, who persuaded the British government (on the pretext of trade enhancement and national security) to grant him an annual subsidy of $275,000 ($46m). Cunard charged passengers $200 ($32,000) for the journey; mail cost 24 cents ($40) per letter.
It did not take long for the same arguments to be deployed in America. Edward Collins petitioned the government for a payment of $3m ($472m) upfront and an annual subsidy of $385,000 ($60m). This would allow him, he argued, to displace Cunard from the transatlantic route, for the greater good of America. Congress granted the subsidy and Collins built enormous ships with opulent interiors. These ships crossed the Atlantic with the same frequency as those of Cunard, but had higher costs. The subsidy obviated the need for improvement, as Congress could always be relied on to increase the subsidy when necessary. In 1852, for example, faced with rising costs, Collins managed to obtain congressional agreement for the subsidy to be raised to $858,000 (over $100m). The subsidised model was also followed in creating the mail lines from the Atlantic to the Pacific.
On both sides of the Atlantic, the subsidised shipping lines enticed new competitors. In Britain, the Inman Line harried Cunard. In America, Vanderbilt began a full-scale attack on Collins. Unable to persuade Congress to remove the subsidies, Vanderbilt launched a transatlantic service of his own. His ships were more advanced technologically and built to a higher standard, reducing ongoing maintenance costs. Taking the capital risk on his ships and avoiding insurance payments helped keep costs down. On the revenue side Vanderbilt created different classes of travel, introducing second- and third-class passengers and marketing these services heavily. He had recognised, as had William Inman in Britain, the need to cover the heavy fixed costs by whatever means possible. While competition undoubtedly harmed both Cunard and Collins, so long as the subsidies remained it was a less-than-lucrative venture for new entrants.
Fortunately for Vanderbilt, his competitive position was assisted by the self-destruction of his main rival. In 1856 two of Collins’s four ships sank, killing 500 passengers. A new ship funded by $1m of taxpayers’ money was built as a replacement. So badly was the ship built that after two journeys it had to be sold, incurring a loss of almost the total amount spent in its construction. Then, in 1858, Congress shifted its stance on subsidising transatlantic shipping and in 1858 cancelled its financial aid. Collins went bankrupt and Vanderbilt became the principal American steamship operator, paralleling the experience of Inman in Britain.
Vanderbilt had not restricted his attention to the Atlantic routes. In fact, he had been conducting a war on a second front, battling it out on the Californian routes as well. Driven by the demand created by the gold rush, Vanderbilt had constructed a canal through Nicaragua in a bid to compete with the Panama route. His route was shorter and faster and he was able to carry passengers profitably at a quarter of the fare charged by the subsidised Californian lines. Their reaction was to plead successfully for a higher subsidy, a figure that eventually reached $900,000 (over $110m) annually. Despite setbacks in Nicaragua, Vanderbilt’s competitive threat was sufficiently potent to force the California lines to pay him 75% of their subsidy not to ply the route. In other words, he was paid $672,000 ($85m) not to run ships to California. This eventually proved politically untenable and the subsidy was revoked. Vanderbilt lost his greenmail payment but was able to simply fall back on his more competitive structure.
Despite his successes, Vanderbilt was not to stay in shipping as his main line of business. Competition on the Atlantic routes from British carriers was intense, and the British concerns had readier access to the technological advances of the age, and to the raw materials necessary to implement them. Within North America, Vanderbilt’s position was more secure, but there were still new competitors seeking to take market share. The opportunity to exit shipping for more profitable ventures came about as the result of war, an event that has always brought great financial rewards to those well-placed to take them. In April 1861 the American Civil War began.
Vanderbilt was appointed the War Department’s shipping agent and received authorisation to buy and lease ships for overseas operations. Thus he was in the position of both buyer and seller. His dealings were conducted through an agent and accounts of the period carry suggestions that Vanderbilt was party to the then common practice of ‘splitting commissions’. It is difficult to assess the extent to which Vanderbilt profited from his position of authority, or from his position as the country’s leading shipping magnate. Whatever the facts, Congress rewarded him for his wartime efforts with a medal.
In many ways, the question of whether Vanderbilt was a profiteer or not is irrelevant. The main point is that the war allowed him to sell on his shipping interests and turn his attention to a new growth area, the railroads. By 1862 Vanderbilt had a fortune of some $11m ($1.3bn), invested in a range of companies. The attractive growth areas of the time, though, fell into two categories. The two emerging industries were gas lighting and the railroads, both of which were to form important parts of Vanderbilt’s portfolio of interests.
Towards a rail network
Vanderbilt’s foray into railroads began with the purchase of stock in the New York and Harlem Railroad. The nature of investment in those times can be gauged through reference to the events that were to unfold. Vanderbilt began buying stock at $9 per share and continued to buy even after he had obtained control at prices of more than $50 per share (for reasons that will become clear later). Once he had control, he paid large sums of money to members of the New York Common Council to grant him a streetcar franchise between Battery and Broadway.⁶ When news of the franchise emerged, the share price of Harlem jumped to more than ten times what Vanderbilt had paid.
This did not go without a response. George Law, a rival of Vanderbilt’s, persuaded politicians of the New York State Legislature to claim an exclusive right to award such franchises and announce its intention to revoke Harlem’s franchise. In tandem with this, a short selling operation was mounted by (among others) Daniel Drew, a noted bear raider of the time. Stock was sold short at $100 per share, with the intention of buying it back later at a lower price. Unfortunately for the short sellers, Vanderbilt had employed his capital to pick up as much as he could of the available shares in the company. He then executed a perfect short squeeze. With no stock available in the marketplace, and insufficient stock to deliver against the short selling obligations, Drew et al were forced to repurchase stock from Vanderbilt at a share price of $179 per share. This manoeuvre gave rise to a profit to Vanderbilt, and an equal loss to his opponents, of over $1m ($80m).
This pattern was repeated a number of times as Vanderbilt sought to
expand his railroad network. His next acquisition target was the Hudson River Railroad, which ran parallel to his own on the other bank of the river. Again the local politicians had to be bought off to gain authorisation for the railroad. Again the stock price advanced as expectations of success rose, and again Daniel Drew orchestrated a large short-selling campaign, in conjunction with rumours that the politicians were to reverse their judgement. Hudson River Railroad stock, having jumped from $25 to $150, plunged. Vanderbilt only survived by organising a pool of funds from associates and using the $5m (nearly $500m) to buy all the Harlem stock which was being offered. Without this pool of capital to back him, the bear raid would have succeeded. As it was, he again achieved a short squeeze which ruined his opponents.
In the years that followed, Vanderbilt steadily built out his railroad empire. Those who would not willingly sell out, he squeezed through his operations, deliberately disrupting services and using any number of ploys to bring the owners into line with his wishes. For example, when the owners of the New York Central resisted his embrace, Vanderbilt severed connections on freight and passenger traffic, forcing passengers to walk across the frozen river to Albany.⁷ Eventually the owners of the New York Central capitulated and a new amalgamated railroad company, whose operations ran from the eastern seaboard to the Great Lakes, was born. The owners intimidated by Vanderbilt in this way were not powerless shareholders, but included the likes of the Astors and Edward Cunard.
Engines That Move Markets (2nd Ed) Page 6