Engines That Move Markets (2nd Ed)

by Alasdair Nairn

  The New York Central did at least retain a balance sheet of reasonable strength, with the debt/equity ratio never exceeding 50%. Despite this, the net income of the company, defined after taxes and interest payments, was frequently insufficient to maintain historic dividend levels and eventually the dividend was cut. The company was never in any real threat of insolvency, however, even during the price wars. Declining margins and net income growth translated into increasingly poor returns on invested capital. A mixture of competition and increased bargaining power for certain clients produced poor share price returns. Total return was largely dependent upon an unsustainable dividend. Yet the railroad was a lucrative venture for the Vanderbilts. Not only did they recover their investment with a massive stock-watering exercise at the time of the recapitalisation of the company, they also benefited from the cash flow of the dividend stream over the period. Control of the railroad also brought them other opportunities, including, it is said, a shareholding in Standard Oil. Unfortunately for the outside private investor, the returns were somewhat less handsome, with dividend payments alone to offset the falling share price. In the 80 years from 1860, it was only during the roaring bull market of the 1920s that NYC shares regained the levels seen in the early 1870s. This, too, was a temporary phenomenon that was soon rectified by the Great Crash of 1929 and its aftermath.

  2.5 – New York Central: watered-down returns

  Source: Commercial and Financial Chronicle. New York Central Railroad annual reports.

  The New York, Lake Erie and Western Railroad – the Erie Railroad

  The scandals of the Erie Railroad created the legends of the ‘Robber Barons’. Drew, Fisk and Gould battled with Vanderbilt and outside investors in a saga of stock watering and disenfranchisement. The simple part of what happened can clearly be seen from the charts, which show how earnings declined while the stock was being issued. The stock issues produced neither increased earnings nor a reduction in debt. Their sole purpose was the enrichment of the Drew-Fisk-Gould cabal. For the outside investor, there could be no rational case for investing in the company during the 1860s. Despite this, the battle for control served to push the share price up from $50 to $600 in the early 1860s, before the stock watering took place in earnest and the price collapsed back to $100.

  How did the stock watering work? A simple example would be where stock was issued to the public and the proceeds were then used to purchase bonds on railroad property from one of the insider parties at a greatly inflated price. As for the operational health of the Erie Railroad, its accounts show a balance sheet that was ruined by the practices of the directors and one which, as a consequence, was in no position to be able to weather any earnings shortfall. The increase in outstanding shares does not show up clearly in reduction in the returns on either equity or total assets. The main reason for this is that the company was already making poor returns prior to the stock issuance. Reported ‘net earnings’ followed the practice of the time of being effectively operating earnings and as such were earnings before financing costs. Since the company had a relatively indebted balance sheet, interest costs were high and absorbed a substantial proportion of earnings. It must have been apparent to investors that the railroads were very sensitive to economic conditions. This might have been a positive when the economy was growing rapidly, but there was still a need for prudent capital structure, something the Erie Railroad demonstrably neither had, nor was likely to get. Shares were issued as part of the process of manipulation and the ownership battle with Vanderbilt. The proceeds of the sales were siphoned off, increasing the debt of the company. As a consequence, the company repeatedly fell into bankruptcy and had a volatile share price as a result. Such volatility based on the fear of insolvency made it easy prey for stock price manipulation. The outside investor who bought at pretty much anytime after the early 1860s had little prospect of making capital returns. Ironically, throughout the period the Erie Railroad had better revenue growth and higher operating margins than the New York Central, which only serves to emphasise the importance of an appropriate balance sheet – structured for the needs of the business rather than the perceptions of the outside world or the benefit of insiders. In the long run, there was ultimately no escape from the disciplines of cash and debt. Since the railroad was run as a stock market jobbing vehicle and paid attention to these key operating metrics only in the context of manipulating the share price, it should not be surprising that the company repeatedly flirted with complete liquidation, particularly in times of economic stress for the national economy.

  2.6 – Erie Railroad: an empty vessel

  Source: Commercial and Financial Chronicle. Erie Railroad annual reports.

  Competition and consolidation

  Gould was by no means finished either as railroad operator, financier or stock market manipulator. Within a short space of time he was using his vast wealth to gain control of Union Pacific. The battle for control of the Erie Railroad had many elements to it. Railroads were profitable for those who controlled them, due largely to the lax legal controls of the time. The ability to issue stock and manipulate a market enamoured by the industry’s growth prospects allowed vast private fortunes to be made. For the railroads themselves, profitable operation depended upon the ability to link producers with consumers, meaning a through route to urban centres and points of embarkation for manufactured, agricultural and extracted goods. The heavy fixed costs involved in setting up a railroad meant it was a natural monopoly. In the early days railroad entrepreneurs used any means possible to become that monopoly, and to receive the pricing premium that accompanied it. The fight for control of the Erie Railroad epitomised all these things, but the end of that particular battle only set the stage for the next development. If combination was not to be allowed, it was only natural for the operators to try and collude in a price-fixing cartel.

  Vanderbilt had not been alone in his efforts to put together a link to Chicago. By the mid-1870s, in addition to the Erie Railroad, there were a further four main systems extending from the Atlantic seaboard to Chicago. Each had pursued a similar course, connecting a succession of shorter lines to complete a through route. Vanderbilt summed up the situation succinctly: “Five great railroads to New York, with only business enough for two of them.” The first casualty of the price war that inevitably unfolded was the Erie Canal, which followed the same slow decline experienced by the canals in Britain.

  To an extent, the next casualties were the railroads themselves. There were various attempts to form price-fixing cartels, but on each occasion the price war soon broke out again between at least two of the participants. It was not until 1877 that a more stable price-fixing pool was concluded. The driving force behind this came from outside America, notably from European investors who had invested heavily in American railroads, experiencing some significant financial failures – for example, the collapse of the Philadelphia and Reading Railroad and the New Jersey Railroad in late 1876. When the Baltimore and Ohio Railroad fell out with Baring Brothers, it fell to J. P. Morgan and Company to raise funds in Britain. Their unsuccessful attempts to raise funds brought home how much scepticism British investors had towards the financial accounts of American railroads. This experience was an important factor in pushing the railroads towards a pooling and price-setting agreement.

  The battle for control of the West

  The railways built to link existing centres within Britain, Europe and the eastern part of America differed substantially from the great drive to open up the Western USA. During the Civil War, Congress had provided a series of incentives to encourage building of a transcontinental railroad. These were contained in the Pacific Railroad Act. This led to the establishment of Union Pacific, which would move west from Omaha and Central, and build track eastwards from Sacramento. As a response to promptings from interested lobbyists such as the Ames brothers (who owned one of the largest shovel manufacturers in America), and undoubtedly for some, in expectation of personal enrichment, Congress
authorised loan payments equivalent to $16,000 per mile in flat land and $32,000 per mile for gradients, to subsidise the westwards expansion. In addition, each line was to be entitled to 20 alternate sections of land for each mile constructed. The economics of construction were therefore inadvertently framed so as to encourage quantity rather than quality, circuitous rather than straight routes, and speed above all else.

  The newspapers recorded the excitement of the time as Union Pacific and Central Pacific raced towards each other across the great continent. The hostility of the terrain and the Indian population displaced by the new lines fuelled the public’s imagination as the ‘West’ was opened up. For the companies, it was obvious that the greatest short-term profit was to be had by building the road as cheaply as possible, and as quickly as possible, so as to garner as much of the government’s largesse as possible. The railroad operators did not find it difficult to accumulate wealth in such circumstances. The Union Pacific was granted 12m acres of land and a $27m ($3.3bn) government mortgage bond, while the Central Pacific gained 9m acres and $24m (nearly $3bn) government bond. Encouraged by this, other promoters soon followed. The Texas and Pacific received 18m acres and the Northern Pacific 44m acres along the Canadian border. These were only the initial fundraising exercises; in due course, all the major transcontinental railroads raised further funds in both America and Europe.

  Despite their subsidies and loans, by the time the railroads finally met in 1869, they were both near bankruptcy. There were many contributory factors. First, the subsidies and incentives promoted speedy but inefficient construction. Second, there was the corrupt legal and political environment of the time. In order to protect their subsidies, railroads entertained the politicians lavishly and ensured that their private incomes were supplemented with bribes ranging from free railroad passes to stock in subsidiaries. History records the Credit Mobilier, the company set up to handle the construction contracts of the Union Pacific, as the most scandalous example. Unlike the Contract and Finance Company, which handled the contracts for Central Pacific, its financial records were found and aired to the general public. What Credit Mobilier did was relatively straightforward. It overcharged for its work. Stock in the company was held by the principals of Union Pacific, and also distributed to influential politicians to ensure the protection of the company’s privileges. Depending upon the estimates one accepts, it charged between two and three times the real cost of construction. The total cost of construction came to some $94m, against an estimated true cost of $44m, leaving some $50m ($4.8bn) effectively unaccounted for.

  When the Union Pacific required coal, for example, the directors of the railroad created a company called the Wyoming Coal and Mining Company, which supplied Union Pacific with coal at three times the cost of production. Those fortunate enough to have been made shareholders in Credit Mobilier prospered mightily, in sharp contrast to those with stock in either Union or Central Pacific. In 1872, the corruption became a matter of public record when one of the railroad’s principals, Oakes Ames, was called to testify before Congress and revealed the list of politicians who had been part of the group to benefit. The list included virtually every senior member of the Congress, Senate and White House. The revelations sent shock waves through the stock and commodity markets.

  2.7 – Background to the 1870s stock market crash – rising interest rates again the trigger

  Source: Global Financial Data.

  The Credit Mobilier affair was not sufficient to end the financial gyrations and manipulation of the railroads, because the scandal did nothing to inhibit the tools used by the speculators; nor did it undermine the growth fundamentals of the railroad business itself. So long as the business was growing, or at least perceived to be growing, investors were willing to continue to commit new funds. Equally, the Erie Railroad saga was neither a self-contained episode nor the conclusion of the struggle to gain pricing power within the railroad system. It was not long after Credit Mobilier that the debt ridden Union Pacific became a target for Jay Gould – and, with his success, brought the unfolding of a familiar scenario.

  The railroad wars intensify

  Both the reputation and the balance sheet of Union Pacific had been seriously undermined by the excesses of Credit Mobilier. Nevertheless, in 1873 the UP–CP route was the only operational transcontinental line and, in the right hands, Union Pacific represented a potentially powerful weapon. For an operator such as Jay Gould, it was probably almost irresistible. Gould knew the potential for the transatlantic routes and in respect of this, in 1872 he acquired an effective controlling stake in Pacific Mail, the steamship operation plying the west coast and linking Far Eastern routes out of San Francisco.

  Gaining control involved the normal double dealing and share price manipulation. In this case it caused a rift between Gould and his erstwhile co-conspirator, Henry Smith, that ended in an acrimonious and irrevocable split between the two. Smith felt Gould had not only abandoned him, but also enlisted with the enemy to ruin him, by assisting Vanderbilt’s son-in-law, Horace Clark, to place a short squeeze on Northwestern Railways when Smith had been executing a bear raid. Smith retaliated by making public damaging documents on Gould’s previous financial practices with the Erie Railroad. This eventually cost Gould around $9m (nearly $700m) in restitution to the Erie Railroad. While Gould was able to afford this, the damage to Smith was much more severe, leading to a memorable exchange. Smith purple with rage, shook his finger in Gould’s face and sputtered, “I will live to see the day, sir, when you have to earn a living by going around this street with a hand organ and monkey.” “Maybe you will, Henry, maybe you will,” Gould cooed softly. “And when I want a monkey, Henry, I’ll send for you.”¹⁴

  This interlude on Northwestern also tied Gould in with Union Pacific, whose stock the Vanderbilts had accumulated to allow them to tie the troubled railroad into the Vanderbilt network. In 1872, Clark had been elected President of UP, and the integration of the UP line seemed inevitable. Gould had accumulated some stock in UP, but the chance to obtain control fell to him with Clark’s sudden death in 1873 and the consequent sudden disposal of his stock on the market.

  In 1874 Jay Gould was president of Union Pacific and, as with the Erie Railroad, soon used his position to enrich himself. The situation at Union Pacific was potentially dire. The balance sheet was burdened by huge debts, there was a price war with other carriers and the eastern markets were experiencing tough times economically. Gould dealt with the first of these problems by withholding interest payments and by capitalising interest expenses as construction costs. This had the accounting effect of increasing assets on the balance sheet, while decreasing expenses on the income statement, thus increasing profits. As regards the price war, Gould had the advantage of a stake in the competitor, Pacific Mail, and was thus able to ‘negotiate’ a truce at a time of his convenience. On the economic front he had no control, but was greatly assisted by the elements, in the form of harvest failures in Europe and bumper crops from the western United States. Gould also had a poorly run, high-cost operation in UP to contend with – one where he could bring his cost-cutting skills to bear.

  As a result of these various factors, there was a sustained increase in the price of Union Pacific shares, which presented Gould the opportunity to sell his stake of 200,000 shares to the public at a profit in excess of $10m (over $800m). Even without this large shareholding, he was to retain substantial influence through his nominees and friends on the board. Nor was this the only profit Gould accrued from his time at UP. While running UP he had personally acquired controlling stakes in a series of railroads, most notably the Kansas Pacific and Denver Pacific, Wabash and Missouri lines. After a sequence of intricate manoeuvres involving William Vanderbilt and Henry Villard of Northern Pacific, and deals with smaller railroad lines, Gould was able to force UP to acquire his network for a further profit of $10m (over $800m).

  Competition of the transcontinental route

  The transcontinental ro
ute was never going to remain a complete monopoly over traffic crossing the continent. The potential returns from the carriage of people and freight between the two coasts was simply too large for it to do anything other than attract new entrants. Two potential competitors sought to build an alternative route in the northern regions. The first was James Hill, who had accumulated capital working in the northern states and Canada as a shipping agent. Hill understood the potential of the area and focused on the St Paul and Pacific Railroad as his vehicle. As part of its initial charter in 1862 the railroad had been granted 5m acres of land in Minnesota, but it had collapsed before any of the land had been settled or developed. The company had been capitalised at $28m, of which half had been raised from a group of Dutch investors, but the funds had been dissipated through a mixture of promotional expenditure and diversion of funds to associated construction companies. Not content with this, the promoters had also indulged in the process of stock watering. The net result was that following the panic of 1873 (the year of the Credit Mobilier scandal and the failure of Jay Cooke, the Northern Pacific’s financier) the railroad ended up in the hands of a receiver. The outlook was bleak since as a small but potential competitor to the Northern Pacific Railroad there was little chance of anything other than stiff competition on its route. There was certainly little chance of a profitable business being run on the basis of trying to amortise all the expenses already incurred.