Engines That Move Markets (2nd Ed) Read online

  The railroad business was no respecter of fortunes or person. After the death of Cornelius Vanderbilt in 1877, the running of the operations of the New York Central were taken over by his son, William. The operating environment had changed little. Stock price manipulation, political patronage, greenmail and price fixing remained the order of the day. Despite the power of the New York Central, it was not immune from threat. It had to buy out the Nickel Plate line in the late 1870s as it found itself held to ransom by new railroad lines running parallel to existing track, and as such threatened with either a price war or (perhaps more dangerously) potential linkages with NYC’s competitors. William Vanderbilt was thus forced to acquire over 1,000 miles of largely valueless track when he bought over the Nickel Plate and later the West Shore Railway companies. The Nickel Plate line had been the brainchild of a group of Wall Street financiers, while the West Shore Railway included among its backers major figures such as John Jacob Astor, keen perhaps to gain a measure of financial revenge for previous losses. To give an idea of the sums involved, the West Shore cost approximately $29m ($2.4bn) to build and was capitalised at roughly $76m ($6.2bn). This was a high-stakes poker match open to any players who could raise the capital!

  Conclusions

  The railways of Britain and America followed slightly different paths, but there were many similarities. In both cases their economic superiority caused the respective canal networks to gradually fall into disuse. The canals made attempts to stop the advance of the railways and when this failed they sought to improve their own efficiency. Unfortunately for holders of their stock, the additional capital they expended was ultimately in vain and as a consequence their stock prices took on an inexorable decline. In both America and Britain, the early railways demonstrated their profitability in such a convincing manner that the initially sceptical investors were quickly won over. The ‘losers’ from the new technology were therefore relatively easy to spot, in that horse-drawn carriages and canals had been superseded by a more cost-efficient competitor. So far as the ‘winners’ were concerned, identification proved more difficult.

  In both countries the first companies unsurprisingly sought to take advantage of the most lucrative routes. These routes normally involved connections between product producers and consumers, or between existing urban areas. They normally also connected points where there was no competition in place. Such opportunities were limited and as new companies came into existence the first round of competition took place between the new railways and traditional carriers, whether canals, coastal ships or horse-drawn transport. When these opportunities were exhausted, the next round involved either seeking to develop new markets or competing with established railways. By this time investors typically were less sceptical on prospects and funding was relatively easy to obtain. It would be possible to turn this round and argue the opposite: that when investors were in a period of optimism typically associated with general prosperity, new ventures were put forward, many of which lacked the compelling economic logic of their predecessors.

  In an environment where capital was relatively easy to obtain, the financial markets quickly became awash with new companies that were only too happy to soak up this relatively undiscriminating excess liquidity. The proprietors and promoters of some of these companies fell into the unscrupulous category and to the extent that supervision of their activities was less than vigilant, or the law was open to abuse, the companies quickly became vehicles for private speculation and personal advancement. In Britain the most obvious example was George Hudson, although his greatest crime was arguably fraudulently favourable accounts and excess dividend payments, which helped to stoke the optimism attached to railway ventures. These actions were not governed by statute and it was illegal personal enrichment that eventually brought him down.

  In America, where legal and financial structures were still relatively immature, the excesses were worse. Foreign investors were unable to exercise control and turned to the emerging breed of financiers in the US to seek protection from the speculation that had enveloped the market. J. P. Morgan and others tried to bring order to a chaotic market. This was not an easy task, and repeated attempts to bring an end to the price wars all met with relative failure. The largest customers of the railroads were able to dictate terms and effectively enjoyed subsidies against their competitors. Long-suffering farmers continued to find themselves at the mercy of the railroads. The backlash against this behaviour was eventually to culminate in a series of antitrust laws which would be repeatedly employed against monopolies, both real and imagined.

  The result of the speculation in railroads and the euphoria that surrounded their prospects was that by the 1880s almost double the amount of track required had been laid. By the mid-1870s, almost 40% of American railroad bonds were in default and by 1879 some $234m ($19bn) had foreclosed. In the six years up to 1879, it is estimated that European investors alone lost some $600m ($50bn) as a result of bankruptcies and fraud. The most striking modern parallel is probably with the lack of discrimination often shown towards investing in emerging markets. There are many countries where the legal regulation of corporate activity still falls short of what was in place in America at the time of the robber barons. In many countries, the law of property rights is not enshrined in a robust legal framework, independent of the arm of government and factionalism. China and Russia are two obvious examples. This is very similar to the prevailing environment of 19th-century America. Property rights existed, but they could be bent by the whim of corruptible judges and local politicians. The United States was undoubtedly the greater emerging market at the time, but few equity investors prospered in such a market.

  British investors in railroads took a somewhat different approach to their investments in American railroads from their Continental European cousins. The British concentration was mainly on routes between established centres of economic activity. The finance houses brought the stock of such companies to the market and agents in America monitored and reported back on their progress. In addition, a number of collective investment vehicles were put in place to allow smaller private investors to spread their risks. Many of these investment companies and investment trusts are still in operation today; in them lie the roots of the modern mutual fund industry. The popularity of American investment helped the development of this industry, but it should be noted that a number of the trusts formed to provide a portfolio approach to investing in the emerging nation of America took advantage of the demand to allow preferential rates of return to their founders, who were also the trustees, well in excess of those available to the normal subscriber.

  * * *

  4 G. R. Taylor, The Transportation Revolution: 1815–1860, New York: Harper & Row, Torchbooks, 1851, p.27.

  5 D. R. Adler, British Investment in American Railways 1834–1898, Charlottesville, Va.,: University Press of Virginia, 1971, p.59.

  6 See M. Josephson, The Robber Barons, New York: Harcourt Brace, 1934, pp.68–70 for a fuller account.

  7 Josephson (1934), pp.71–3.

  8 Ibid.

  9 J. Strouse, Morgan: American Financier, New York: Perennial, 2000, p.256.

  10 Josephson (1934), p.125.

  11 Josephson (1934), p.129.

  12 M. Klein, The Life and Legend of Jay Gould, Baltimore: Johns Hopkins University Press, 1997, p.91.

  13 Josephson (1934), p.142.

  14 Klein (1997), p.132.

  15 Letter from the Secretary of the Interior on the Union Pacific Railroad, 43rd Congress, 1st Session of the House of Representatives, 27 January 1874.

  16 Annual report of the Union Pacific Railroad, 1874.

  17 Ibid., 1879.

  18 Ibid., 1889.

  19 Ibid., 1893.

  chapter 3

  Investing at the Speed of Sound

  How the telephone changed everything

  “Well-informed people know it is impossible to transmit the voice over wires and were that it were possible to do so, the thing would
be of no practical value.”²⁰

  Editorial in the Boston Post, 1865

  “What use could this company make of an electrical toy?”²¹

  William Orton of Western Union turning down the offer of Bell’s patents for $100,000

  Origins of the telegraph

  Many wars have been won through intelligence and the speed with which it is communicated to the central command. Historic methods of signalling ranged from hilltop fires to semaphore, from relays of riders transporting written messages to the use of carrier pigeons. Advance notice of events was also crucial to the financial sector, and businessmen stood to make or lose fortunes based on advance knowledge of the eventual outcome of armed conflicts. Little wonder, then, that these two groups, the military and the business community, were at the forefront of the development of rapid communications.

  In Britain, as systems to shift passengers and freight evolved during the 18th and 19th centuries, these were typically quickly augmented to include the carriage of letters and communication. For centuries before the Industrial Revolution, passenger transport had relied heavily on horses and ships. Similarly, from the late 17th century to the 1830s, Britain’s postal service was a horse-drawn coach system operating along the main highways. Over the years the service was continually upgraded with better roads and coach designs, until journeys were recorded at the princely average speed of 12 miles per hour.

  By 1839 the Post Office was handling 76m letters per year at an average cost (to them) of 2.5 pence ($8.22). However, the public was charged up to four times this amount, as there existed no competitive mechanism to force prices down. Ultimately, the system itself was limited by the physical endurance of the horse. With the advent of the railway, the potential gains in speed and efficiency ensured that the coach and horses would soon be left far behind. The gains in speed ensured that the railway owners would quickly win the majority of the Post Office’s mail business. The relatively modest £1,313 in revenue ($1m) they received from the Post Office in 1837–38 had grown to over £80,000 ($58m) ten years later and to nearly £200,000 ($135m) five years after that.

  The railways not only had the advantage of speed – they had size and thus capacity. Other efficiencies included carriages that were built to allow for mail sorting in the railway carriage itself while it was in motion. For all the rapid gains in revenue, the mail service represented a lucrative extra rather than a key revenue stream for the railways. For most British rail companies, the earnings from the postal service rarely exceeded 3–4% of net income. However, for the horse-drawn operators, the damage caused by their new competitor was fatal.

  The use of new information systems to make the railways safer and more efficient was to play a more important part. In the early years, railway signalling had been undertaken by employees using flags during the day and lamps in darkness. Gradually, this changed to a series of fixed manual signals, augmented by a small lighthouse with a powerful parabolic light known as a ‘signal box’. Eventually the signal box would see the addition of a new technological advance, the telegraph.

  The origins of the telegraph lay in Europe. In the late 1790s the French military developed the ‘optical telegraph’, based on semaphore, and this was adapted by the British Admiralty for sending messages from London to Portsmouth. As electrical transmission developed, semaphore signalling was replaced with a rudimentary form of telegraph. It did not happen immediately, however. The Admiralty turned down an electrical telegraph in 1816 on the basis that, with war concluded, there was no need to incur the additional cost of upgrading a satisfactory working system. This early version involved a dial with 25 magnetic needles which, when turned by electrical impulse, pointed to letters in the alphabet.

  As in Britain, the traditional method of land-borne mail delivery in the United States was based on the horse. In Britain there were the mail coaches, in America there was the stagecoach and the pony express. As steam-powered transportation developed through steamships and the railroads, so the use of horses for information-carrying diminished. As the railroads developed, so did the telegraph distribution network. In America though, unlike Britain, the system was to remain in private hands – albeit after initial, if somewhat hesitant, support from government.

  The telegraph was resuscitated by the needs of the railroads, and its practical application was significantly improved by the work of Samuel Morse, a young American inventor. In 1837, Samuel Morse invented the first practical telegraph in America and in 1838 he applied for a patent following work he conducted with Alfred Vail. Eventually, the railroads would come to see the potential for the electric telegraph to monitor and control traffic. Morse also devised a telegraphic code consisting of dots and dashes – shorter and longer electrical impulses sent down the wire. The ‘Morse code’ system was important not just because it represented a simplified system, but because widescale adoption of the telegraph demanded the use of a single signalling system.

  While studying at Yale University, Morse had met Benjamin Silliman, a noted academic chemist and founder of the American Journal of Science. Professor Silliman would later testify on behalf of Morse when his claims to the invention of the telegraph were disputed. Morse’s experiences were very similar to most individuals holding patents on inventions which subsequently became valuable. He was assailed by claim-jumpers, people who either genuinely believed that their work predated the inventor with patent, or who were willing to fabricate evidence in support of their earlier claim. Money is a powerful motivation, and scientists would frequently demonstrate their venality by attempting to take credit for someone else’s work.

  In 1835 Morse had constructed a rudimentary model of his telegraph. Over the next two years he tried to drum up interest. Initially, the US government showed some interest in this potentially new form of communication, but quickly grew tired of Morse, describing him as an individual “whom ten Congresses regarded as a nuisance.”²² Morse also failed to enlist support in Britain or Europe. In Britain, where scientists had also been pursuing a form of telegraphic information transfer, he could not even obtain a patent.

  Eventually, though, Morse’s persistence paid off. In the US Congress of 1842–43, a bill was sponsored providing funds of $30,000 ($1.75m) to develop and test his invention. Not everyone was convinced; during the debate, Representative Cave Johnson from Tennessee said that if Congress wanted to promote electromagnetism it should also encourage Mesmerism, and proposed that the appropriation should be split with a lecturer on that topic. Another amendment proposed that half the money should go to the Millerites, a religious group predicting the second coming of Christ in 1844.

  In spite of such ridicule, there was sufficient support for the Bill to be passed. At the same time Morse was granted a patent on his work. Morse and Vail built a working model between Washington and Baltimore and performed repeated demonstrations of the ability to transmit information beyond visible distances without significant delay. In 1844, his first message from Baltimore to the US Capitol was: “What has God wrought?”

  Nevertheless, the two men were left with a sceptical audience, and the government remained sufficiently sceptical as to its practical use and its potential for earning meaningful revenue that they turned down an offer from Morse to sell them the telegraph for $100,000 ($15m).

  The British experience

  Meanwhile, back in Britain a series of inventors – notably Charles Wheatstone and William Fothergill Cooke – saw their telegraph models installed by the railways. In July 1837, Wheatstone and Cooke ran a telegraph line along the railway track from Euston to Camden Town in London, and successfully transmitted and received a message down the line. The practical application of these early two-needle telegraphs was greatly enhanced by the standardisation of signalling introduced by Morse’s new code system. The Morse code’s great merit was its simplicity, something which widescale adoption of the telegraph demanded. The British government played a key role in the expansion of the telegraph system in the UK. Unlike
the US Congress, it quickly recognised the strategic importance of the telegraph, and its capacity to replace existing semaphore-based transmission mechanisms.

  Notwithstanding the early successes of Wheatstone and Cooke, the railways were slow to spot the potential of the telegraph. They also had concerns over its cost. It was government pressure that forced the introduction of the telegraph on a meaningful scale. While the commercial potential gradually became clearer, it remained a business that the railways regarded as peripheral. The need for traffic signalling made the telegraph indispensable for all railroads, but it was not an important source of revenue in the early stages.