Engines That Move Markets (2nd Ed) Read online

  Optimism and gearing

  The behaviour of the railway stocks exhibited some ominous similarities to the mining stocks of 20 years earlier. It was not just the optimistic basis on which many schemes were promoted. Like the mining stocks, the railway stocks were highly geared instruments. Investors made an initial scrip payment of 5%, with an obligation to provide further funding in the future. If the company’s future prospects were well regarded, as they usually were at the time, the scrip would trade at a premium to its issue price. The implied gearing in the scrips – for a 5% scrip, this was 20 times – was similar to the level of gearing in many modern-day traded options. This gearing added to the risks in an investment whose fundamentals were already being put at risk by the inexorable laws of supply and demand. As figure 1.3 shows, movements in the railway share price index were closely matched by increases in the supply of new issues.

  The early railways were successful commercial ventures but their share prices were soon raised to unrealistic levels by the inflated optimism of investors. This optimism was to prove unsustainable. As with Nasdaq in 1999–2000, it led to share prices being bid up to levels that far exceeded the level of returns that the shares could possibly deliver on any rational assessment of their value. The first railways to be built enjoyed what today would be called ‘first-mover advantage’, but one of the clearest lessons of corporate and investment history is that without some barrier to entry, first-mover advantage can be swiftly lost. Moreover, when capital is freely available, competition can arise even when there is no apparent sustainable commercial case for it, creating an environment in which returns are forced down for an entire industry or sector.

  This is certainly what happened with the railways. The impact of the vast amount of capital which was invested in British railways, and culminated in the great railway mania of the 1840s, can be seen in figure 1.3. This shows both the rapid rise in share prices in the years before 1845 and the huge influx of new capital that this stimulated. It is not that the new technology was not demonstrably a success. Investors could see for themselves the very real benefits, such as new products and travel opportunities, that the new technology created. Not only was it part of a new era, it also appeared profitable. The dividends that the railway companies paid provided a return that was often three times greater than that available from Consols (the government bonds of the time). Dividends of 10% and a rising share price combined to create an environment in which it was possible to suspend disbelief, at least for a while.

  1.3 – Bubbles are magnetic: British railway share prices and investors’ capital 1826–1850

  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.

  Heroes and villains

  Not surprisingly, as usually happens in such booms, new popular heroes emerged. Of these, the most famous by far was George Hudson. Hudson had married into a relatively wealthy family drapery business. He had also been left a sizeable fortune by an elderly relative. He lived in York, and was a prime mover in two ventures. The first was a joint stock bank, the York Union Banking Company, which was opened in 1833. The second was the construction of the York and North Midland Railway. Competition for the railway route was fierce. The railway would connect the coalfields of Yorkshire and the general industrial base of the North to ready markets in London. Hudson’s advantage was that he had assiduously courted interested parties and also had access to funds of the newly created bank. In the technical arena the masterstroke was probably allying himself with George Stephenson, the leading figure in railway technology, and the engineer who had built not only the Stockton to Darlington Railway but also the successful Liverpool to Manchester line.

  At the time, all joint-stock companies required approval by Parliament. Hudson helped one of his supporters get elected as Member of Parliament for York. He was subsequently questioned by a Commons committee about allegations of bribery. Hudson successfully ensured that the necessary bill was shepherded through the House of Commons and then through the Lords (after payments were made to an aristocratic landowner to ‘compensate’ him for the line passing through his estates). Hudson followed up his success by arranging to have himself elected Mayor of York, from which position he liberally dispensed largesse to the great and good of the city. Although Hudson came in for trenchant criticism from opponents, as long as the share price continued to rise, his popularity remained high. This was undoubtedly assisted by his partial ownership of a number of newspapers which he acquired for precisely this purpose.

  To retain the confidence of his investors, Hudson’s railway company paid substantial dividends. In 1840 he declared a dividend of 6% of profits, ignoring pertinent questions about the company accounts from some shareholders. Hudson’s practice was to charge a number of revenue items to the capital account, which had the effect of increasing profits (and hence dividend capacity) at the expense of the balance sheet.

  The apparent success of the railway meant little attention was paid to such questions at the time, though there were enough clues in the published figures to raise suspicions, despite the absence of auditors and other controls on accounting manipulation. Hudson’s quest for profitability also led him to cut costs, potentially impairing safety.

  Despite these faults, he clearly understood the economics of railways. His objective was always to create as near a monopoly as possible. He also saw the need to gain control of the main arterial routes through the country, which he achieved by acquisitions of other, less successful, railways. Through the early 1840s Hudson acquired a series of ever larger rivals. Their investors turned to him in the hope that he would return them to profitability and dividends. In many cases, Hudson actually guaranteed to do just that. Such was Hudson’s apparent success that he eventually gained control of nearly a quarter of all the railway track in Britain. He became known as the ‘Railway King’, was elected a member of parliament and had discussions with figures such as the Duke of Wellington, Queen Victoria and Prince Albert.

  Such was the success of the railways that more and more new lines were proposed. In order to maintain some semblance of order, the Board of Trade set a deadline of 30 November 1845 for all new plans to be submitted. Riots broke out as more than 800 groups of promoters sought to reach London on time. Roads were blocked as coaches vied with each other, and existing railways refused passage to their new potential rivals. As with many dot-com companies 150 or so years later, few of these proposals for later lines rested on rigorous analysis of their revenue-generating potential. Few investors attempted to calculate whether revenue would exceed costs by a sufficient margin to provide an adequate return on invested capital. Such was the environment that the scrip shares issued on companies immediately went to a premium, providing instantaneous paper returns. The parallel with the IPO boom of 1999–2000 could not be clearer. The scramble for new lines more or less marked the peak of the railway bubble, just as the 3g mobile phone auctions marked the peak of the TMT bubble.

  The lure of quick and easy gains was irresistible, not only to the investing public, but also to promoters of new issues, at least those willing, able and fast enough to obtain approval in Parliament to launch a new joint stock company. Existing railways understood the dangers associated with the massive increase in new track and hence competition. They lobbied hard in Parliament against the creation of new companies, but with limited success. A further factor that contributed to the buildup of a frenzy in railway shares in the mid-1840s was the general improvement in economic conditions. This in turn created the conditions in which interest rates could fall.

  As a consequence, noted one contemporary account:

  “[T]he rate of interest had been gradually decreasing since 1839. From six per cent in August of that year, to five per cent in January 1840; from five to four, and from four to two-and-a-half per cent had the value of money fallen by September, 1844. Nor is it unworthy of notice that u
p to that point, while railway enterprise maintained a legitimate form, the rate of discount was four per cent. But when in that month two-and-a-half was the published rate, it was not long before a remarkable effect occurred in the general increase in all kinds of schemes and speculations.”²

  “[T]here followed in the next few years a fever of railway speculation. Attracted by a bull market and the irresistible appeals of the financial press, groups of middle-class folk, who hitherto had never known the Stock Exchange, hurried to place their small accumulations in securities. The public funds and foreign government bonds were now eclipsed as the chief objects of speculation, and their brokers and jobbers were crowded out by the specialists in railway securities.”³

  How the boom ended

  The boom in railway shares continued into the second half of the 1840s before it finally ran out of steam. The eventual decline was the result of four factors. All four are typical of those that help to bring periods of financial excess to a close. First, as a large number of the shares were partly paid, many investors found they were overgeared and unable to make further payments without selling some of their holdings, which put further downward pressure on the price. Secondly, the financial projections with which many companies had raised money proved wildly over-optimistic – critically, they neglected to take account of the increasingly competitive nature of the business. Thirdly, the environment of speculative euphoria encouraged a fair amount of fraud and business practices that later did not stand up to scrutiny.

  Finally, the economic and interest rate environment began to change. In October 1845, the Bank of England raised interest rates from 2.5% to 3%, and interest rates continued to rise thereafter. In 1846 the Irish potato crop failed and imports of foodstuffs soared. The outflow of bullion to pay for these imports forced interest rates higher and further contributed to the loss of liquidity. At the same time, deteriorating economics coincided with the outbreak of the revolutions of 1848 across Europe, raising the spectre of political instability. The impact of the rise in interest rates can be clearly seen in figure 1.4. Almost without exception, all periods of speculative excess in financial markets are assisted by easy money and brought to an end when interest rates start to rise once more.

  1.4 – Cheap money and bubbles, expensive railway money and crashes

  Interest rates and railway share prices during the 1840s mania

  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. Mitchell, British Historical Statistics, London: Cambridge. Sydney Homer, A History of Interest Rates, Princeton: Princeton University Press, 1967. (NBER) Parliamentary papers, pt. I, Report from the Select Committee on Bank Activity, 1857, p.x.

  The first sign that the boom was coming to an end for railway investors was the disappearance of substantial premiums on scrip issues for new companies. Share prices of existing railway companies began to fall: only the companies perceived as higher quality managed to maintain their share prices. The companies themselves called for more cash payments from investors as the lines they were building repeatedly failed to come in under budget. This should have come as no surprise. Even the best railways underestimated the cost of construction. For example, the Birmingham to London line, built in the 1830s, cost more than twice the estimates in its initial prospectus.

  Despite this, many companies continued to maintain substantial dividend payouts. Even in the 1840s, when building was at its peak and competition was increasing, the bigger companies managed to maintain a dividend at anywhere between two and four times the prevailing market rate of interest. The subsequent rise in interest rates exposed the fact that many companies had effectively been paying dividends out of capital, a process that could not be sustained indefinitely.

  However, as Hudson had demonstrated, investor confidence – liberally watered with dividends – was the key to continued success. Investors who ignored the evidence of declining profitability and accounting fraud were to find that as interest rates rose, even companies whose profits actually covered their dividend payments could no longer sustain their level of payout. Figure 1.5 shows the drastic fall in the dividends of the leading railway companies at a time when interest rates were rising sharply. Suddenly the gloss had been removed from railway shares. Investors found themselves with scrip shares where payments were being demanded and where they had no cash to fulfil them.

  1.5 – Dividends fuelled expectations but could not fight commercial reality indefinitely: British railway dividends during the 1840s mania

  Source: Railway Intelligence. Railway Chronicle. Railway Times.

  The adulation which had previously been given to Hudson quickly turned to vilification. Hudson was exposed as a crook, who had produced fraudulent accounts to bolster profitability and had allowed dividends to be paid out of capital. Other transgressions, which enabled him to profit from private transactions at the expense of his companies, also surfaced in the public domain. Hudson’s fall from grace was swift, although in hindsight it can be clearly seen that he was as much a scapegoat as the villain of the piece. Although he was undoubtedly guilty of offences, they were relatively minor. His greatest offence was probably to perpetuate the myth of effortless profitability, a myth that the investing public was all too desperate to hear and believe. Faced with this unhappy situation, the British Government was forced to pass another parliamentary act to allow the railway industry to consolidate. Nearly 20% of the track authorised for construction was abandoned. The industry witnessed a series of mergers and combinations as the remaining companies sought to rebuild their profitability.

  The sharp reversal in the stock market fortunes of the railway companies was reflected in the press coverage of the time. Hudson quickly moved from being an icon to a figure of ridicule. The role of the press during the railway mania closely anticipated that which was experienced with the Internet bubble. On the one hand, the quality press of the day provided sober assessments of the excesses and their likely consequences. In April 1845, for example, the Economist correctly forecast the way that the boom would end (figure 1.6). At the same time, the speculative boom prompted the emergence of a wave of new specialist journals which were in effect dedicated not just to reporting on but also promoting the new railway technology. They tended towards wild optimism about the stock market prospects of the industry.

  1.6 – Quality press warnings on speculation in vain

  Source: Economist, 5 April 1845.

  This was an early example of a pattern that is still being repeated. New technology always creates a surge in journals catering for those fascinated by the lure of the new. The number of new journals and their longevity tends to mirror the movement in stock markets and provides a useful barometer of optimism. The mainstream press tends not to get carried away to the same degree. During the UK railway boom, they frequently cautioned, in increasing tones of incredulity, the scale of the potential that was apparently being discounted by current share price valuations. The scepticism was also reflected in satirical publications such as Punch, both before and after the bubble.

  1.7 (a) and (b) – ‘Find a Hero, Who to Praise? Find a Scapegoat, Who to Blame?’

  Source: Times (London), 24 October 1845, 10 April 1849, 1 March 1849; Punch, vol. 9, 1845; Punch, vol. 16, 1849.

  Conclusions

  There were several years of strong share price growth when the railways were supplanting canals. The bubble of the 1840s deflated under the weight of overheated expectations and changing economic conditions. In the 50 years that followed, investments in railways were not rewarding ones in either an absolute or a relative sense. There were occasional pockets of excitement which would cause railway shares to trade once more at levels that could not be justified in terms of underlying profitability. These pockets though were short-lived and set against a backdrop of a long-term declining trend. But the economics of the railway business remained solid. It was not until the ad
vent of the automobile at the end of the century that the competitiveness of the railways was itself undermined.

  1.8 – Technology wins, investors lose: the British railway index 1826–1920

  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. K. C. Smith and G. F. Horne, An Index Number of Securities, 1867–1914, London and Cambridge Economic Service Special Memorandum, no. 37. Banker’s Magazine and Railway Times (various issues 1849 to 1868).

  Given that dividends were paid for most of this period, anyone who invested at the peak might perhaps have earned back his investment by the end of the century. In aggregate, over a very long period of time, there is no question that, for all their economic impact, the railways provided negative returns, whether you measure that in real, relative or absolute terms. This illustrates the general truth that in the aftermath to any period of speculative excess, when companies are funded on the expectation of instantaneous stock market returns, huge amounts of capital are wasted on non-economic projects. Many companies end in liquidation after such a phase. Although the promoters usually emerge with positive returns, and the technology itself succeeds in delivering the results that were forecast, the average investor frequently struggles to emerge with significant returns.