Investing in Iron Horses: Railway Mania's Wealth and Woes

by elmads

Introduction

The railways were one of the most important innovations of mankind during the industrial revolution.

In a time where automobiles and trucks were not yet invented, the railway was the fastest mode of transportation, not just for people but also for raw materials and goods. This aided the rapid growth of economies during the 19th century across Britain. Infrastructure was built left and right at a rate faster than what their nation was able to have built before.

Nonetheless, for every successful innovation that changes everyone’s lives comes profit. Where there is a sizeable amount of profit, there will be people who want to have a piece of that pie, and as the flock grows, so will the speculation.

It is a tale as old as time.

The Liverpool and Manchester Railway

The Liverpool and Manchester Railway which opened in 1830, was the world's first steam-powered, inter-urban railway designed to transport both passengers and goods. That said, a few years ago, in 1825, the Stockton and Darlington Railway in the northeast of England, United Kingdom, was the first railway built for the main purpose of carrying coal. Though it did transport passengers, coal was its primary freight.

The Stockton and Darlington Railway proved that there was a lot of money to be made in railways as it substantially cut the costs of transporting coal.

This led to the initiative of various businessmen to collaborate and build a railway from Liverpool to Manchester. Why these two cities when there are many cities across England? This is because Liverpool was the central port of North England, while Manchester was the heart of Britain’s cotton industry during that time, giving it its name “Cottonopolis”.

The businessmen who built the Liverpool and Manchester Railway were not able to build it without any predicament. They received strong opposition from other people, particularly from a company named Bridgewater Canal.

Before the innovation of railways, the main source of transportation from the port of Liverpool to Manchester for raw materials and manufactured goods was the Bridgewater Canal. (See the image below for the Bridgewater canal map.)

Despite several years of opposition, the businessmen were successful and were granted approval to build the Liverpool and Manchester Railway. It opened on September 15,?1830.

The construction of the said railway substantially decreased the transportation time and costs of raw materials and manufactured goods. Ultimately, it boosted the economic growth of both cities.

Less cost means more money to be allocated to other things in the business, such as maintenance expenses, investment capital expenditures, acquisitions and mergers, debt repayments, and dividend payments to its shareholders.

“How long did it take to get Liverpool to Manchester in the 1830s? 12 hours by canal, 3 by coach, and 1 hour, 46 minutes by rail.”

That was how poor the transportation time of resources was before the Liverpool and Manchester railway was built.

Inherent Problems with New Innovations

Any new invention always certainly encounters problems. This is because the people utilising it are entering uncharted territory. This is what the Liverpool and Manchester Railway experienced.

William Huskisson, a member of parliament from 1823 to 1830, died at the opening of the Liverpool and Manchester railway.

The tragedy happened when the locomotive named “Rocket” halted to refuel. The passengers went down the tracks while the train stopped; unfortunately, the locomotive “Rocket” suddenly charged straight ahead on the tracks where some of the passengers alighted. One of the casualties was William Huskisson. He was brought to the hospital, but later passed away from his wounds.

The above image is the locomotive "Rocket" made by Robert Stephenson.

Problems kept on coming to the railway, which was understandable because it was one of its kind during that time. There were no railway templates to follow, and everything was unknown. The management solved each predicament through trial and error, which was the same for any new innovation.

“People waved and cheered as the eight locomotives and their carriages steamed past. Others threw stones. One journalist reported spectators crowding around the tracks, trying to rip them up. Soldiers and cavalry lined sections of the railroad to protect the passengers and carriages from the masses. As with many leaps in technology, people worried how it would affect their livelihoods.”

The same happened with the advent of the Internet. People were sceptical about it and even thought of it as a destroyer of the livelihoods of most people around the world. Today, we are faced with the same problem with artificial intelligence and blockchain technology.

It’s true that there are certain jobs that will eventually be obsolete because of technological advancements, but we forget that when there are jobs lost, there will be new jobs created based on the changing times. This is why it is imperative that people continue to learn and be updated with these changes.

Regardless of our beliefs, whether conservative or liberal, the constant thing in our lives is change, and life doesn’t care if we’re ready for it or not. It is the ability to be flexible with the changing environment without compromising our own beliefs, values, and integrity.

The Birth of Railway Speculation

With the opening of the Liverpool and Manchester (L&M) railways in 1830, it was estimated that the railway generated revenue worth approximately ￡150,000 with a profit of ￡70,000. That was a 46% net income margin; that’s a phenomenal margin rate rivalling the profit margins of our current big tech companies today, such as Microsoft's 34% for fiscal year 2023.

Subsequently, in 1844, the L&M railway had a revenue of around ￡250,000 with ￡130,000 in profits. Their net income margin increased substantially to 52%. An astronomical 15-year performance for the company. It was indeed an innovation that rakes in money; it was the Big Tech of the 19th century.

This made people turn their attention to the railway industry.

It was timely because in the 1840s, the Bank of England cut the base rate (national interest rates). This meant that the cost of borrowing was cheaper. Financing endeavours for starting new businesses happened, and the most profitable industry during that period was the railways.

Railways were built left and right, such as the Great Northern Railway and the Sheffield, Ashton-under-Lyne, and Manchester Railway, to name a few; competition intensified within the industry.

As the base rate decreased, government bonds became less attractive, and stocks became more attractive. This pushed banks and investors to allocate their money on stocks, most specifically the hot stocks and the booming industry, the railways. This caused the stock price to increase, most notably for the railway companies.

This seems familiar, isn’t it? This happened as well with automobile stocks, airline stocks, and internet stocks. It is even happening now with the A.I. stocks as you read this.

On top of this, the British government repealed the “Bubble Act”, which was made after the disastrous South Sea Bubble of 1720.

https://elmads.com/?p=10401 - The South Sea Bubble: Hail the Great British Empire

The “Bubble Act” forbade the creation of joint-stock companies such as the South Sea Company without the specific permission of a royal charter. With this act revoked, any investor can now invest in a new company.

The British government also approved several plans to build more railways across England. It was estimated that the amount of money spent by the government on the railways exceeded its military spending at that time.

The stock market during this time was modernized. Public companies can now easily promote themselves, and shares can also be bought with a 10% deposit. This made it easy for every social class to invest.

The railway companies were heavily marketed and advertised as safe investments; they used the words "full-proof venture”. And it worked.

It was a perfect storm.

• Bank of England decreasing the base rate
• The Bubble Act was revoked by the government.
• A 10% deposit to purchase shares of a company was allowed.
• Railway companies were marketed as one of the safest investments during that time.

Thus, the stock price of railway companies skyrocketed in the 1840s. Many people invested their life savings in the hot railway stocks.

The End of the Bubble

Exuberance over the railway stock took hold in Britain. People threw money away by buying shares of different companies that operate in the railway industry.

Unfortunately, this did not last long. There are many railway companies that have realised that it is not easy to maintain and operate one. It required a lot of money, resources, and time to build railways, while the train was another problem. Maintenance expenses are also required, which is not the cheapest compared to other industries. In short, they believed that having their own railway business was very lucrative and easy, when in fact it wasn’t.

While this realisation among new railway companies started to form, the Bank of England increased the base rate. This means that the cost of borrowing will be more expensive, making investments and reinvestments expensive when done via debt financing.

This also directly influenced money allocation within Britain because bonds now became more attractive than stocks due to the increase in the base rate. The flow of investments shifted from stocks to bonds.

These three caused a sell-off in stocks, most especially with railway equities, as they were priced at higher multiples than the real earnings of the railway companies.

The prices tanked dramatically from 1845 onward.

“The index of railway stocks peaked at 1,984 on August 8, 1845, and stayed close to that level for two months (all figures and tables can be found at the end of this article). It then fell to 1,623 by the end of November 1845 and reached a low of 673 on April 19, 1850.”

It was a -66% decline from peak to trough of its index stock price. In comparison, the S&P 500 had a -56.8% drawdown from its peak during the 2008 global financial crisis, while it only fell by approximately -34% during the COVID crash of 2020.

As Britain entered the 1850s, the majority of all the railway companies that started and operated before the slow decline of railway stocks in 1845 had failed. The other railway lines left by the failed companies were bought by large and stable railway companies like the Great Western Railway.

There are always financial casualties for every speculation, and usually those are the ordinary citizens of a nation and the speculators.

The British Railway Today

As horrible as this financial history and market exuberance are, we can’t disregard the silver lining it brought to Britain, which is the vast expansion of the British railway system.

Though there were a lot of shenanigans during the infancy of the railway industry, it still brought substantial growth to the nation’s economy. And with the problems that occurred, including the bubble, new laws were passed to regulate the industry, and guidelines were made to promote safety for passengers, resources, employees, and the environment.

Today, the UK railway system boasts that it is one of the safest, most reliable, and most punctual rail networks anywhere in the world. In a regional context, these achievements are reflected in higher passenger approval and safety rankings than key European competitors.

The images above were taken from the UK Rail Industry: A Showcase of Excellence brochure on the British Government website. See the link provided. https://assets.publishing.service.gov.uk/media/5a7d5baf40f0b60a7f1aa076/UKTI_Rail_Brochure.pdf

The Problem isn’t the Innovation, but the Speculation

All successful innovations in human history that have shaped our lives have contributed to where we are today, such as mills, printing presses, factories, and Babbage’s concept of the analytical engine.

Such successful innovations were followed by profitability. This is because we seek out things that will make our lives better, and if one idea, gadget, or machine delivers that for us, then we will, without a doubt, be willing to purchase them to realise their comfortability and ease of navigating life.

And for every profitable invention, invite attention. It's as simple as this: Why leave money on the table when you can have a piece of that profit? And how do some people get that piece? It’s by either starting their own business or being a shareholder of a business that sells the product or service of an innovation.

This is where businesses of different sizes start entering this new industry. A land of new opportunities, as some say. Businesses like mushrooms, where they suddenly pop out of nowhere. People flock to places where there is money.

Businesses usually make more money when they become public companies. This is another set of problems because it can further inflate the exuberant market and industry.

Can you see where this is leading? It’s not the innovation that is the problem; it is the people who want to get a lot of money in the pot. In this context, it is a booming industry.

Investors are investing in public companies that may not even be generating income from their businesses. Or if they are generating income, investors usually push up the price multiple times above what the company generates in net income.

This is what is called a multiple in investing. Every stock price of a company has a certain multiple of how it is being traded relative to its actual net income, called the price-to-earnings ratio. There are other multiple ratios, but P/E is usually the most commonly used ratio.

https://elmads.com/?p=3672 - Relative Valuation – The Price-to-Earnings Ratio “Part 1”

Some companies trade at higher P/E ratios, well beyond what they can generate in the future. To give you context, let’s say you want to buy a pair of Nike shoes. At the Nike store, the shoe that you want is worth $150, but it is now out of stock. There are other ways you can buy it, like in the secondary shoe market like StockX; unfortunately, the shoe you are eyeing to purchase is being sold for ￡450. This means that it is being sold at three times its retail price.

From an investing point of view, think of the net income of the company as its suggested retail price, while the stock price of the company is the secondary market price. How much you’re buying the company today has a corresponding P/E ratio; either it can be 8 times the current net income of the company, or 17 times or 39 times.

There is this considered undervalued, valued, and overvalued P/E ratio in investing, which I’ve discussed in my P/E Ratio blog.

During the railway mania, the concept of the P/E ratio wasn’t coined and used yet, but they estimated that it was on average 30 times the actual net income of most railway companies at the height of the speculation.

With high speculative prices relative to actual business performance and future prospects, when the tide turns around and speculation dies down, it’s the people who bought at the highest peak that usually get financially destroyed.

These are usually the speculators, the people who only hope to make money but don’t have any basic idea of what they’re getting into.

To Sum It Up

“Don’t fly too close to the sun."

This is a reminder for equity investments. Prices are only a reflection of what people are willing to pay at a point in time, but this doesn’t reflect the value of its underlying business.

The same is happening today with blockchain and AI stocks. Understand what you own and why you own it. Emotions shouldn’t have any participation in it.

• (The Liverpool and Manchester Railway), established in 1830, was the world's first steam-powered inter-urban railway for passengers and goods. It succeeded the Stockton and Darlington Railway of 1825, which primarily carried coal and demonstrated the financial potential of railways. Overcoming significant opposition, the Liverpool and Manchester Railway significantly reduced transportation costs and times between these key cities, revolutionising commerce and travel. .
• (Inherent problems with new innovations) Innovation often brings unforeseen challenges, exemplified by the Liverpool and Manchester Railway's early difficulties as it ventured into uncharted territory. The tragic incident involving William Huskisson, a member of parliament, highlighted the risks associated with new technologies. .
• (The Birth of the Railway Speculation) In the early years of the Liverpool and Manchester railway, it achieved remarkable financial success with impressive net income margins, making it the 19th-century equivalent of today's tech giants. This success drew attention to the railway industry, which flourished against the backdrop of decreased national interest rates, similar to stock market booms seen with industries like automobiles, airlines, and the internet in later years. The British government's repeal of the "Bubble Act" and their substantial investments in railway expansion, combined with more accessible stock markets, created a perfect storm for the railway industry's stocks to soar, with investors of all social classes buying in. .
• (The End of the Bubble) The enthusiasm for railway stocks in Britain led to widespread speculation, with people eagerly investing in various railway companies. However, the harsh reality set in as many companies realised that the railway business was not as lucrative or easy to operate as they had initially thought. A series of factors, including an increase in the base interest rate and the attractiveness of bonds over stocks, triggered a massive sell-off in railway stocks, resulting in a significant -66% decline from their peak by 1850, leaving many railway companies in ruins. .
• (The British Railway Today) Today, the UK railway system boasts that it is one of the safest, most reliable, and most punctual rail networks anywhere in the world. In a regional context, these achievements are reflected in higher passenger approval and safety rankings than key European competitors.

Knowledge is my Sword and Patience is my Shield,

elmads

www.elmads.com

DISCLAIMER:

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.