In 1846, the Pennsylvania Railroad was created. It was one of the stodgiest blue-chip stocks in American history, even making dividend payments during the Civil War. In fact, from 1846 through 1946, it never cut its dividend and found itself boasting the longest streak in world history without a dividend cut. It was a symbol of American capitalism, as it operated 10,515 miles of rail line throughout Delaware, Illinois, Indiana, Kentucky, Maryland, Michigan, New Jersey, New York, Ohio, Pennsylvania, West Virginia, and Washington DC.
To a lot of people, it was America. It employed 250,000 people at its height. Pennsylvania’s breadth and power was so extensive that one out of every 2,000 men in the country worked at this east coast railroad company. When the dividend held steady at $2 per share during the Great Depression, it was those $200 checks for every 100 shares owned that prevented some families from joining the bread lines. It sounds foreign to us now, but railroads consisted of 63% of the American stock market at the time the Dow Jones created its first index in 1892. If a husband put together a portfolio of stocks to take care of his wife after his death, the wife’s ability to remain self-sufficient was due to those railroad dividend checks that literally showed up in the mail every three months. When children inherited stocks, it was statistically likely to be railroad companies from 1900 through 1950.
Penn Central was considered the safest of the railroads. That changed in 1965 when CEO Stuart Saunders hired Devid Bevan to engage in financial engineering to boost Penn Central’s profits. Bevan completed the merger with New York Central Railroad in 1968, desperately to any terms that would grow the empire. One of the terms was particularly burdensome—Saunders and Bevan agreed to guarantee employment for all works after the merger. This promise had no chance of being kept because the combination of railroad lines consolidates rail power and reduces the need for at least 25% of employees.
So what did Bevan and Saunders do? They cut salaries and put employees on furlough. Needless to say, railroad union employees didn’t like this. During their furloughed days off, they would steal trains that were sitting in the station and make them disappear. This was in the days before electronic trails and cameras monitoring everything, and causing mischief was the uninhibited response when you felt someone was trying to pull something over on you. The railroad union employees were particularly bold in St. Louis—they would take trains delivering Eastman-Kodak film and toss the contents of the train into the Mississippi River. They did this repeatedly because The St. Louis Post-Dispatch reported that Eastman Kodak was buying commercial debt from Penn Central through Goldman Sachs, and the union employees considered Eastman-Kodak an ally of the management team they detested.
As railroad deliveries became difficult, Saunders and Bevin concocted a scheme. They would force their railroad subsidiaries to pay them dividends backed by debt, and use the money to invest in real estate. Neither of these two men had any idea how to value New York properties, but this did not stop them from trying. They drained the New York Central Transport Railroad of its assets by forcing it to pay $14.5 million dividends to the parent company while making only $4.5 million in net profits.
They used this money to buy land on Park Avenue between Grand Central and the Waldorf-Astoria Hotel. But they had to keep borrowing to fund these real estate adventures. This is the moment when Goldman Sachs lost its reputation as a credible bank. Nowadays, people use the term Goldman banker as a synecdoche for greed. But it wasn’t always that way. During the Great Depression, Goldman’s partners would step in and pay for the difference on any client losses for investments they had characterized as “very safe.” That reputation was lost in 1968-1970 when Goldman learned that Penn Central was borrowing money at a rate that would eventually lead to its collapse, but nevertheless issued $87 million in corporate paper to American Express, Disney, Welch’s Foods, and Younkers at 100 cents on the dollar. They allowed Penn Central to continue borrowing at a reduced rate by covering up the budding real estate failures by Saunders and Bevin. The $87 million debt offering run through Goldman is the only reason Penn was able to keep making its $2.40 dividend payments.
In 1970, the railroad operations had lost $102 million, and Bevin and Saunders had three months to pay off $100 million in debt issued to fund their real estate operations. They went to National City—Penn Central’s lead bank for almost half a century—and sought $100 million in commercial paper offerings to keep the company running. The bank said they could not recommend Penn Central’s debt to consumers any longer, and declined to offer a lifeline. Unable to make the debt payments, Penn Central filed for bankruptcy on June 21, 1970. The bankruptcy was so large and unruly—executives committing suicide, employees destroying trains—that the government took over and created Conrail and Amtrak.
The financial markets were shaken. No one wanted to touch railroads. All four of the major railroads were struggling, and the price of Norfolk Southern, CSX, Union Pacific, and Burlington Northern Santa Fe began to fall. Retirees didn’t want to touch this stuff, unsure of what could be lurking on the balance sheets of the other major railroads after the collapse of Penn Central.
Now, here’s the cocktail party fact—from 1960 through 2010, only five sectors of the U.S. economy outperformed the general stock market as a whole. It was the tobacco sector, the electrical sector, the healthcare and chemical companies, food companies, and railroad companies. If someone invested into an index of railroad stocks in 1960, they would have allocated a large chunk to Penn Central that eventually got wiped out. And yet, they still would have compounded their wealth at a 10.5% compared to a 9.8% rate for the U.S. stock market.
What accounts for this outperformance? It is that the railroads got so cheap in the aftermath of the Penn Central bankruptcy that dividend accumulation during the 1970s and 1980s had a “return accelerator” effect as Dr. Jeremy Siegel likes to put it, and railroad investors experienced a half a century of better returns despite: (1) the mega-trend that saw railroads shrink from 63% of the U.S. economy in 1892 to less than 1% of the U.S. economy by 2010, and (2) the largest specific railroad investment experienced a wipeout bankruptcy early in the investment period.
This is where investing becomes the most counterintuitive. There are many people lamenting the recent stock market performance of Exxon, Chevron, Conoco, BHP Billiton, Royal Dutch Shell, BP, you name it. These stocks aren’t attractive to a lot of people because of their recent performance. But yet, it is precisely these fluctuations and periods of undervaluation that create the outperformance over the very long periods of time. It is the interaction of dividend reinvestment at times of reduced expectations that create gains over the long haul. Volatility for profitable enterprises really is a blessing rather than a curse, but it requires a rational understanding of the historical data rather than the emotional satisfaction of seeing stock prices rise each year to reach this conclusion and act upon it.
Originally posted 2015-04-03 06:00:31.