Welcome to the weekly free edition of The Diff! Subscribers-only posts you missed this week include what J.P. Morgan is seeing in the broader economy (and why it matters), how demographics will reverse a financial law of nature everywhere except Japan, and thinking of your research time as a portfolio.
Coming attractions include a look back at the “productivity paradox,” a profile of YouTube as a business, and a look at how continued improvements in search have changed the way we look for information (and made us truly spoiled relative to our data-impoverished ancestors).
This newsletter goes out to 32,107 readers, up 430 since last week. In this issue:
AWS for Industry, But Better: The Railroad Investment Case
If you’re choosing where to work, you probably want to aim for secular growth. Growing industries have more employees, fewer responsibilities and better economies of scale. This is good news for your career prospects, regardless of whether you are looking to become a manager or a contributor. In a shrinking industry, you suffer the tyranny of the long generation, where organizations get more risk-averse as the median employee ages, and start to promote more based on seniority at exactly the time when the people who already work there are accumulating a lot of it.
For investors, the picture is more complicated. Growing industries can make fortunes. The biggest net worths are those that result from growth. However, growing industries face more competition and the expected returns on capital will decrease if it is not available faster than the opportunity. Railroads are, in relative terms at least, the most non-growth industry imaginable, since they used to be most of the market and went through a roughly century-long decline featuring massive losses, painful consolidation, and the largest bankruptcy in history up to that point from the Penn Central. This decline had several causes:
Passenger rail was an important revenue source early in railroads’ existence, but total passengers peaked in 1920 and had declined by more than half by the 50s thanks to the rise of the automobile. Rail-based passenger transportation can work in some contexts, like dense cities (the MTA carried 5.5m riders each weekday in 2019, above the entire US rail system’s passenger traffic at its peak, but short hauls have different economics than longer ones, and the MTA still needs heavy subsidies).
Trucking devoured market share in freight transportation in the mid-twentieth century. The Interstate Highway System played a major role in this. In the ten years that followed, trucks surpassed railroads by 7 points, making them the largest single type of freight.
Railroads benefit when more supply chains are domestic, and containerization made it easier for low value-added parts of the manufacturing process to move overseas. For example, a car manufactured in the USA might require trainloads full of steel. A steel mill will need trainloads full of iron and coal. Railroads are impacted by the movement of parts of the supply chain overseas. They earn revenue from each step that takes place on land.
Railroads were especially well-adapted to bulk transportation. As they lost share in other kinds of transportation, they remained dominant for coal, but coal has been in terminal decline since 2008.
Unit economics for railroads look best when each locomotive is pulling lots of cars. Railroads that wanted to optimize their unit profitability traded-off on scheduling: if one customer was a day behind for a big shipment, they’d wait, but that meant that the next customer would be behind, too. (The popularity of just-in-time manufacturing is not compatible with a delivery date where the error bar is 20% on either side.) These scheduling issues were problematic for a unionized workforce that had many rules about work hours. A shipment that arrives a few hours late might arrive at the end of its last shift, rather than in the middle. This would force the railroad to hire a new crew, even though it had already paid the former one.
As a legacy of the industry’s growth, there were many cases where multiple companies could service the same routes. Their total volume decreased, so they had to compete more on price. Fixed costs were always the same regardless of how much they carried. It was better to make a small profit than have idle tracks, equipment and workers.
Because of all these negative trends, smart managers generally avoided the industry. This only adds to the problems. This makes it more difficult for an industry to adapt when workers are trying to keep their pensions. It won’t accept many risks when there have been only minor downsides over the years.
So every secular trend possible has been conspiring against the train industry for an astonishingly long time. This is just one side of the story. The other side is that the US has the best freight rail infrastructure in the world, and rail transportation is about 80% cheaper than trucking per ton-mile. And trains and trucks can be combined to achieve rail’s cost savings for one part of the route and trucking’s flexibility for the rest. If the industry got its act together, that cost advantage and irreplaceable route network could produce some good returns for investors.
The industry did, in fact, get its act together, and attracted interest from smart investors. Warren Buffett bought BNSF in 2008, Pershing Square won a tough proxy fight with Canadian Pacific in 2012, which turned into one of his most successful investments ever by 2016, and this interview with Eric Mandelblatt at Soroban is a good overview of the current bull case on railroads. This interview with Eric Mandelblatt at Soroban is a great overview of the current bull case on railroadsRailroad Tycoon II, but hadn’t looked seriously at the industry until recently. )
The story of how that happened is partly about a bad situation that ran out of ways to get worse, and partly a story about how the assets these companies have were valuable all along. The bear case against railroads has a part to do with environmental issues. Coal is still a large source of revenue and spillage can prove extremely dangerous. But the bull case, too, is an environmental one: drawing a line on a map, flattening it, and ramming steel into it at scale is just not something the US will really allow; all it takes is one recalcitrant landowner or one potentially-endangered species anywhere between point A and point B to nix the project. Railroads had to find a way that would fit into a just in time environment. They did this by rethinking the unit economics of their operations and leveraging their cost advantage.
Why American Rail Infrastructure is Great
The economic model for railroads is not too far off that of big tech: there’s a fixed asset that leads to a hard-to-match competitive advantage, and variance in outcomes is driven by how well companies exploit that asset. Although it might seem strange to think that someone who enjoys investing in software companies would also like to invest in an industry that emits smoke, it is true. Cascade Investment Group was the family office of Bill Gates and used some of its Microsoft sales proceeds to become Canada’s largest shareholder.
Understanding the railroads starts with understanding that asset base.
America in the present, is very fortunate to have been very sloppy and irresponsible in the distant past. Over-optimism and market manipulation are the reasons America has such an impressive railroad network. Railroads were about two thirds of the market in 1900, and other big chunks like banks, steel, and telegraphs were intimately tied to the railroad industry’s fortunes. The market has never been dominated by any industry, and it will not again. Right now there are basically three publicly-traded railroads in the US, with a collective market cap of around $250bn, worth about as much as Coca-Cola. In 1900, they had a million employees, and total revenue that was three times Federal tax receipts. Today, they employ around 135,000 people, and total revenues for North American Class I railroads were $73bn in 2021. (Back to the soft drink comparisons, that’s a bit smaller than PepsiCo’s $79bn. )
There were a few big drivers for the 19th century growth of the North American railroad industry:
Early on, railroads had a cost advantage relative to other forms of transportation.
They were also capital-intensive enough that they had to raise money through capital markets rather than banks. They were also capital-intensive enough that they had to raise money through capital markets rather than banks. A British investor might be skeptical about making a loan to an American company. However, he could purchase American railroad bonds or shares and know that there were American banks watching the situation and that there was a secondary market.
Railroads, especially transcontinental ones, were heavily subsidized through government loans and land grants. As generous as these subsidies were, the railroads found ways to extract more value from them: the Union Pacific’s lawyers found a poorly-written clause in a subsidy law, allowing them to reinterpret their interest obligations from subsidized loans in a way that added $43m in subsidized interest to an intended $77m loan.
Meanwhile, railroads operating before the advent of modern accounting, not to mention modern data storage and analysis, had no idea what their unit economics looked like. They couldn’t figure out the breakeven price of a load or the incremental return from adding a branch.
This doesn’t mean that there weren’t reliable ways to make money from the railroad system. There were two popular ones:
Directly skimming money from construction, by creating a captive construction company owned by railroad insiders and politicians that overcharged the railroad and then paid dividends to supporters.
Insider speculation in land based on foreknowledge about what route the railroad chose.
Both of these were harmful to the railroads’ owners, and didn’t do anything for customers, either. It did provide a strong incentive to companies to continue building as many as they could. The new track brought more subsidies, land grants, opportunities to earn money, and the possibility to flip acreage along the route.
Since railroad investors weren’t fully aware of how much they were being ripped off, they tended to overestimate profits. Every incentive was available to increase track mileage, including subsidies, speculation and theft. Rail mileage peaked at over 250,000 miles in 1916, by which point the industry had already gone through several cycles of boom and bust (a quarter of the rail system by mileage was in bankruptcy by 1893).
Since then, there’s been a long retrenchment; total railroad mileage is around 92,000 today, with the pace of decline leveling out in the last fifteen years or so.
Transcontinental railroads shaped the US economy and culture (and politics, leading to the abrogation of several treaties with tribes whose land was along routes railroads wanted). This is even more true in Canada where the inclusion of British Columbia was contingent on the completion the Canadian Pacific Railway. This was a strong argument for industrial policy, or against the corporate welfare state. Your discount rate is a key factor in determining whether this proved to be a strong argument in favor of the power of industrial policies. The railroads created the largest financial market in the world, created the US manufacturing base and a dense network that provides cheap over-land transportation.
The Railroads Today
This map is a good look at where things stand today. Every major port has a railroad connecting it. Although they no longer serve a primary purpose of transporting people, the cost to transport goods is very competitive.
Whether that cost advantage accrues mostly to railroads’ customers (and their customers’ customers, i.e. The extent to which the industry is consolidated and how it’s managed will determine whether this cost advantage accrues primarily to railroad customers (and their customers, i.e. American consumers) as well as railroad shareholders. Consolidation was painful and long-lasting, as were the management changes.
It’s always tricky to attribute industry-wide changes to specific individuals, but two stand out. The first was Hunter Harrison, a former CEO of the Illinois Central and Canadian National Railways, Canadian Pacific, Canadian Pacific and CSX. He was a busy manager and job-hopping caused serious problems for all parties. Harley Staggers was the other, sponsoring a bill to de-regulate railroads. This would allow them to set their own rates as long as there are competitors. It also allows railroads to establish contracts with other shippers and reduce railroads’ influence on each other’s rates.
One reason Harrison was so effective was the Long Generation effect mentioned above: he joined the St. Louis & San Francisco in 1963, when the department he worked for had made just one or two hires since the end of the Second World War. Harrison was also an exemplar of working as an individual contributor well past the point where it’s directly economically rational: at one point, as a CEO, he booked a hotel room with a view of a rail yard, spotted an idle train, and called the station to demand an explanation. He was also a CEO and noticed congestion on his network status dashboard. He called the dispatcher at the station and worked for the whole night as a dispatcher.
This kind of obsession about detail is somewhat unreasonable, and could be quite expensive; Harrison was making tens of millions of dollars a year, so in terms of opportunity cost he spent around a dispatcher’s annual salary by working as one for a single night. It can have a multiplicative effect if the CEO is good at negative feedback (e.g. yelling at people and firing them) is more effective than positive feedback.
The more repeatable element of Harrison’s impact was that he rethought railroad unit economics. Railroads have always aimed to build the longest train possible. Since every incremental car costs less, you can measure P&L when trains are moving. But railroads are also a capital-intensive business; CSX’s $13.1bn of annual revenue requires a $40.5bn asset base, and that asset base ignores the value of the long-since-depreciated-to-zero rights-of-way that make railroads so valuable in the first place.
If the sole priority is longer trains, something has to give–many things, in fact. For example, if a customer arrives late, but can fill more cars in a few days, schedules will fall. It is possible for idle equipment to multiply and train can end up with suboptimal route. Customers have an understanding of railroad economics and can demand lower prices as well as more delays.
All this means that a railroad that doesn’t adhere to a relentless fixed schedule is more capital-intensive than one that does. Harrison was determined to correct this problem, focusing on the schedule and allowing customers to be available when they were not. This decreased idle time and made the whole system more predictable. Customers who relied on rail transportation now have an alternative, but more costly, in trucks. This gave them an economic incentive to continue to pay.
Harrison’s manifesto is actually available on Amazon (for $400), but this book is a good summary, albeit one highly favorable to the Harrison view of things. Two strong data points support Precision Scheduled Railroading. First, when Harrison agreed to join CSX it added $10bn to the company’s market value in a few days; CSX was worth 28% more with Harrison as probable CEO than it had been before. And second, other railroads ended up adopting the same methodology; if you Google “precision scheduled railroading” today, the top result is from the blog of Union Pacific, which adopted it in 2018.
Railroads still face challenges. As of 2019, around 14% of their traffic still consisted of coal, which has been declining at around 6% each year. Over the past decade, railroad traffic has remained flat. However, traffic excluding coal has been increasing in the low single digits each year; as coal declines further, the secular trend toward more railroad shipping will drive traffic up.
And that’s just a general bet on economic growth. The interesting part is looking at what happens when supply chains change. The US is a country with high wages, low-cost capital, flexible capital, relatively cheap energy and land, compared to other countries. Manufacturing becomes more capital-intensive and possibly more energy-intensive as it matures. It also tends to become less labor- and resource-intensive. One way to view the global macro trend in manufacturing is to see that the US’s relative disadvantage in manufacturing begins to decrease as it becomes less sensitive to the cost of manufacturing and more dependent on the price of manufacturing.
This doesn’t mean that we’ll run the story of globalization in reverse, and that the US will once again be the world’s dominant manufacturer; you generally don’t want your country to be making lots of shoes, lawn furniture, and toys domestically, unless the alternative is subsistence farming or starvation. However, it does mean that outsourcing some types of manufacturing becomes less cost-effective over time. This is especially true when it becomes harder to trust long, distant supply chains, regardless of whether they are due to American or Chinese foreign policies. The US is not capable of imposing the kind of severe Covid lockdowns that have been enforced by the Chinese Communist Party. Therefore, the US manufacturing base can be harder to disrupt.
Because of their cost advantage in intra-US transportation, and because of monopolistic economics that are politically and technologically infeasible for anyone else to duplicate, the railroad industry represents a sort of royalty on the growth rate of domestic manufacturing (and, to a lesser extent, consumption of bulky products like cars, lumber for houses, grain for food, oil, etc.). Just like how cloud computing affects the growth of software or ads in consumption, spending more on the end product results in higher spending and higher margins on hard-to-replace intermediate products.
One thought experiment to use on the railroad industry is to imagine that Congress decides to give Elon Musk rights-of-way on a 92,000-mile network connecting all major US ports and manufacturing centers. This would make The Boring Company’s ambitious plans look boring and lead to a revolution in domestic manufacturing. Now that the railroad industry is on board with higher operating standards that fit well into a just-in-time world and a trend away from offshoring, they start to approach that hypothetical Musk asymptote. Thanks to errors of commission in the 19th century and errors of omission throughout the 20th, North American railroads have gotten massive overinvestment, leading to a wonderfully valuable asset that can keep on throwing off cash for years to come.
Paying subscribers can read Part 2 tomorrow, where we’ll do a deep dive on a single railroad and look at what drives their economics and how to value them.
A Word From Our Sponsors
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At a CFTC roundtable discussing a new futures margin proposal from FTX, a representative of futures exchange ICE claimed that at least one major trading firm technically defaulted early in the Covid pandemic, but was given a pass and ultimately did not collapse ($, FT). Although the comment didn’t give any details about what had happened, it did leave out the warning that “that person sitting in this room knows exactly who I am talking about”). “)
It’s not immediately obvious which is better for financial stability: a system where someone can slightly default and get away with it, or one where market chaos is compounded by the collapse of a trading firm, which would probably take down other firms and perhaps exchanges with it. There are anecdotes here and there about similar situations; in his memoir, Jim Cramer claims that at the peak of the 1998 meltdown, his hedge fund should have gotten a margin call from its brokers, but they didn’t get around to it in time and prices recovered. This happened to Archegos as well: they refused to provide more margin even though the collateral value was continuing to decline.
There may be a load-bearing level of forbearance within the industry, especially on the part of exchanges that may know their counterparties are hours away from fixing whatever put them in default. This proposal by FTX is intended to eliminate this discretion by automatically adjusting margin requirements and liquidating positions in reaction to market movements. This proposal is more elegant than the existing system because it’s easier to read, but it could be that the legacy version’s illegibility was what allowed it to continue running.
College enrollments are down for a fifth straight semester, with community colleges slowing more. Although this is not a Covid trend, it has been slowing down more than others. Students who went to college online realized that they could have a similar experience for a fraction of the cost through coding bootcamps or other options. The ROI is still there, even if it doesn’t compare to college.
While EVs are still rising in popularity, with US sales up 85% Y/Y in 2021, there’s a shortage of charging stations ($, WSJ). While cars and gas stations had their own economic models, it was difficult to create the same type of drivetrain with electric vehicles. The gas station business depends on foot traffic, which is a good thing. State grants for charging stations have been snapped up mostly by established companies; in Texas, 85% of a $21m grant went to Shell and Buc-ees.
China is allowing foreign investors to access its onshore bond market ($, FT) starting at the end of next month. China’s bonds are popular due to its large size and ability to offer better real returns than other sovereigns. It’s not directly comparable because the Chinese financial system is not compatible with fully open financial flows. I’ve previously written about how this closed system limits China’s prospects as a reserve currency issuer. Any move that opens up their markets further improves their chances of achieving reserve currency status. It also indicates the government’s intentions in this direction.
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