Investment market update - May 2018

04 May 2018

To print this update, download a PDF version.

The Australian share market was one of the better performers over the last month. Resource companies rallied on the back of higher commodity prices and we also saw a welcome bounce in the infrastructure sector.

As many members know, UniSuper is the largest shareholder in Transurban, Sydney Airport and APA Group—all of which have delivered excellent returns since our initial investments in them. However, over the last 12 months, their share prices have underperformed the broader market. This update outlines the reasons why—and why we aren’t overly concerned.

Performance of key markets

See performance information for all options

Transurban, Sydney Airport (SYD), and APA Group (APA)

Great long-term investments, poor short-term returns

You might be familiar with our large investment in three of Australia’s premier infrastructure assets—we’ve discussed them in a number of past investment updates. We call them ‘fortress assets’ because of their monopoly-like characteristics. If you’re travelling on a toll road, flying to or from Sydney or transporting gas in Australia’s Eastern states, at least one of the above companies is earning money. So it should come as no surprise that we consider them to be ideal assets for a number of our investment options.

We started to accumulate large stakes in these companies around 2011 and, as Chart 1 shows, they’ve outperformed the broader market by a large margin (an investment in Sydney Airport would today be worth 2.5 times the equivalent investment in the market).

What we also see in Chart 1, however, is that their share prices have weakened over the past year or so—underperforming the broader market.

While each company faces specific concerns impacting its share price (discussed below), the common driver has been a rise in bond yields.

The negative reaction to rising interest rates (implying higher interest costs) is somewhat understandable, given the companies generally hold higher levels of debt than is commonplace for other companies. However, we’re not overly concerned for the following reasons:

• Given the ‘fortress’ nature of their assets, Transurban, Sydney Airport and APA generate strong sustainable cash flows to service their interest payments. This, in turn, allows them to take on more debt than the average company. Even with the higher debt profiles, all of the companies maintain a solid investment-grade rating from the rating agencies.
• All three have taken advantage of the low interest rate environment to lengthen the maturity of their debt profile, so there’s minimal refinancing risk. In any case, these types of companies have very little problem refinancing—even in tough times.
• While interest rates have risen quickly, they still remain at very low levels and the dividend yields the companies generate remain at a healthy premium to bond yields.

Company-specific issues

In addition to interest rate rise impacts, there are also some company-specific concerns that may be dragging on their share prices.

Transurban is currently bidding for the WestConnex project in Sydney. This is a major road infrastructure project and involves extensive tunnelling—so there are large risks involved. Four consortiums are bidding on the project, which effectively eliminates any chance of winning it ‘on the cheap’. Transurban is seen as having a bidding advantage due to its established toll road network, and in the event that it wins, it will need to raise more capital (i.e. sell new shares on the market). So some investors figure on buying the shares at a cheaper price in future.

While we acknowledge the possibility that overpaying for WestConnex is a genuine risk, we take comfort from the discipline Transurban has demonstrated in the past. The deals they’ve won (e.g. Lane Cove Tunnel, Queensland Motorways) have worked out well and they’ve walked away from opportunities they considered too expensive. Winning WestConnex at a reasonable price would be a great outcome, in that it would underpin the growth profile of the company for the very long term. 

APA has been negatively impacted by new regulations that allow users of some of its gas pipelines to seek arbitration if they’re not satisfied with the price APA is charging. While this poses a risk that price growth will be harder to achieve in future, a mitigating factor is that the average life of existing contracts is 13.5 years. Furthermore, since the new regulations were introduced, APA has renegotiated 19 gas contracts at commercial rates, without the need for arbitration.

Sydney Airport will ultimately lose its monopoly status when a new airport starts operating at Badgery’s Creek in 2026. However, we’re comfortable that expected growth in the volume of traffic will be sufficient to support two airports, and Sydney’s close proximity to the CBD will always give it a competitive advantage. Indeed, one could envisage an optimistic scenario whereby Sydney actually benefits from a second airport—with slots being freed up to accommodate higher-margin premium airlines, while lower-margin budget airlines use the new airport.

Focusing on the fundamentals

While share price movements will ultimately track the fundamentals of a company (such as profits and dividends) over the long term, over the short term, we often see wide divergences. With this in mind, the recent share price weakness of Transurban, Sydney Airport and APA does not in any way reflect a deterioration in their underlying fundamentals. Charts 2, 3 and 4 show the share prices of the companies (blue line) plotted against the dividend streams (green bars).

Points to note:

• We invest in quality infrastructure assets to benefit from their resilient cash flows, which ultimately flow through as dividends. We haven’t been disappointed—none of the three companies have missed a beat.
• Despite the recent share price weakness, we actually expect dividends this financial year to grow (dashed orange bar). For Transurban, this is being driven by increased traffic growth (up 2.7% in the March quarter). For Sydney Airport, it is passenger growth (up 4.1% in the March quarter), and for APA, gas volume growth and expansion projects are driving earnings growth close to 2.7%.
• In addition to volume growth, all three companies have pricing power which protects against potential rises in inflation. This point is often overlooked by some market participants. Bond yields are currently rising because global economic growth is solid, and we expect this to feed into higher inflation rates. While higher inflation erodes the profits of companies without pricing power, it can actually benefit companies with pricing power.

Transurban, Sydney Airport and APA are held across a number of our investment options, with a particularly heavy concentration in our Conservative and Conservative Balanced options. While these options have benefitted from the companies’ stellar long-term returns, the short-term share price underperformance has adversely impacted them.

However, given the companies’ strong fundamentals remain intact, we’d argue this isn’t a cause for great concern. For us, they remain ideal—and very important—investments, in the context of achieving the objectives of the options that hold them.