The meteoric rise of Magellan Financial Group is well known to investors who have embraced co-founder Hamish Douglass' call to go global for stocks. But another Magellan success story has gone largely unnoticed.
Under Gerald Stack, Magellan's infrastructure funds business has amassed $6.6 billion of assets and topped the global performance charts for listed infrastructure funds.
"In the context of Magellan, we're a small part of the business. But as a standalone entity, we have done what we have set out to do," Stack tells AFR Weekend in a rare interview.
The Magellan Infrastructure Fund has delivered double-digit returns over one, three, five and seven years, and 8.5 per cent since inception in July 2007. That has led it to hold the number one Morningstar ranking of listed infrastructure funds.
Stack has been analysing infrastructure investments since the early 1990s and was brought across to Magellan with his team from Capital Partners. He is part of a seven-strong team that includes another founding member, Dennis Eager, and former Sydney Airport chief financial officer Stephen Mentzines.
In that time, he has become dogmatic as to what is a true infrastructure asset – and it is that discipline he believes has ensured the fund's success, particularly over the past 12 months to March, when the fund returned 11.5 per cent as the broader index declined by 3.5 per cent.
Necessity the mother of investment
To qualify for investment, the asset must be essential for the efficient functioning of the community and not sensitive to commodity prices, competition or sovereign risk. At least 75 per cent of the earnings should "regulated".
Of course, one of the reasons infrastructure assets have performed so well of late is the continuous decline in long-term "real" interest rates. As rates have fallen, the long-term stable cash flows attainable from infrastructure have increased in value as the discount rate has declined.
Stack explains that the long-term US real interest rate (once inflation is factored in) has historically been about 3.5 per cent. At present it's a paltry 20 basis points.
But, he says, infrastructure assets are still being valued to reflect about a 2 per cent real rate, which assumes some increase in long-term rates from this point. The fund is positioned well, so long as real interest rates stay below 2 per cent, Stack says.
"If I look over 10 years, I think there's probably at least an equal chance rates will stay below those levels [2 per cent real]. And if they stay below them, then arguably assets are cheap today.
"But if you believe real interest rates are rising – in our case above 2.5 per cent – then you have concerns."
When it comes to selling infrastructure as an asset class, the two main selling points are that the earnings are reliable and that they're linked to rises in inflation, therefore protecting investors.
Private v public
But this is a world where deflation is as much, if not more, of a risk than inflation.
"At the moment investors shrug their shoulders on the inflation leg, but inflation will come again," Stack says. "We are not trying to predict inflation – we are trying to select assets where inflation is passed through and is less of a risk."
Stack is particularly passionate about the trade-off of investing in unlisted private infrastructure assets and those that trade on public sharemarkets.
Throughout his career, private investments have attracted a premium of 15 to 30 per cent of the regulated asset base, which is partly a reflection of the funds raised by private investors.
"There is a lot of money chasing a lot of deals, in essence," he says.
London City Airport recently sold at a 28 times earnings multiple, a hefty premium compared with a multiple of 13 times for publicly traded European airports.
While there may be good reasons to pay up for an unlisted asset, the volatility of the sharemarket is not one of them, Stack argues, especially if the underlying earnings are stable.
"[Share market volatility] is not risk, it's the measurement of something we are trying to equate with risk and it's the best measure we have. But it's not risk.
"Whether you do it at the public or private doesn't matter – what does is the quality of the asset and the price you pay for it."
Toll roads rule
The fund's investments are spread around the world, with about 17 per cent invested in Australia, which is an overweight position. Its largest holding is Transurban, the ASX-listed toll operator that owns Sydney's Eastern Distributor.
"We think urban toll roads are the kings of infrastructure assets," he says.
The attraction is that as the population grows, the capacity of the free road system is almost full, pushing more vehicles on to tolled roads. And it seems that price hikes are no deterrent.
"When you put prices up on toll roads, Economics 101 tells you that when price goes up demand goes down. But look at the Eastern Distributor – prices have gone from $3 in 2000 to $6.70 and traffic has grown every year. It is highly price inelastic with structural reasons to believe you will get strong traffic growth."
Sydney Airport is another holding, and one that has delivered sharemarket investors spectacular gains to the point where even believers are questioning its current valuations. Its earnings power, however, cannot be doubted.
"International passengers are growing at 10 per cent, while domestic passenger growth is about 3 to 4 per cent. The total mix is somewhere in the order of 5 to 6 per cent, and if you add some inflation that gives you 8 per cent revenue growth. Without cost growth that gives you double-digit earnings growth, and if you compound that even over a short period, that's an attractive proposition."
The Eastern Distributor and Sydney Airport investments show just how good infrastructure operators have it in Australia. And the fund is a beneficiary. But he also believes Australia and most of the developed world has not invested enough in infrastructure.
"I believe countries and economies and societies who systematically invest in infrastructure over the long term in a logical and strategic manner set themselves to win.
"In 1990, Victoria was an economic basket case and it invested in transport networks. It has been one of top-performing states in subsequent periods and infrastructure has been a very important part of that."
There is no question, Stack says, that developed economies have underinvested in infrastructure for the past 50 years.
"There's a strong postwar relationship between the investment in infrastructure and GDP but that broke down in the late 1960s-early '70s, where GDP has gone ahead and investment in infrastructure has fallen behind. Some of the structural issues we have had is because of the underinvestment."
