Twenty-four central banks have cut interest rates this year and not a single one has raised them yet. You can see with your own eyes the effect on risk asset prices of liquidity pumping. The dash from cash is accelerating globally with anyone, who relies on investment income to live, basically forced into equities.
There remains absolutely no doubt in my mind that the cash rates and bond yields we see in front of us today will continue to lead to equity dividend yields being bid down, leading, inversely, to further capital gains in the right equities. That is why twice already this year I have lifted my ASX200 trading range (currently 5700-6200) on the basis of global and domestic demand for high equity dividend yields.
Not only is demand for equity yield increasing, the corporate world is paying out a greater proportion of earnings as dividends. Payout ratios are rising, which is leading to a double-whammy re-rating of predictable dividend stream equities. I am convinced for the medium term that any equity with bond like characteristics is going to be priced like a bond: i.e. inverse to its yield.
That strategic thesis is proving right and I am going to stick with it, despite all the howls from equity valuation purists. My view is we have never seen cash rates and bond yields this low, so there is no historic playbook to what comes next. Historic valuation and share price target setting approaches are somewhat obsolete, perhaps even dangerous in the short term, in a world where central banks are so dominant. My job is to predict how investors react to macro settings and how and where capital will flow.
Let’s just remind ourselves of current first world cash rates and 10yr bond yields. I can hardly believe I am typing some of these numbers, but they are the reality of the day
You can see why I think the RBA cash rate is headed to 2.00% then eventually 1.50%. I simply look at Canada, a resource rich economy similar to ours, and I see 0.75% cash rates and 1.34% 10-year bond yields, significantly below our current rates.
Either way, Australian cash rates are in the process of re-correlating to the rest of the developed world. This is one of the key reasons I have been bearish the AUD/USD cross rate. My forecast, in 2015, was that the RBA would cut cash rates 50bp and the Fed raises them 50bp. That forecast looks well on track.
The other forecast I am making is the Australian Government Bond (AGB) 10yr yields will drop below US 10yr bond yields as the Fed raises rates (albeit slowly).
The chart below graphs the Australian Government Bond/US Government Bond 10yr yield spread over the last 10 years (blue line). I have then overlayed the AUD/USD spot price (green line) to remind you that currencies are all about interest rate differentials.
If I am proved right and AGB 10yr yields go below parity to US 10yr yields this year, (currently 33bp premium, down from a peak of 270bp when AUD 108usc), then I feel certain my 68usc AUD fundamental target will be hit and then 64usc technical target will also be in sight.
As I believe long bond yields are right about an extended period of low inflation, low growth and ultra-low cash rates, I continue to look to reinforce my high conviction ideas that have both pricing power and dividend growth. If they benefit from falling interest costs, that is helpful too.
Today I want to look at Transurban Group (TCL), a stock I believe has all the attributes for outperformance in that medium-term macro overlay.
Warren Buffett says “a monopoly toll bridge is my dream investment”.
Well Mr Buffett, in Australia we have a company that owns and operates a series of “monopoly toll roads” around Australia’s three largest cities. Even better, they have legislated toll rises, long concessions, rising traffic numbers and falling financing costs. Electronic tolling devices make the whole experience painless for drivers/customers.
It is now verging on impossible to drive across or around Sydney, Melbourne or Brisbane on a motorway and not pay TCL a toll of some kind. I already paid TCL $2.43 earlier today, just to use one exit from the Cross City Tunnel.
Let’s start by reminding ourselves of the motorways TCL operates.
Melbourne Network
Sydney Network
Brisbane Network
Yet these are NOT mature assets. They are GROWING assets and the average weighted concession length has increased to 28 years.
In Melbourne, the “CityLink Tulla” widening will add +30% more capacity. Construction starts in October this year.
In Sydney the M5 widening was completed in December 2014. That added +50% capacity to the motorway, with 150,000 single trips experienced in a single day. TCL also raised the truck toll multiplier to from 2.2x to 3x on this critical heavy transport infrastructure route.
NorthConnex (M2-M1 missing link tunnel) has started with full construction activities scheduled to begin in May 2015. The GLIDe tolling system roll-out across the M2 and Eastern Distributor is complete, while the Lane Cove east facing ramp opened.
In Brisbane the acquisition of Queensland Motorways (QM) has the integration program progressing well and ahead of budget. The contract for the Gateway Upgrade North will be awarded in mid-2015, while the Legacy Way opening is due in mid-2015. TCL is assessing road enhancement opportunities on the Logan Motorway.
At the interim result TCL confirmed the outlook was strong and LIFTED FY15 distribution guidance.
And these are the assets driving that growth.
Click here to view larger image
There should be absolutely no doubt that TCL owns wonderful long-duration, scalable critical infrastructure assets in the key Australian population growth markets. The part that is arguable underappreciated is how well the run these assets. The table below confirms ebitda margin enhancement across their entire portfolio. When traffic grows and tolls rise, these are tremendous ebitda margin assets. Free cash rose +57.5% in the half, or by +22.2% per security.
And here are the two slides why TCL is a massive winner in an extended period of low inflation and low interest rates.
Tolls are going up, traffic volumes are going up and debt costs are coming down. That equates to positive JAWS and positive JAWS equates to positive distribution growth.
TCL is a “growth bond”. Based off current FY15 distribution guidance, the stock is trading on a FY15 distribution yield of 4.24%. An Australian government 15-year bond currently yields 2.57%.
TCL will give you GDP+ distribution growth. I can’t see any logic in owning an Australian Government Bond over TCL shares at an appropriate yield spread to compensate for equity risk.
TCL shares have only recently broken out of a stubborn 10-year trading range. To me, this is the start of the re-rating to a lower distribution yield and lower yield premium to comparable duration Australian Government bonds.
I believe in the months ahead, TCL will be bid down to a 4.00% distribution yield. I also believe the total FY15 distribution will be .5c higher than the current guidance, coming in at 40c. On that basis, I set a 12-month price target of $10.00 TCL reiterate its place as a high conviction buy.
TCL and SYD are Australia’s true “monopoly toll bridges” and I am bullish on them both.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
