Value and traps in interest rate sensitive stocks

Investors are forever on the hunt for steady and reliable income streams, which often come in the form of utilities, infrastructure stocks and REITs. And given the expectation of further rate cuts and the subsequent rallies in bond prices, these issues have witnessed a significant bump in their share prices.

But while these stocks may be a safe place to invest given the outlook for bonds, shareholders need to be mindful of the underlying fundamentals of these investments, which will only become more important as they rerate due to lower discount rates.

Listen as Jeremy Hook from TMS Capital hosts Monash Investors' Shane Fitzgerald and Michelle Lopez from Aberdeen Standard Investments, who let investors know what to look out for in this part of the market, while also offering a couple of defensive stock ideas.

Transcript

Jeremy: Welcome to Buy Hold Sell. Investors are always after reliable and steady income streams. They've come always in the form of utility stocks, infrastructure stocks and REITS. And there's been a real bump in those lately with expectations of further rate cuts and rallies in the bond market providing better gains in these stocks. To talk about these today, we've got Michelle Lopez from Aberdeen, and Shane Fitzgerald from Monash.

Jeremy: Welcome both.

Jeremy: Shane, I'll start with you.

Jeremy: Is this in the area that you like and invest in?

Shane: Look it's not an area our fund invests in a lot, we are more about finding stocks going through a step change in their outlooks and hence share price re-ratings and you don't tend to see that in these companies, but I can really understand why they are attractive to people, particularly yield-focused investors looking for a solid income returns.

Jeremy: Yeah sure. Now Michelle, is it a space that you can see appeal for your funds?

Michelle: There's a part, yes, it plays which is the defensive bucket within the portfolio. But perhaps it's important to understand why these sectors and these stocks, specifically, are more sensitive to interest rate changes and if we take a step back, we have seen expectations now moving forward of negative interest rate revisions and that has moved the bond yields. So, the valuation in that causes a negative correlation between bond yields and valuations and since January this year, what we've seen is the Fed come out and change their stance. So, they've gone from a tightening to an easing and that's caused a valuation uplift in a number of these companies.

Jeremy: So, it's a nice safe place to be for a period of time with the view on bonds. Obviously that highlights some of the risks as well.

Michelle: Absolutely and the important thing to note here is there's two parts to this part of the market. You've got the cyclical upswing that you get from lowered discount rates but then you've also got to consider the underlying fundamentals of each and every one of these investments and that part is going to become more important given we've already seen the re-rating happen from the cyclical part of it.

Jeremy: Alright. Shane, so the risks are there as well. I mean it's a nice income story but capital risks exist. What are the pros and cons investors should be aware of?

Shane: Well look the pros are pretty obvious, they tend to be very stable, predictable earning streams you get from these companies. You also get a play on population growth generally coming through on these stocks as well. The other thing I think is a key positive for investors as well is they have very low betas, so they're very uncorrelated to the market generally so that adds to that defensive characteristics.

Shane: On the cons in the sector, I think the three things you've got to look out for is a number of these types of assets have a shadow tariff or a regulatory rate of return attached to them, and it's during review periods of those that you've got to be careful cause that tends to be a political process and we know what that can do.

Shane: The other two things that you've got to look out for also is when these stocks are in their capex phase and there's investing, they're very asset-heavy businesses.

Jeremy: Right, yeah.

Shane: So, when they're in that investment phase, they can struggle. It's more when they're in the harvest phase they do well and the final thing I'd also point out too as something you've got to look out for is when they're in the ramp up phase of those assets.

Jeremy: Right.

Shane: You can just go look at toll roads. You know often on toll roads it's the second or third owner of the asset that has actually done well. So, the ramp up profiles can be a bit sketchy.

Jeremy: Yeah, the pricing can be wrong on those numbers …

Shane: The assumptions on the usage rates, all these things they're modelled on the spreadsheet but when you get to the real world often those spreadsheets can be thrown out.

Jeremy: Yeah, excellent, that's great.

Jeremy: Talking valuation Michelle, I mean right now with that move that you mentioned with bond yields and the follow-on move and all these kinds of stocks, is there value in this space now?

Michelle: Sure, well the metrics we use to value these stocks, so if I consider the utilities and the infrastructure space, you tend to look at DCFs, dividend yields and metrics against peers so EV to RAB, or regulated asset base, to Shane's point there and the EV to EBITDA. On the rate side its dividend yield and price to NTA or price to net asset value. So, if you pull all that together the sector is looking rather expensive and to my point previously was you need to disengage or disintermediate between the valuation uplift of the cyclical component and look more at the fundamentals. The other thing to note as well from the valuation perspective is in the past, historically these valuations have risen when bond yields fall but that is also coincided with very strong top-line growth.

Jeremy: Right.

Michelle: In a number of these players.

Jeremy: Economic growth happening as well …

Michelle: Correct.

Jeremy: …helps a lot of those assets.

Michelle: Absolutely. And going forward we question whether that growth will remain, so we really need to look a lot more at the fundamentals.

Jeremy: Okay great.

Jeremy: Shane, obviously Michelle's not seen a lot of value there. Is there a different point of view you guys have got?

Shane: No, we would say that it's outright expensive. I can see why they're trading on these sorts of multiples given the market's desire to have defensive asset classes if you like, we just don't think there's any margin for safety what so ever at this point, so we much prefer to play the sector other ways.

Jeremy: Even if the bond market rallied further would you see valuations increase?

Shane: Look, you're getting into the same sort of valuation in any long duration stock.

Jeremy: Yeah sure.

Shane: Right, so given a lot of these stocks are priced, in my view, an inch of their life in some respects, any hiccup of any kind can be pretty bad.

Jeremy: Now this might be hard based on that view, but is there a single stock in either of those sectors we can find that would be a buyer?

Shane: Yeah look the one we would point out would be Service Stream. It's not an infrastructure play, but it services these infrastructure plays. It's an exceptionally well-managed company. It's got very strong growth coming from the NBN rollout and as that moves into the maintenance and remediation phase, they're likely to pick up an even a greater share of that capex from the NBN and then they are now getting half their income revenues coming from water infrastructure.

Jeremy: Yes.

Shane: And that's a very ageing system, a lot of capex is going to go into that in the coming years. It's not a sexy part for government to spend money on, but it needs to be done.

Jeremy: They've got to make money, that's the thing isn't it? Service Stream from Shane.

Jeremy: Michelle, a favourite of yours?

Michelle: We're still seeing a very good buying opportunity in Auckland International Airport.

Jeremy: Good, okay.

Michelle: And here's an example of a defensive company that has a regulated asset base in aeronautical earnings, but also an opportunity for significant capital return. And that comes from sort of three buckets within it, so they've spent a lot of capex. So, going forward in three years there is going to be a lot of uplift in the regulated asset base.

Michelle: So, that's the first and probably the largest component. The second part is the capex that they've poured into their retail offering. Again, that is going to offer quite significant earnings growth over the next two years and then finally the part that's probably mispriced by the market is the land bank that they're currently sitting on. So, they've got a decade worth of redevelopment available and on our numbers the land bank looks to be up to a billion dollars undervalued.

Jeremy: Wow, okay.

Michelle: So, again that's an example that you can play the defensive and the capital growth story.

Jeremy: And the councils still owning a lot of that …

Michelle: Correct.

Jeremy: … stock, so that's nice and tight, which we like.

Jeremy: Terrific. Well investors will always want stability in returns, obviously price is what you need to consider and there's a good few considerations from our panel today.