Investing in toll roads

Magellan Asset Management

November 2023

While we tend to think of toll roads as a recent phenomenon, they have been around for thousands of years. Toll roads today are a popular way for cash-strapped governments to raise money and improve the quality of, and reduce the congestion on road networks. Given the huge capital costs (toll roads often cost billions of dollars to build), for most investors the listed market is the only way to gain access to these assets. 

Types of toll roads

There are two main types of toll roads; inter-urban toll roads (those between cities); and intra-urban toll roads (those within cities), which can be further be divided into radial, orbital and high-occupancy toll (HOT) lanes.

Each road varies in terms of its dynamics but, in general, this difference stems from the types of users and the trips undertaken. 

Intra-urban toll roads typically host a higher proportion of cars - with a significant part of this related to people traveling to and from work and going about their daily lives. Consequently, in an economic downturn, while some traffic will divert to the alternative free route, as long as people have jobs to go to or errands to run, the diversion is likely to be minimal. By contrast, roads between cities tend to have higher proportions of commercial traffic and discretionary trips, which are more economically sensitive.

Key Earnings Drivers

As is generally the case for transport infrastructure, the revenue for a toll road is a function of volume and price. In the case of toll roads, this can be put simply as: Toll road revenue = Traffic volume x toll price

Pricing Mechanism for toll roads?

The typical business model for a toll road is that a government agency enters into a concession agreement (contract) that entitles a toll-road operator to collect tolls for a defined period and increase those tolls on a regular basis in a defined way. 

The basis on which tolls are increased is controlled by the terms of the concession agreement and the level of tolls is generally linked to inflation. Table 2 shows how contracts differ. In Canada, the owner of the 407 ETR tollway can raise tolls with minimal constraints, while in Australia toll increases are linked to the consumer price index, the rate of inflation or 1 per cent per quarter. 

The pricing mechanism for these toll roads generally tracks increases in inflation with minimal lag. Consequently, most toll-road owners have the ability to respond quickly to any rise in inflation.

The impact of price demand

As tolls increase, there is generally a temporary switching effect where some users shift to the toll-free alternative. This causes competing routes to get more congested, which boosts the attractiveness of the tolled route. This results in an increase in total revenue, all things being equal, as the toll increase more than offsets the temporary decline in traffic. This can be seen from the below case study 1, that shows traffic on Sydney's Eastern Distributor, which grew 118% over 18 years despite tolls increasing 151% over the same period.

The volume of traffic

Three main factors affect the volume of traffic on toll roads.
1. Trip-time certainty
A critical point in the decision-making process for drivers is how predictable travel times are. Drivers will pay a premium for a predictable trip and overestimate average driving times on trips with highly variable conditions. 
2. Demand for toll roads is tied to economic development
Experience shows that the demand for transport is related to economic development. Increases in populations and wealth lead to more demand for transport; in a growing economy, we can expect the number of vehicles on roads to rise over time. 

Case Study 2 below, shows the number of cars per thousand people in different countries around the world. It shows that as countries become wealthier, the demand for transport and mobility leads to increases in car ownership. The direct relationship between the demand for transport and economic development underpins the need for transport infrastructure.

3. Capacity constraints on the existing network 
A new toll road is typically supported by governments to add capacity to a network that is at, or approaching, capacity. If alternative routes to the toll road are congested, traffic growth on toll roads is likely to be higher than that of the corridor for long periods of time. This is displayed below in case study 3, which shows the traffic along a key corridor in Sydney, Australia. It shows that, despite the addition of the M5 toll road in 1992, the average daily traffic on the existing network remained unchanged and all traffic growth in the corridor was via the toll road. 

What are the risks?

1. Misalignment of incentives
A misalignment of incentives of management and advisers is the most fundamental risk to the financial success of a toll road. Recent history is littered with high-profile bankruptcies in toll roads located across the globe. Examples include the Cross City Tunnel, the Lane Cove Tunnel, the RiverCity Motorway and BrisConnections in Australia; the ITR, the SR125, the SR130, the Pocahontas Parkway and the Chicago Skyway in the US; and the M6toll in the UK. What these failures have in common is they were a result of misalignment of incentives, with (mostly) investment banks using highly aggressive traffic numbers and/or capital structures to generate investment banking fees or increase assets under management on which they could charge management fees. The other instances were largely where companies' bonus structures rewarded growth in assets rather than long-term investment metrics.

This is one of the reasons Magellan places so much emphasis on the governance or agency risk of these businesses. Incentives drive behaviour. A management team with incentives that align with the needs of long-term asset owners is less prone to such errors. 

2. Congestion charges
Eight cities including Milan, London, Singapore and Stockholm have congestion charges, aimed at reducing traffic in parts of the central business district, that largely have proved effective. Other cities, including Sydney, Australia and Washington DC, have considered such measures. 

A congestion charge increases the cost of a trip into the charged area, which would be expected to shift people to other modes of transport; in particular, public transport. Other solutions such as Washington DC's dynamic pricing on parking meters may also reduce traffic at the margins.

3. Technological disruption
As we have noted in our paper, 'Self-driving cars - implications for toll roads', we expect autonomous vehicles and driverless cars to prove positive for the earnings of toll roads over the next 10 to 20 years, particularly for urban toll roads. 

Toll roads today typically can handle about 2,200 vehicles per lane per hour. A study by the University of California1 concluded that full penetration of self-driving cars could double this capacity. This is because computer-driven vehicles will be able to travel much closer together, at much higher speeds and in much thinner lanes. 

The long-term impact on toll roads will depend on the balance between additional trips created by driverless cars minus the additional capacity that is created on the free roads 

4. Working from Home
Working from home has been a more common working approach post-pandemic. However, we note that for most roads, commuter traffic only represents a minority of trips, with school-runs and other local trips representing the majority. 

5. Declining licence uptake among younger adults
Much has been made about the decline in teenagers and people in their early 20s getting a driver's licence. 
In the University of Michigan study, the most common reason given for not getting a licence was that people said they were too busy (37%), followed by the cost of owning and maintaining a vehicle (32%). Interestingly, 31% said it was because people said it was so easy to get a lift from a friend. Ultimately, though, these people are more likely to get a car once they leave university and enter the workforce, and especially once they have children. This is supported by the NSW Household Travel Survey, which found weekday car trips by households with children were 3.9 times that of single-person households. Their main reason for using the car (22.7% of trips) was to ferry children around. 

An Australian study into the same phenomenon2 suggested a range of explanations. Potential causes included increasingly restrictive access to learners and full licensing requirements along with lifestyle factors - increased tertiary education, staying at home longer and delaying working and having children, and the reduced status symbol of a car. The study found that young people who maintain frequent contact with friends through technology are more, not less, likely to see their friends in person. 

Toll roads can generate growing and inflation-protected income streams for long-term investors. While the risks are low compared with most equities, the risks of these assets are nonetheless real - particularly when they pertain to agency risk. In-depth research and a good understanding of the drivers of the business and incentives of management teams should allow investors to reap the benefits of these largely misunderstood assets.

Funds operated by this manager:

Magellan Global Fund (Hedged), Magellan Global Fund (Open Class Units) ASX:MGOC, Magellan High Conviction Fund, Magellan Infrastructure Fund, Magellan Infrastructure Fund (Unhedged), MFG Core Infrastructure Fund

Important Information: 

This material has been delivered to you by Magellan Asset Management Limited ABN 31 120 593 946 AFS Licence No. 304 301 ('Magellan') and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation.  This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should obtain and consider the relevant Product Disclosure Statement ('PDS') and Target Market Determination ('TMD') and consider obtaining professional investment advice tailored to your specific circumstances before making a decision about whether to acquire, or continue to hold, the relevant financial product. A copy of the relevant PDS and TMD relating to a Magellan financial product may be obtained by calling +61 2 9235 4888 or by visiting www.magellangroup.com.au.

Past performance is not necessarily indicative of future results and no person guarantees the future performance of any financial product or service, the amount or timing of any return from it, that asset allocations will be met, that it will be able to implement its investment strategy or that its investment objectives will be achieved. This material may contain 'forward-looking statements'. Actual events or results or the actual performance of a Magellan financial product or service may differ materially from those reflected or contemplated in such forward-looking statements.

This material may include data, research and other information from third party sources. Magellan makes no guarantee that such information is accurate, complete or timely and does not provide any warranties regarding results obtained from its use. This information is subject to change at any time and no person has any responsibility to update any of the information provided in this material.  Statements contained in this material that are not historical facts are based on current expectations, estimates, projections, opinions and beliefs of Magellan. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon. No representation or warranty is made with respect to the accuracy or completeness of any of the information contained in this material. Magellan will not be responsible or liable for any losses arising from your use or reliance upon any part of the information contained in this material.

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What is the Fed's Senior Loan Officer

Survey and what is it telling us? 

Challenger Investment Management

November 2023

Funds operated by this manager:

Challenger IM Credit Income Fund, Challenger IM Multi-Sector Private Lending Fund

For Adviser & Investors Only

[1] All the data in this report is sourced from the SLOOS which is produced by the Federal Reserve. https://www.federalreserve.gov/data/sloos.htm

The 'low emissions' megatrend:

Is it too early to invest in green hydrogen?

Insync Fund Managers

December 2023

The 'low emissions' megatrend is decarbonising business models, driving long term value for investors and helping corporates and countries attain climate related goals.

Insync Funds Management CIO, Monik Kotecha said, 'The main levers of the low emissions megatrend are cost competitive renewables that have experienced massive drops in their establishment, then production costs, compared to their fossil fuel and nuclear peers.'

This, he said, is what is driving the 'electrification of everything' including transportation, heating, industrial operations, etc. 'More than just clean energy generation, it also encompasses digitally optimised energy efficiency systems, decentralised energy generation and overhauling entire electricity grids.'

Half of the world's demand for energy is projected to be served by 'clean molecule' sources by 2050 and hydrogen, the first, lightest and most abundant element in the universe, is set to play a vital role.

'Electrification alone won't get us to net zero,' Mr Kotecha said. 'Hydrogen as part of an energy mix could supply sectors not suited to electricity, such as heavy machinery and heavy industries, in lieu of fossil fuels.'

Seen as a potentially environment-friendly transformative force Mr Kotecha said hydrogen is an enticing prospect for investors, green hydrogen in particular. 'However, it is vital to temper enthusiasm with a dose of realism, given the hurdles on the path to profitability.'

At the heart of the challenge, he said, lies competition with fossil fuels. 'Currently, they are more cost-effective and often heavily subsidised by governments, which means green hydrogen is dependent on external private financial support. Subsidised carbon economics continues to dominate over environmental concerns, and this will remain a challenge until subsidies, scale, infrastructure, and technology advances for green hydrogen level up the current 'unlevel' playing field.'

Most hydrogen today is produced by extracting it from oil, coal or natural gas. In order to justify substantial capital investment for an environment-friendly production source, high-capacity utilisation is essential.

'Green hydrogen is made by splitting the water molecule via electrolysis to create hydrogen. This demands a stable green power source, which is no small feat - although this complex issue is rapidly being overcome.'

A variation to green hydrogen is pink hydrogen (electrolysis powered from nuclear energy). New salt based nuclear reactors already under construction could proffer a cost effective and far safer and environmentally friendly power source than today's typical fission reactors, thus meeting the need for stability of supply.

However, it is likely that the green hydrogen sector will require a more extended investment horizon to realise its full potential or until new technology breakthroughs like those encountered in solar impact the economics.

'In other words, unfortunately, we don't think green hydrogen has yet reached an essential economic tipping point to be a profitable component of the low emissions megatrend, nor produce companies that meet our high profitability criteria, but we will continue to watch and see.'

Funds operated by this manager:

Insync Global Capital Aware Fund, Insync Global Quality Equity Fund

Disclaimer
Equity Trustees Limited ("EQT") (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Insync Global Quality Fund and the Insync Global Capital Aware Fund. EQT is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT). This information has been prepared by Insync Funds Management Pty Ltd (ABN 29 125 092 677, AFSL 322891) ("Insync"), to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Insync, EQT nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

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Market Commentary - November

Glenmore Asset Management

December 2023

Funds operated by this manager:

Glenmore Australian Equities Fund

China Property: Has the "Grey Rhino" been tamed?

Ox Capital (Fidante Partners)

December 2022

Stabilization of property market in sight = Time to buy quality growth stocks in China.

Relative to most governments in the world, the Chinese authorities proactively controlled and deflated the property
market bubble to sustain a stable economy in the long run. Policy measures, including tighter lending standards and
house price restrictions, were put in place to dampen real estate speculation while containing escalating home and
land prices. Notably, latest statistics from China indicate signs of stabilization in the property market.

1. Policy measures have been effective: Measures put in place over two years ago have been effective and
authorities have started relaxing some policy measures given :

1) Property sales are down ~50% from 2021 levels (near 2015 levels).

2) Housing starts have declined over 60% from peaks to 2023 YTD. Urbanization rate in China is only ~60%,
much lower than that of developed countries, and the lack of new starts in the system will ultimately reduce
overall supply (less completions) in the next few years. As such, supply and demand dynamics will increasingly
tighten.

2. Affordable housing vs. other counties: China property prices are affordable relative to other EM/DM counties
while affordability will improve further as mortgages rates decline.

3. Stimulating growth: The Chinese authorities have started to stimulate the economy, showing an intention to boost growth, increase consumer sentiment and investor confidence. We believe further reforms are likely to mitigate risks to the broader economic recovery. Notably, our base case for China is that of continual policy easing and continued government stimulus, an environment ripe for improving economic activity.

Equity market correction provides entry point. Although we do not believe it is the time to buy China developer stocks given structural headwinds facing the sector (i.e. Lower household formation), and we believe the property sector is set to stabilize rather than a robust recovery.

However, we do believe this set-up of "stimulating growth" is a similar playbook to the GFC in USA and Europe in 2009 when it was a great time to own quality growth companies at deeply discounted valuations. As such, we view a similar set up for many quality growth stocks in China at inexpensive valuations now.

Funds operated by this manager:

Ox Capital Dynamic Emerging Markets Fund

Why government bonds remain a natural choice

JCB Jamieson Coote Bonds

November 2023

Funds operated by this manager:

CC Jamieson Coote Bonds Active Bond Fund (Class A), CC Jamieson Coote Bonds Dynamic Alpha Fund, CC Jamieson Coote Bonds Global Bond Fund (Class A - Hedged)

Investing Essentials: Diversification -

The shield against investment volatility

Bennelong Funds Management

November 2023

As any investor will tell you, investing can be a rollercoaster.

Not all investments behave in the same way - different types of investments behave differently under certain economic and market conditions. Some may go up while others go down. Some may be entirely negatively correlated.

This is where diversification comes in. Essentially, diversification means investing across a range of different investment types that behave differently across a full investment market cycle. While nothing will give you an absolute guarantee against loss, spreading your investments across different investment categories and types of assets limits your exposure to individual related risks.

Risks can be in the form of market risks, where the market may become less valuable for assets within a particular class due to external factors, like interest rate changes, war, or weather events. Or, they can be asset-specific risks, which come from the performance of investments or companies themselves, often dependent on management's performance, operational activities or competitor actions, for example.  

There are all sorts of ways to diversify your portfolio to mitigate these risks. Diversification can occur across asset classes (e.g. equities, property, cash), industries (e.g. telecommunications, agriculture, financial services), or regions (e.g. countries, markets, economies).

Diversifying by asset class
Different asset classes - like real estate, equities and bonds - generally behave differently under similar economic conditions. For example, if a market crash sends the stocks in your portfolio tumbling, the assets in other uncorrelated asset classes may not lose value at the same rate, or they may move in the opposite direction and increase in value, thus providing a stabilising impact.  

For example, commodities like gold may not have a correlation to real estate.

Diversifying by industry
Like asset classes, different industries often encounter different risks at different times based on a number of market factors. When one industry encounters a downturn, another might flourish. Diversifying your investments across sectors ensures that your financial wellbeing is not totally dependent on the fate of a single industry.

For example, if you decide to invest all your money into one type of agricultural crop such as wheat, then adverse weather conditions could wipe out the crop rendering your entire investment worthless. But if you had invested across other industries that aren't impacted by weather, such as healthcare or financial services, only a portion of your savings would be impacted by this weather event.

Diversifying by region
The same applies for regions. The landscapes of countries, markets, and economies are based on unique dynamics, and certain risks may affect some regions rather than others.

For example, one region may be in economic expansion while another is in contraction. Exposure to different currencies, and to different political and regulatory environments can have an impact on an investment.

Having your investment diversified across asset classes, industries and regions is important for investment success, and helps to ensure that your range of investments don't all perform in the same way at the same time. Therefore, overall investment returns may be achieved in a less volatile way, relative to holding only one or two different assets.

In determining the right asset allocation for your portfolio, you'll need to consider the overall risk and return of each asset, and how different assets correlate with each other.  It's also important to determine your own risk and return level that you are comfortable with and able to tolerate.

Diversification serves as somewhat of a safety net, capturing the potential benefits of various investments while mitigating the risks associated with market fluctuations.

It's always important to remember that any decisions you make should be in line with your own financial objectives, as each person's investment needs will be different.

For more insights visit www.bennelongfunds.com

Disclaimer

The content contained in this article represents the opinions of the author/s. The author/s may hold either long or short positions in securities of various companies discussed in the article. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the author/s to express their personal views on investing and for the entertainment of the reader.