Expert Investor: David Costello – Can Infrastructure Investing be Sustainable? | Magellan Financial Group

HOSTS Alec Renehan & Bryce Leske|7 July, 2021

Meet your hosts

  • Alec Renehan

    Alec developed an interest in investing after realising he was spending all that he was earning. Investing became his form of 'forced saving'. While his first investment, Slater and Gordon (SGH), was a resounding failure, he learnt a lot from that experience. He hopes to share those lessons amongst others through the podcast and help people realise that if he can make money investing, anyone can.
  • Bryce Leske

    Bryce has had an interest in the stock market since his parents encouraged him to save 50c a fortnight from the age of 5. Once he had saved $500 he bought his first stock - BKI - a Listed Investment Company (LIC), and since then hasn't stopped. He hopes that Equity Mates can help make investing understandable and accessible. He loves the Essendon Football Club, and lives in Sydney.

David is the portfolio manager of MFG Core Infrastructure Fund (a product that’s been running for institutional investors for 11 years but was only made available to retail investors in December). David joined Magellan in 2015. Prior to working with Magellan, David led EY’s financial modelling practice in Brisbane. Prior to his role with EY, David worked with National Australia Bank and SFG Consulting. David holds a Bachelor of Laws (Honours) and a Bachelor of Commerce (Honours), both from the University of Queensland. David is a CFA Charterholder.

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Bryce: [00:00:15] Welcome to another episode of Equity Mates, a podcast that follows our journey of investing, whether you're an absolute beginner or approaching Warren Buffett status, our aim is to make your journey as easy as possible and break down the barriers from beginning to dividend. My name is Bryce and as always, I'm joined by my equity buddy Ren. How are you going? [00:00:32][17.6]

Alec: [00:00:33] I'm very good. Bryce very excited for this interview. You know, as we've grown Equity Mates we've had the opportunity to speak to bigger and bigger fund managers and we've been chasing this fund manager for a while and now we can't get them off the show. We we've got we've got another expert investor from Magellan. Yes. On the show, we've been talking a lot about infrastructure lately. It's an asset class that we are really interested in. And there seems to be a lot of government spending. So we've been trying to understand it. And no one better to help us understand this asset class than one of Magellan's infrastructure experts. [00:01:12][39.7]

Bryce: [00:01:13] That's right, Ren too many talented fund managers, Magellan, to get through, but we're going to do it slowly. It is our pleasure to welcome David Costello to the virtual Equity Mates Studio. David, welcome. [00:01:23][9.9]

David: [00:01:24] Bryce Alec, great to be here. And I have to say, I really admire what you've done with the platform. It's a really valuable service that you're providing to the investment community and particularly to new investors for Bryce. I have to say, I've heard some of your comments on infrastructure. And while I know you think it's boring, I think by the end of the day we'll have you selling your crypto and loading up on infrastructure, I'll say. All right. [00:01:48][24.3]

Alec: [00:01:49] All right. [00:01:49][0.2]

Bryce: [00:01:49] Let's let's let's take that as a challenge. If by the end of this I have sold my crypto, we'll invite you back onto the show. If not, this might be the end of it for us, but we'll say no. I appreciate those comments and I appreciate the support that Magellan and you guys give us in sharing your expertize in a number of the topics that are important to the Equity Mates community. But for those of you in the community who haven't come across David before, he is the portfolio manager of Magellan's Core Infrastructure Fund. And it is a product that's been running for institutional investors now for 11 years, but is now available for retail investors on the ASX. So David joined Magellan in 2015. Prior to working with Magellan. He led Ernst and Young's financial modeling practice in Brisbane and has also held roles at the National Australia Bank and SFG Consulting. David holds a Bachelor of Laws, Honors and a Bachelor of Commerce honors both from the University of Queensland. He's a CFA charter holder as well. And we are going to be unpacking all things infrastructure, the role it's playing in decarbonization and RSG and then having a chat about some specific stocks that David's looking at in the portfolio. So plenty to get through today. Very much looking forward to it. But let's get stuck in, as always, with our game [00:03:13][83.4]

Alec: [00:03:13] now, Bryce, before we get into the game, I think I do need to correct you on one thing. You said the fund was available on the ASX. I believe that. Yes. Yes. People in the Equity Mates community who haven't heard of the China, it's a another exchange in Australia. And we're going to be asking David about the Chinese and why the fund they chose to list the fund there. So stay tuned. I guess we'll get stuck into that. But, David, we do like to kick it off with a bit of a game overrated or underrated is what we call it. But it's really just an opportunity to throw a few different indexes and investing themes out there just to get your opinion on them, because we might not otherwise Covid them in the interview. So if we start at home and we start with our major index, the ASX 200, overrated or underrated? [00:04:03][49.3]

David: [00:04:03] I'd say overrated. You know, the ASX 200 represents about two percent of the global equities opportunity set. You wouldn't go into a restaurant and read two percent of the menu before ordering. So I don't see why you do that with your equities portfolio either. [00:04:18][15.0]

Bryce: [00:04:19] Love that. I love that analogy. Overrated or underrated. The Nasdaq one hundred underrated. [00:04:23][4.4]

David: [00:04:24] I mean, the Nasdaq's home to some of the most dynamic and competitive advantages businesses in the in the world today. And I think in the long run, a bet on the entrepreneurialism of US capitalism is going to reward investors handsomely. [00:04:40][15.8]

Alec: [00:04:41] Very on brand answers from you, David, to begin with, Magellan, truly a global fund manager. I still remember that ad that Magellan had when the cricket was on years ago, and it was all about investing globally. So so no, no surprises there. But if we move to an alternative asset class that has been the talk of the town in twenty twenty one, overrated or underrated Bitcoin, it's [00:05:07][26.0]

David: [00:05:07] going to shock you to hear that the infrastructure guy thinks Bitcoin's overrated. Really, three reasons for my view, that Bitcoin's overrated. So firstly, obviously, it doesn't produce any cash flows, so it can't be valued and sorry, Bryce, that means it isn't an investment. [00:05:24][16.9]

Bryce: [00:05:26] Secondly, Ren Ren also has bitcoin, by the way. [00:05:28][2.7]

David: [00:05:34] So if it's not an investment, maybe it's a currency. And the name cryptocurrency seems like a good start there. But if you think about the attributes that make for a currency, it doesn't really pass those hurdles either. I mean, currencies are a store of value and with its volatility, Bitcoin doesn't seem to tick that box. And further, I'd note that currencies should be a medium of exchange and you're hardly going to go and buy a four dollar coffee when the transaction fee on bitcoins, you know, anywhere between. I've seen some estimates that suggest twelve point sum up to sixty dollars. So it's not a good medium of exchange. What that leaves is speculation and that's fine, but it's not, for me, [00:06:16][42.0]

Bryce: [00:06:17] overrated or underrated. And this is one as the infrastructure guy, I'm sure you have an opinion on inflation fears. [00:06:24][6.9]

David: [00:06:25] Yeah, I'm going to draw a distinction here because I think this one's important. So I'll give a qualified answer in the general sense that equities are long duration assets that are sensitive to real interest rates. Inflation and interest rate concerns are always appropriately founded. But in the specific sense that you've seen some of the breathless commentary in the financial press calling for a return to 1970s inflation, I think that's very much overrated. It's very obvious that Covid and the fiscal stimulus that followed has given rise to some unusual base effects that are driving very high levels of printed inflation at the moment. But I expect those to be transitory. And ultimately I'd expect interest rates and inflation to be anchored at relatively low levels in the longer term, driven by demographics and and some technology impacts. [00:07:17][52.2]

Alec: [00:07:18] And then, David, final question for this game. Overrated or underrated? Australian residential property [00:07:24][6.2]

David: [00:07:25] overrated. And this one stings because I can't afford it. Look, I just observed that I think the tax regime in Australia is yielding some pretty perverse social outcomes in in property. If you compare it just for the sake of argument. I'm certainly not, said executive, that if you compare an executive that generates a million dollars of personal services, income and maybe some dividends, they're facing a tax rate of more than 40 percent. If you compare that with another individual who generates a million dollars of income on the sale of their primary place of residence, they pay precisely zero tax. [00:08:02][37.4]

Bryce: [00:08:03] So before we get stuck into investing in infrastructure and also it's in its role in decarbonization, we love to start at the start of your investing journey, David. So are you able to tell us the story of your first investment? [00:08:18][14.5]

David: [00:08:18] Yes, certainly. So. My first direct equity investment was a very small position in Qantas when I was at university. Now, obviously, the airline industry has notoriously difficult set of economics. It's a cutthroat, competitive industry. It's incredibly capital intensive. And while Qantas enjoys an unusually advantaged position in the domestic market, it certainly wasn't an auspicious start to my investing journey. The due diligence I did was entirely superficial. Qantas was trading on a depressed PE and this was on the back of the GFC, so I thought I could see the multiple rewrite and get some earnings growth as load factors improved. It didn't go much deeper than that. And of course, that thesis didn't come to fruition. The stock went precisely nowhere. But worse than my due diligence was my cell discipline. So I think my decision to offload the stock was really driven by university holidays and needing some money to go drinking with my mates. So needless to say, my rigor has improved dramatically and ensure any of the listeners who are invested in the fund that we do things in a much more sophisticated fashion at work. [00:09:36][77.4]

Alec: [00:09:38] Well, look, David, honestly, the due diligence that you just outlined there is probably more than a lot of people's first investments, definitely more than my first investment. So I don't think you can be too hard on yourself there. But look, from from that first investment in Qantas to now you've worked at the National Australia Bank. You've worked in a while. You now work at Magellan. That's that's a pretty good, I guess, training ground in terms of learning the, you know, the ins and outs of investing in that time. Have you developed a personal investing philosophy? [00:10:12][33.7]

David: [00:10:13] Yeah, very much, and I have to say, it's this is inevitably inherited and in my case, it's very much inherited from some of the doyens of of value investing. And while it's always sort of hard to boil it down to the most quintessential elements, I appreciate you guys sending the questions through. And I had the opportunity to kind of think about the quintessential elements. And I think there are really three for me. The first comes from Ben Graham and the Intelligent Investor, which was one of the the first books I was presented with on my investing journey. And it's really the assurance that in the long run, the market is a weighing machine. Know while it's a voting machine in the short run and near-term markets are entirely unpredictable, the notion that if you can buy with a margin of safety in the long run, you'll achieve attractive results. And then if you think about how that then progresses, obviously Ben Graham's most prominent disciple is is Warren Buffett. And from Buffett, I take, you know, his two rules of investing. And these have really become paramount for me, both personally and in my role at Magellan, Buffett said there are two rules of investing. The first rule, never lose money. The second rule is never forget rule number one. And the mathematics of investing really make that crucial. The reality is, if you lose 50 percent on investment, you need to make 100 percent return just to recoup your initial investment. So avoiding downside and drawdowns is critical. And then finally, I guess the final element of my personal investing philosophy comes from Warren's business partner, Charlie Munger. And it's this notion of your circle of competence. You can't be a jack of all investments, as Greenblatt says. And so I've found in my personal investing journey a lot of my investments have been at the periphery of my professional coverage. So they were things that we couldn't invest in Magellan because they were too small or too illiquid. But the knowledge that I could derive from that deep understanding presented me with a bit of an edge. [00:12:27][134.2]

Bryce: [00:12:28] Now, David, you run the core infrastructure funds, as we said, portfolio manager that is available on the X, the ticker is M c. S I. So let's get stuck into the infrastructure component. You noted at the start that you think you think. I think that infrastructure is boring. Fair call. It is often seen as a bit boring dividend paying sort of inflation, hedge type of asset. So to kick off this discussion, can you get May? Well, and the community is excited about the opportunity in infrastructure. [00:13:02][33.7]

David: [00:13:03] I'll do my very best. And look, I think it's a really compelling case. The essence of the case for investing in infrastructure is really about compelling risk adjusted investment returns. So while there's this perception that infrastructure delivers boring, quite modest, absolute investment returns, the reality is infrastructure has kept pace with other higher risk asset classes for a long time now. So if we take the MFG Core Infrastructure Fund, I manage that. Funds return twelve point three percent per annum, net of fees since December 2009 inception. Now, if you compare that to the MSCI All Countries World Index of developed and emerging market equities, it's almost exactly on par, I think in Aussie dollar terms. Over the same period, the MSCI all countries world return twelve point five percent per annum. So you know that that's an attractive return. Secondly, obviously framing this against risk is is critical infrastructure by virtue of the essential services it provides and its predictable cash flows is lower risk. And so when you define that appropriately, you can really protect on the downside. And in our case, the Core Infrastructure Fund, we've recorded a downside capture ratio since our inception of zero point one. And for the members of the audience, that might not be familiar with that metric. What downside captions really telling you is it's a measure of the relative fall in our fund relative to the global equities benchmark, measured in hedged Aussie dollar terms in periods when the global equities benchmark declines. So our downside capture ratio of point one tells you that we've avoided 90 per cent of the downside in global equity markets over an 11 year track record. So going back to Buffett's two rules, never lose money, never forget rule number one, infrastructure is really added some value there. And then finally, the case for infrastructure reflects its unique attributes. So you point out it is an inflation hedge and that's quite an unusual and. Difficult to replicate attribute, but of course, because of the different sensitivity that infrastructure has, principally because it's not sensitive to the broader economy, it exhibits low correlation with other asset classes. So in a well diversified portfolio, it really adds risk reduction. So, you know, I'm not suggesting that anyone would go and invest 100 percent of their portfolio in infrastructure, but as a complement to a good global equity strategy, for instance, it really improves the overall dynamics. [00:15:42][159.5]

Alec: [00:15:43] Now, I'm convinced of the role of infrastructure, David, but look, I'm not the judge here. Bryce, are you excited that you're willing to spend the rest of this interview? [00:15:51][8.3]

Bryce: [00:15:52] I don't think I've ever been as excited about infrastructure. [00:15:55][2.9]

Alec: [00:15:58] Let's check in with you at the end of the interview and see how you're feeling. But David Magellan has a couple of infrastructure investment options. Your fund, the MFK Core Infrastructure Fund listed on the cheeks and then Magellan's infrastructure fund listed on the ASX four for the Equity Mates community that might be now interested in infrastructure. What are the key differences between the funds? [00:16:23][25.0]

David: [00:16:24] Yes, certainly. So. The first point I'd highlight is both of those funds premised upon Magellan's heritage for high quality, rigorous, fundamental investment research and both of them in bed, our strict proprietary definition of infrastructure. So you're starting from a really good place where the key differences arise is really around portfolio construction, how that manifests in three critical ways. So the first is that the core infrastructure fund that I manage is very broadly diversified. It's got eighty six securities. By contrast, the Magellan Infrastructure Fund under the code Mitsch, it's typically twenty five to thirty securities. Now the portfolio construction also differs in the manner in which we strike the whites. In the case of the Core Infrastructure Fund, there's no valuation overlay here. The scheme is a free floating market cap weighting scheme adjusted for a series of risk controls that produced targeted diversification. By contrast, in the Magellan Infrastructure Fund portfolio, whites principally reflect our view on value and a risk overlay. So Gerald Stack, who's the lead portfolio manager on that strategy, can take a view on the macro economy and go to 20 percent cash, for instance, whereas I'll always be fully invested. Finally, the implication of those two differences is quite a significant difference in price points. And my fund has a management fee of 50 basis points. We can do that because of this rules based approach. While the Magellan Infrastructure Fund has a management fee of one hundred and five basis points. So both are very compelling products, but they cater to different parts of the market, reflecting that different level of diversification and and your tolerance for the idiosyncratic risk that the concentrated strategy takes to try and exploit mispricing. [00:18:25][121.4]

Bryce: [00:18:26] So I guess the question as well is, whilst on trial and not the ASX, does it change how investors can access the fund? Or is this just because we want to see a bit more competition between exchanges here in Australia? [00:18:39][12.7]

David: [00:18:40] It's a really important question. And I do want to emphasize to the listeners that there's absolutely no impact in the trading, that they'll say. So if they log in to a platform like Comsec, buying a security that's listed on ChiX looks exactly the same as buying security that's listed on the ASX. As to our rationale for listing the core series funds on tracks, as you pointed out, or a challenger in the listing market in Australia, they're an extremely innovative company and they're competing aggressively in that space. And that carries important implications around pricing for us. And that's instrumental to us. Being able to deliver that 50 basis point management fee that I referred to earlier that allows us to go after money that might otherwise be allocated to passive products. But as you also rightly point out, there's a commercial rationale here as a funds management business. It's not a great place to be exposed to a monopoly that can extract economic rents. So there's a very clear commercial driver to try and create some competitive tension in the space. I'd also point out that, of course, China was recently acquired by the Chicago Board of Options Exchange, the biggest options trading platform in the world. And so they're likely to enjoy a great degree of financial resource that will continue to drive that innovation that we were already seeing from China. [00:20:04][84.5]

Alec: [00:20:05] Now, David, there's a big political debate in the US at the moment around what is infrastructure and you mentioned. That Magellan has a nonstandard definition of infrastructure. So I guess the question is, how do you answer that question? What is infrastructure? And I guess the flow on effect of that is what's your investable universe? [00:20:25][20.1]

David: [00:20:26] Yeah, this is absolutely critical because the risk you'll encounter when you dig into infrastructure is that sometimes what's on the label doesn't match what's in the tin. The manner in which Magellan defines infrastructure is very much grounded in the conviction that infrastructure should deliver extremely reliable investment returns. Now, many other investment managers define infrastructure by reference to the essential nature of the services provided. They reasoned that because electricity and water and toll roads are essential to the community, the demand for those services ought to be predictable. But then they tend to make something of a leap of logic. They assert that if demand for these services is predictable, then investment returns ought to be reliable. At Magellan, we take a slightly more nuanced view, and we'd agree with other managers that the essential services are an indispensable characteristic of infrastructure. Contrary to some reports that we've seen, salmon farming is not essential to the community. So it's not infrastructure. But to us, that's only half the story. Our experience tells us that to generate reliable investment returns, you need a business with reliable cash flows. And to be confident that you've got reliable cash flows, you need to be confident that earnings won't be eroded by competition, by commodity price movements or by sovereign risk. So the assets that we invest in exhibit the purest infrastructure characteristics there have stable earnings underpinned by transparent regulation and by long term contracts with creditworthy counterparts. It really is key, though, as to what you exclude. So I mentioned those three categories of competition, commodity price movements and and sovereign risk. So maybe it's helpful to unpack some of the assets that don't meet our definition. You're under that heading of competition. We exclude merchant power generation. So companies like AGL and Origin and similarly within their universe, we exclude competitive energy retail. In Queensland and Victoria, we commonly see customer churn rates in the region of 30 percent and that yields aggressive discounting. I'm sure you've all had the experience where you call your energy retailer and tell them that you're going to leave and suddenly they can discount your standard service offering by 20 30 percent so that discounting limits margins and undermines the stability of investment returns so we don't invest in those assets. Similarly, under the topic of competition, we want to invest in satellites because while these assets were once infrastructure, streaming services like Netflix have really eroded the essential nature of that service on exposure to commodity prices. Our second category of exclusion, this rules out the vast majority of oil and gas pipelines for us that bear commodity price risk. Now we do invest in a subset of assets that we call energy infrastructure. But these are oil and gas pipelines that are secured by take or pay arrangements that mitigate that commodity price risk and then finally, sovereign risk. So for us, the big exclusion is China. This is an interesting one because China exhibits some extraordinarily attractive schematics for infrastructure investors dealing with a rapidly growing population of middle class people to rapidly urbanizing population. And, you know, things like car ownership are going through the roof. Car ownership in China has been growing at something like 18 percent per annum for the last decade. But when you're investing in infrastructure, these are capital intensive assets with a long, useful life. So you need to be really confident that you can enforce your contractual rights and you're not going to have your property rights expropriated. We simply don't have that conviction in China. There's no rule of law or separation of powers in the sense that we understand those concepts in a Western democracy. So we also won't invest in Russia, we won't invest in markets like Indonesia. But I want to underscore that this is not just an emerging markets concern. So we also won't invest in Japanese utilities, for instance, out of concern around sovereign risk. [00:24:42][256.7]

Bryce: [00:24:43] Incredibly interesting. A lot to unpack there, David. Yeah, so particularly the China stuff. But before we do, there is an expectation at the moment that governments are going to spend their way out of covid. So where does that sort of leave the opportunity in your eyes for infrastructure over the next few years? Or is it is it not a big an opportunity as people expect? [00:25:07][23.6]

David: [00:25:07] The potential scope of the opportunity here is enormous. There's always a. Degree of caution and wariness warranted whenever politicians start talking about extremely large sums of money, because that actually needs to be delivered and you need to see projects getting to the ground. But there is cause for optimism at this point, particularly in the US and the European Union. So, of course, we saw last week the Biden administration announced the bipartisan infrastructure framework, and that came as something of a compromise after Biden's initial American jobs plan. So the compromise framework has one point two trillion dollars of investment committed towards infrastructure in the quite traditional sense of largely roads, bridges and crucially for US, electric power infrastructure. So, of course, a central plank of the Biden administration's energy policy is a carbon free power sector by 2035, and there is about seventy three billion dollars in the bipartisan framework directed towards a clean energy transition. Now, something like 70 percent of power delivered in the US is delivered by investor owned, regulated utilities, the kind of companies that we own. So we think that will drive increased investment for them. And I should point out that the 73 billion somewhat understates the scope of the opportunity here, because much of that spending reflects tax credits. That might be a 30 percent tax credit, for instance. So that 30 percent credit, if it drives 30 Dollars of government commitment, is driving 100 dollars of of private sector capital commitment. So there's a huge growth opportunity here. Equally, we see spending allocated towards electric vehicle infrastructure. The administration wants 500000 charging stations in a nationwide network, and that's an enormous opportunity for transmission and distribution networks that, frankly, just aren't set up to deal with that kind of load. The existing power grid just can't handle two electric vehicles charging in every driveway in the European Union. We have seen a very large stimulus budget, two trillion euro with about 700 billion euros allocated towards a digital and green transformation. So we're hopeful there's something of a dearth of of detail there, but we're hopeful that will yield results. And frankly, one of the big impediments to investment in Europe has been permitting and bureaucratic challenges. So if some of that investment can free up that process, there is no shortage of projects that are required to get Europe to net zero, for instance, in the electric power space. And we think that would drive meaningful investment. So it is an interesting time to be looking at infrastructure and and the growth opportunity is potentially significant. [00:28:06][178.8]

Bryce: [00:28:07] David, before we move to Infrastructure's role in decarbonization, we'll just take a quick break. David, in doing research for this, it's become clear that Magellan have a clear view on Infrastructure's role in decarbonization. And ESG is a big focus of the Equity Mates community and infrastructure is often seen as quite carbon intensive. So how do you think about ESG side of infrastructure investing? [00:28:34][26.7]

David: [00:28:35] Bryce. This is a really critical question and it's appropriately top of mind for investors as we increasingly grapple with the energy transition and the path to net zero. You're right when you say that infrastructure measures as being extremely carbon intensive. So in the case of the MFG Core Infrastructure Fund, our strategy has carbon intensity. That's about eight and a half times that of the MSCI Global Equities Index. And when you dig into where that carbon intensity arises from, you find it's an application of the Parado Principle, the top 20 percent of most carbon intensive firms in our strategy contribute 80 percent of portfolio carbon intensity. And when you peel back the layers on these companies, what you find is inevitably they are electric utilities and typically they are vertically integrated, regulated utilities in North America. Now, that's really important because that carbon intensity has prompted some investors to be wary of utilities and infrastructure more broadly. And at the extreme, you've even seen environmental activists sort of calling for investors to divest these assets and deprive them of capital. We think that misunderstands the framework and the path to to net zero. I'll try and be as succinct as possible in unpacking all of this. But at its essence, our view is that regulated utilities, particularly electric utilities, represent incredible impact investments that are for. Should investors the opportunity to both accelerate progress towards net zero and generate really attractive risk adjusted investment returns? So while these companies screen with very high levels of carbon intensity, they've actually been leaders in the energy transition. The companies in our portfolio that have the highest carbon emissions have generally reduce their emissions by somewhere in the region of 40 to 50 percent already since, let's say, a 2005 baseline. And they generally have extremely ambitious targets to get to net zero around 20, 50. When you unpack the source of global emissions, what you find is that power generation is the most significant component of global emissions worldwide. It accounts for about 25 percent of global emissions. The rest, the other 75 percent. We sort of understand the the big drivers of that. It's things like transportation, it's industry, and it's things like agriculture and forestry. But when you unpack any of the plans to get to net zero that we see being advanced by policy makers, at their core, they're premised upon two things. Firstly, you need to replace dirty fossil fuel fired generation with sustainable generation. So whether that's wind, solar, hydro, perhaps nuclear in some jurisdictions, and then critically, you need to electrify as much of the economy as possible. So electric vehicles are a huge element of decarbonizing that transportation piece. In the case of industry solutions like electrification of steel production or the use of hydrogen steel production, but critically, you won't get to net zero, certainly won't get there as quickly unless you can replace that legacy thermal generation with renewable generation. And that's the opportunity for utilities that comprise about 50 percent of our portfolio. So also, very importantly, they do have these old coal fired assets that need to be retired. But the regulatory regime protects investors around the retirement of those assets. So we've not seen a single instance in the United States where we are exposed to these assets of regulators, leaving investors with stranded costs. So this decarbonization journey is already driving attractive growth rates for these companies. We're seeing these very low risk utilities that just deliver the most predictable cash flows year in, year out, guiding to, let's say, five to seven percent long term earnings growth. You add a dividend yield of on average, let's say, three percent, and you're looking at a total shareholder return in the region of eight to 10 percent with very little risk. Now, given the scope of investment required to get to net zero, those sorts of growth rates are likely to be sustained for a generation. So if you can compound capital, let's call it eight to 10 percent for 30 years. The potential returns here are enormous and it really is a generational investment opportunity. [00:33:21][285.7]

Alec: [00:33:22] Hmm. So, David, it's a really interesting thesis, I guess, on the on the role that infrastructure plays in decarbonization. It would be great to get specific just to sort of illustrate some of those points that you've made there with specific companies and making that transition. So maybe if you can share one or two companies in your portfolio or on your watch list, you don't have to you don't have to share any of the secret sauce. But if you can share some specific examples of infrastructure companies making that making that transition to the decarbonized electricity grid, well, and I guess towards net zero. [00:34:01][39.3]

David: [00:34:01] Yeah, definitely. And by no means is this secret source or am I divulging any confidential information. We've been very public about the investment thesis for some of these assets, and I'd highlight Xcel Energy. So Xcel Energy is a fully regulated, vertically integrated, predominantly electric utility in the US. Most of its key assets are in two states, Minnesota and Colorado. It's also got some exposure to Texas and New Mexico, Wisconsin and Michigan. But those are small jurisdictions for the company. And before I get into the specific thesis as to why the energy transition is such an enormous opportunity for Xcel is probably useful just to take a step back and provide a brief primer on the way in which regulated utilities generate their earnings. Because it's a little bit counterintuitive, investors will be used to thinking about capital expenditure and investment as a cost that should be minimized to generate good returns. That logic needs to be flipped for regulated utilities when they build a power line or a new power plant. The cost? That investment gets rolled into the regulated asset base or that rate base, as they call it, in the US, and they earn a set rate of return on that investment. So in the US, those rates of return are very attractive. You're talking about a return on equity of nine to 10 percent. So given low interest rates, that's quite attractive. At a fundamental level, the way utilities maximize their earnings potential is to commit as much investment as possible. But of course, it's not quite that simple because if you invest too much, customer bills go up and the last thing you want to do is a utility is provoke your regulator to go and cut your authorized rate of return. The nine to 10 percent that I referred to earlier in an effort to alleviate customer bill pressure. So you introduced that new and some the goal becomes to maximize the amount of investment you can pump into your network to try and increase your earnings potential without increasing customer bills too heavily. And generally, these utilities will try to keep bills to inflation, regrowth or less so with that background. Let's get back to Excel. The opportunity for Excel really reflects the potential to go and commit huge levels of investment to decarbonization, replacing coal fired power with wind in particular, and solar connecting new renewable assets with transmission lines and building out their distribution grid to support things like electric transportation. So excels guiding to five seven percent earnings growth has an approximately three percent dividend yield, so it's in line with that eight to 10 percent expected total shareholder return that I outlined earlier. And we expect that that opportunity can be sustained for a decade, probably longer. In fact, it's likely to be 30 years. And that conviction really reflects a unique dynamic that Xcel enjoys by virtue of having some of the most advantaged renewable resources in North America and arguably the world. So in those Midwestern service territories, the levelized cost of electricity from renewables. So the capital costs, including the cost of firming to ensure that that power operates all the time, because obviously renewables intermittent is about just under 20 dollars a megawatt hour. Now, if you compare that to the variable cost of coal, so the cost of the coal to fire a coal fired power station and the labor for the people to operate the plant, that's about twenty two to twenty three point megawatt hour. So what Xcel can do is they can go and retire. These coal fired power plants, commit huge amounts of new investment to wind power, but do it without raising customer bills. In excels case, while they've grown their rate base of about seven percent per annum for the last decade, customer bills have been flat in nominal terms. So as a share of the customer's wallet, their bills actually being diminishing because their wages have been growing to some extent. Now, as I said, that opportunity, given the scope of investment required to get America to net zero, is likely to persist for 30 years. So to just give you a sense of the scale of this opportunity, a recent study by Princeton University suggested that America needs something like and this is America alone, I might add, this is not the world might need something like three point four to six point two trillion of incremental investment in wind and solar and another two and a half to three point seven trillion of investment in new transmission capacity. And that's to say nothing about the augmentation of the distribution network that you need to power electric vehicles. So we think those returns, particularly in risk adjusted terms, having regard to the benign risk profile of utilities, is extremely attractive. [00:39:02][300.2]

Bryce: [00:39:02] So, David, are you able to walk us through some of the countries that are presenting best opportunities for for what you're talking about at the moment? And maybe, yeah, I guess some specific examples. [00:39:14][11.9]

David: [00:39:15] Yes, certainly the US really is at the vanguard of this. That's partially an artifact of the market structure in the United States. So these vertically integrated utilities that own both the generation, the grid assets, the transmission and distribution network and the customer relationship, that phenomenon is quite unique to the US. So while countries like Australia and countries in the EU will benefit from the upgrade to the network assets, the transmission and distribution grid, in many other cases, the generation assets sit with other companies. Here in Australia, those assets sit with companies like Origin and AGL that we exclude from our universe because they face competition. So America presents the biggest opportunity set for us. And the thematic I described for Xcel exists. To a greater or lesser extent in effectively all of the utilities that we look at, their most significantly in those that are in generation, but even those companies that just own the network just on the grid, they'll be connecting up huge amounts of renewables. They'll be building up their network to support electric vehicles. And of course, the US represents 40 per cent of our core infrastructure fund and electric utilities transmission distribution. Integrated power companies represent about 50 percent of our strategy. So it does really provide investors with access to this thematic. You will also see, though, in Australia, opportunities to access this theme and sell assets like AusNet Services will be linking up new renewable connections. Similarly spok infrastructure. So there's a number of ways to play this. But again, it's somewhat ironic that the areas that raised most concerns for people, typically because they look at this high carbon intensity, they're in fact the biggest beneficiaries of this trend. [00:41:14][119.2]

Alec: [00:41:15] So, David, you mentioned Australia there and you said there was some opportunities, I guess more holistically. You said the US is on the vanguard and there's a lot happening there. How do you think Australia sits generally? Do you think, you know, our infrastructure plans could be doing more or maybe even our politicians could be doing more? Where does Australia sit in relation to the rest of the world? [00:41:41][25.2]

David: [00:41:41] Yeah, I'll unpack a couple of elements of that. So as far as decarbonization goes, obviously Australia has been burdened by inconsistent and rapidly evolving energy policy. The things that give me comfort, though, around Australia's progress to net zero is that we benefit from some of the most advantaged renewable resources anywhere in the world. You know, our solar assets have some of the highest capacity factors in the world because of our weather. So there is a huge opportunity for Australia to, for instance, move to an economy that decarbonize some of the difficult areas. So Australia could be a hub for green steel production, for instance, using the cheap renewable energy that we can generate to produce renewable hydrogen, green hydrogen that you could then use to create steel instead of using coal or natural gas, which is obviously emissions intensive. So it is an extraordinary opportunity for the Australian economy more broadly to both decarbonize big chunks of the economy, but also to capture more economic value and do a lot of that processing here in Australia rather than in markets like China or South Korea, where we currently see that happening. So Australia does have a huge opportunity that the other piece that is encouraging for Australia is Australia does have a world renowned and extremely sophisticated infrastructure sector, know some of the financial, engineering and development of infrastructure as an asset class is very much homegrown here in Australia. So I do have confidence that where there's a solution, you'll have clever people in this space working to make it financially viable and to effectively accelerate that progress. [00:43:33][112.3]

Bryce: [00:43:34] Well, David, we have reached that point in the episode where we are about to do our final three questions. So just a massive thank you for your time today. Thanks for to Magellan for supporting this episode. And if you do want to check out David's fund, head to the ticker is CSI. Additionally, there's plenty of information on the Magellan website as well about everything that David is doing with the infrastructure funds there. So, David, thank you very much. But we haven't we haven't finished just yet. There are three final questions which Alec will get stuck into now. [00:44:11][36.6]

Alec: [00:44:12] So, David. David, just like infrastructure, we are nothing if not predictable. So we'll get into the three questions that we end every interview with. The first one is, do you have any books that you consider must write [00:44:25][13.3]

David: [00:44:26] far too many. My wife's complaining that I'm always reading when I should be doing something else. So obviously there's the the tried investing books here. I alluded to Ben Graham's books earlier. Anything by Warren Buffett's incredible. But I know those have all been Covid in great detail on your show. So I'm going to go somewhere slightly different and highlight one of the books that I think has really been most impactful for my career. It's not an easy read, but it's a book called The Pyramid Principle by Barbara Minto. Barbara worked at McKinsey in the 1960s and 1970s, and in this book she outlines a mode of communicating. And at its essence, the idea is that you should or you communicate best when you begin. With your conclusion or your key premise, and then you make a series of mutually exclusive and collectively exhaustive arguments that support that view. So, you know, when you implemented, your communication is transformed. But arguably even more important, I've found, is the value it affords you when you start to think in those terms, when you start to try and break down ideas in such a logical fashion, it just doesn't leave any room for false inferences or lazy reasoning. So I've really found that to be hugely beneficial and I'd encourage any of the listeners to have a look and work through it. It does spend a lot of time talking about the vagaries of language and inductive and deductive reasoning. But if you can make the investment, the potential rewards are enormous. [00:46:05][98.5]

Alec: [00:46:06] Yeah, well, David, I think our listeners could definitely tell that some of your answers have been very well considered and you've stepped through the logic around infrastructure very clearly. So clearly that book is is a good one. So we'll definitely check that one out. The next question is in 60 seconds or less, what's the best company you've ever come across? [00:46:28][22.9]

David: [00:46:29] Yes, certainly here I'd nominate Transurban. So Transurban is a leading provider, in fact, the world's largest provider of toll roads in the Australian eastern seaboard. It's got assets in Canada and in North America more broadly. And the investment case for Transurban really comes down to the unique properties of urban toll roads. You know, this is an asset class that exhibits effectively no elasticity of demand. They're incredibly advantaged because the product they're providing, a road that flows quickly has effectively no competitor. Its competitor is a free road that's already full at peak times. So when you observe toll roads, put up their tolls, you might see commuters get off the road for a week in objection. But a week later they're back because they were sitting in bumper to bumper traffic on the free road. It's incredibly frustrating. So if you think about the growth algorithm for a company like Transurban, you're getting traffic growth, which broadly mirrors population growth, let's call it two percent tolls grow at the greater of inflation or in some cases and this is true of CityLink and the Eastern distributor, a fixed nominal rate of four percent. So you're at let's call it six percent revenue growth, but of course, incremental volumes on your toll road don't add any costs. You don't need to do anything to have one more car on the road so you get huge operating leverage and they've got margins in the region of 70 to 80 percent. So that operating leverage gets you to high single digit earnings growth. And then, of course, you've got all of the optionality that their extensive network provides. So occasionally they'll widen the road and add traffic or they'll invest in a new project that they are in the prime seat to win by virtue of their knowledge of the existing roads. So this is an asset that's going to compound earnings consistently at a low teens, perhaps even mid teens level with no elasticity of demand. It really is an extraordinary asset. And I'd highlight one anecdote around the hotlines that they operate in the US that just demonstrates the unique economics of these assets. So these assets operate a little differently to the toll roads you see in Australia. In principle, they seek to maintain a target speed, let's say, 60 miles an hour, and they do that by allowing the toll to vary. So if the road becomes too slow, they raise the price until commuters get off and the road gets back to the target speed. Now, it emerges when you survey road users their happiest, when the toll is at its capped level of about twenty five dollars for the use of the road. And that's deeply ingrained human psychology. The reason they're happiest then is because they're flying at 60 miles an hour and they're looking at the free lane right beside it. And it's bumper to bumper traffic at a standstill. So we think that Transurban, an urban toll, roads more broadly are the most advantaged assets, infrastructure or otherwise in the world. [00:49:33][183.8]

Alec: [00:49:33] Yeah, that's fascinating. I didn't realize that they did that variable pricing to maintain speed in the US. It's a it's a fascinating, I guess, business model that they have that it's unusual. But David, moving to our final question, if you think back to your younger self, you know, making that very first investment in Qantas while you were at uni. What advice would you give your younger self? [00:49:59][25.5]

David: [00:49:59] Yeah, I think the advice I'd give my younger self is don't be married to your ideas. You know, I think it's so important to maintain a degree of intellectual humility and just constantly introspect and challenge. You're thinking because ultimately, particularly when it comes to investing, it's far more important to be right than to feel that you're right and that, you know, you've won the argument. So that's the advice. It's very hard to do, particularly when you're young. You know, you want to be seen to be smart. You want to win the debate. Much more important to get your thinking right. [00:50:34][34.6]

Bryce: [00:50:35] Great piece of advice to end on there. David, it's as Alex said, it's very clear that what you're doing at Magellan and the thought that is going into, you know, managing this infrastructure portfolio is very deep and well considered. So we very much enjoyed that interview, took plenty out of it. And I know that a lot of the Equity Mates community equally would have found that very valuable. So, as always, appreciate appreciate the support that we get from Magellan and also for you sharing your time with the community today. It was an absolute pleasure. [00:51:05][29.9]

David: [00:51:05] Of course, guys, it was an absolute pleasure on my end. And Bryce, when I see Bitcoin tanking later today, I'll know it's because of cellular infrastructure. [00:51:13][7.3]

Bryce: [00:51:15] Yeah, the wireless will be selling and I am excited about infrastructure, that's for sure. But yeah, it's it's one of those asset classes that is a lot going on and hearing the sort of insights from you really helps to unpack it. So. Yeah. Thank you. [00:51:33][18.4]

David: [00:51:33] Absolute pleasure. It was good to be on, guys. [00:51:33][0.0]

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