Chris Higgins: We recently took a deeper look at three Mexican airport companies: Sureste, Centro Norte, and Pacifico. All these airport operators offer investors the opportunity to invest in small-cap stocks with wide moats, a competitive advantage possessed by only 5% of the small-cap stocks Morningstar covers.
The active hurricane season, U.S. State Department travel warnings in August, and an earthquake near Mexico City have dampened air travel demand to certain locations, but Mexican domestic and international air traffic growth in 2017 still looks quite strong. We believe disruptions will be short lived. Our air travel model for Mexico generates 5.7% average annual air traffic growth from 2017 to 2021. Over the long term we believe underappreciated demographic trends in Mexico combined with a growing middle class will drive air traffic demand higher.
Given the high operating leverage inherent in the airport operator model, margins sit comfortably above 50% for all three operators, and returns on invested capital come in at roughly double their cost of capital. A 50-year concession agreement with the Mexican government effectively grants the airports a monopoly in their respective regions and underpins their wide moats.
This intangible asset reinforces the powerful efficient scale moat source, which includes high sunk costs, asset specificity, and the ability to expand capacity at low marginal costs. In exchange for the concession, the government regulates airport passenger charges. However, the operators drive significant pricing power via unregulated revenues primarily through retail tenants and car parking.
Among the three companies, we prefer Pacifico. Shares look a bit undervalued, and it currently has a 3% plus dividend yield. Moreover, we think its high-quality airport locations plus its diversified base of air traffic, which taps U.S. tourists visiting its Los Cabos and Puerto Vallarta locations as well as business traffic going into its Guadalajara airport, makes the company a compelling investment opportunity.