Starship may have built their city on rock and roll, but in the real world, cities are built on airports, transport lines, and telecommunication networks. In other words, on infrastructure. And as the planet’s population rapidly grows, cities are being built faster than ever.
So, advisers looking to diversify and recession-proof clients’ portfolios could do worse than to build them around infrastructure investments.
Infrastructure is considered an effective asset class because of monopolistic market conditions, with high barriers to entry and returns underpinned by regulation or contract. It’s also considered a defensive asset class, as it generally has lower volatility of earnings and a higher yield to the new broader equity market.
An asset class for all seasons
An infrastructure portfolio can be positioned to take advantage of both the opportunities and challenges the asset class offers, as it comprises two quite distinct and macro diverse asset subsets: regulated utilities and user pays.
Regulated utilities (i.e. electricity, water and gas providers) can be adversely impacted by rising interest rates/inflation and are slower to realise the benefits of economic growth.
User pay assets are where users pay to use the asset (airports, toll roads, rails and ports), and they are positively correlated to gross domestic product (GDP) growth and wealth creation.
Sarah Shaw, chief investment officer (CIO) and portfolio manager of 4D Infrastructure, said infrastructure is an asset class for all stages of the investment cycle.
“The way we look at infrastructure is there are two quite distinctive subsectors within infrastructure and their popularity will come and go depending on the macro environment,” Shaw said.
“This is why infrastructure is a great asset class for all points in an economic cycle or market cycle, because you have these really distinct subsectors.”
Shane Hurst, portfolio manager for RARE Infrastructure Income Fund, said within a portfolio, infrastructure offers investors the potential for lower volatility, stable cash flows, inflation protection and diversification.
“Due to the essential nature of infrastructure assets, demand is relatively stable providing lower volatility than traditional equities, and resiliency of infrastructure revenue during various business cycles,” Hurst said.
“Even at times of economic weakness, consumers continue to use water, electricity and gas, drive cars on toll roads and use other essential infrastructure services.”
Gerald Stack, Magellan’s head of infrastructure, can consider himself an authority on infrastructure investments, having come away with Money Management’s Fund Manager of the Year award in Infrastructure Securities last month for the Magellan Infrastructure fund.
“If you think about infrastructure equity, it needs to provide different risk/return characteristics, and what we believe infrastructure delivers you is very reliable and predictable returns,” Stack said.
“That’s what we believe investors expect out of infrastructure and that’s the promise.”
Stack said infrastructure should be about making sure you are getting reliable earnings and cash flows.
“That’s the magic of infrastructure, the fact that earnings are reliable and dependable, no matter what the world throws at them,” Stack said.
“The specific test we apply is 75 per cent of earnings have to be derived from either regulated utilities or transport infrastructure assets.
“If you apply that test, then our universe as we measure it is about 140 stocks, with a market cap of about one and a half trillion US dollars.”
Hunting for value opportunities
For Magellan, utilities are the bigger part of their universe, contributing about 60 per cent, while transport infrastructure contributes about 40 per cent.
“Within transport infrastructure, space, airports and toll roads had traditionally been very popular, and communications assets are quite popular as well,” Stack said.
“And now that popularity will ebb and flow depending upon the valuation opportunity, we would say today that everything looks reasonably priced.
“Therefore, there will be the odd opportunities that are particularly attractive, but we don’t see anything that’s structurally cheap today.”
Kirsten Whitehead, QIC head of portfolio management of global infrastructure, said the opportunity set for infrastructure is huge and no two assets are the same.
However, there are some areas they believed offered attractive relative value supported by long-term growth thematics.
Infrastructure is one of those foundation themes, but technology and societal change drove them to auxiliary options.
“Consider the growing importance – and recognition of the importance – of energy efficiency and sustainability, amongst communities, governments and investors,” Whitehead said.
“This truly global drive for waste reduction and sustainable waste treatment is creating an enormous opportunity for investment in the waste-to-energy sub-sector.
“And we only see this increasing, thanks to China’s ban on waste imports, and the direct link to increasing urbanisation.”
An explosive growth in demand for data and computing had made digital infrastructure another key area of focus for QIC.
“Telecommunication is one of the most capital-intensive sectors globally,” Whitehead said.
“It will require a significant capital infusion to accommodate the roll-out of 5G, national fibre networks, the centralisation of computing and the ‘Internet of Things’.”
The final theme they look at is decentralisation, where infrastructure sub-sectors transition toward decentralised models of delivery.
This is due to trends in technological innovation and heightened customer expectations for customisation, efficiency, responsiveness and resilience.
“Energy assets are becoming smaller in scale, decentralised in configuration, modular in deployment and smarter in application,” Whitehead said.
“Urban mobility and healthcare services are also increasingly being delivered by highly-tailored networks of distributed assets.
“The outlook for these assets is robust for those infrastructure investors that have long-term ‘patient’ capital and the capability to actively manage such dynamic businesses.”
DOMESTIC V INTERNATIONAL V EMERGING ECONOMIES
One justification for a global perspective of portfolio diversification across geographies, sectors, regulators and political regimes as that it ultimately dampens down risk.
This opened access to different economies and market cycles by investing in both developed and developing markets, RARE believed.
“Currently the RARE Value Universe has 200 global companies that satisfy their definition of infrastructure, but only seven are Australian companies,” Hurst said.
And when it comes to the success of taking a global approach, the proof is in the pudding. According to FE Analytics, of the top 10 performing funds in the Infrastructure Equities sector over the last five years, tracked in the below chart, only Magellan had more than 20 per cent of their regional weightings in Australia.
The two top performers were both focused on offshore investments. The Macquarie Global Infrastructure Trust saw the highest performance, with annualised returns of 21.06 per cent over the five-year period to last month’s end, followed by the same manager’s True Index Global Infrastructure Securities fund, with a performance of 13.4 per cent.
Stack said there’s nothing wrong with investing in domestic infrastructure however, and there are great infrastructure companies in Australia.
Internationally there’s a greater degree of choice though, which means you’re more likely to find stocks that are mispriced.
“When it comes to emerging markets, what they particularly offer you is growth,” Stack said.
“Toll roads where traffic grows, airports where passengers grow and you get a passenger service charge - they can be particularly attractive in emerging markets.”
Whitehead said QIC had a global remit, and the ability to invest both domestically and internationally.
This ensured they were able to find assets which represented the most attractive relative value for their client’s portfolios.
“The ability to invest globally also provides us with important portfolio diversification, particularly where we gain exposure to offshore macroeconomic drivers such as inflation and economic growth,” Whitehead said.
“That said, international investment also brings foreign exchange risk, which is why QIC has a strong in-house capability to appropriately manage this.”
For Shaw, the difference between domestic, international and emerging markets wasn’t distinctive as it comes down to a county-by-country basis.
“We determine invest-ability at the country level first, based on things like economic, financial and political risk,” Shaw said.
“Then we take it down into the asset level, and really look at whether that country environment is favouring utility investments or macro-sensitive user pay investments.”
Hurst said the main advantage of investing in emerging markets is exposure to its secular growth.
“Although all emerging markets will go through periods of higher and lower growth, at RARE we seek assets that are directly leveraged to the longer-term growth thematic and the associated increased demand for higher quality infrastructure from the growing middle classes in these economies,” Hurst said.
“Emerging market investing also reduces risk in RARE’s strategies, with exposure to different economic and market cycles.”
Stack said emerging markets offered choice and high growth, but the companies and governing environment are less mature, so there can be high risk.
“The fact there are opportunities in those markets means that from time to time, if you can identify locations where not just companies, but industries are not particularly mature, then you can find pretty exciting opportunities,” Stack said.
He pointed to Mexico as an example: despite being a less robust economy with the likelihood of swings between highs and lows, it still offered opportunity.
“There’s a secular change of people moving from buses to aviation, that’s meant the number of passengers using airplanes in Mexico is growing strongly,” Stack said.
“It’s attractive, and emerging markets give you opportunity, but there’s also a different set of risks.”
4D Infrastructure relied on emerging markets for 34 per cent of its portfolio, so watching geopolitical trends and policies was a priority.
They were optimistic about a US/China trade deal being done, which Shaw said will support the Chinese recovery and continue to evolve their middle class.
But in terms of which emerging markets had the strongest outlooks, it might be Indonesia that remained the most attractive option.
This was largely due to their emerging middle class and a strong political environment on the back of their last election, with incumbents focused on infrastructure investments.
“We’re a big believer in the emergence of the middle class, and when Indonesia is the third largest population in the world that emergence of the middle class is really going to help their country to evolve and support infrastructure investments,” Shaw said.
“We also believe Indonesia was unfairly sold-off last year as a result of the US Federal Reserve interest rate hike, and that was a legacy issue about the exposure of Indonesia to US dollars, which is much lower today than it has been historically.”
Shaw said if we see the economy shift towards a recession, they would move their exposure from user pay assets into regulated utilities.
Their current portfolio is a diversified mix of both user pay and regulated utilities, with regulated utilities offering downside support.
However, they are currently overweight with user pay because the macro outlooks remained positive.
“It’s not as strong as it has been, but it is still positive territory,” Shaw said.
“But if we see that shift, if we see error by the US Federal Reserve or the US/Chinese trade deals totally collapse or a sustaining version of the yield curve, all of these factors we’re following very, very closely.”
“I’m not saying in a market downturn that utilities won’t fall, but they won’t fall as much, and the earnings resilience will still be there.”
RARE finds by tilting towards defensive utility stocks in a poor economic environment, and towards GDP-sensitive user pays stocks in a strong economic environment, they’re safe regardless of the economic outlook.
“In the end RARE invests in essential service infrastructure, with the underlying assets delivering consistent cashflows through all parts of the economic cycle,” Hurst said.
“This stability in underlying cashflows ensures in times of economic stress, infrastructure assets provide a defensive exposure in listed markets.”
Stack said their key contingency was how their portfolio was defined; regulated utilities get a regulated return, irrespective of how many customers they serve.
“For transport infrastructure, toll roads, airports and data communications networks, there are underlying trends in terms of the number of people who use the roads, airports, or their mobile phones,” Stack said.
“That means in the short term a recession may lead to some impacts on underlying financial performance, but it should be somewhat muted.”
“Over the long run it should be largely irrelevant, so we would feel a recession is unlikely to have a significant impact on the underlying financial performance of those assets.”
At QIC, they’re deliberately planning around this happening and they’re focused on building truly diversified portfolios that demonstrate resilience against these types of macro events.
“We have a long history of successfully building–from the ground up–diversified portfolios which deliver strong and robust returns throughout market cycles, taking into account both macro and asset-level risks,” Whitehead said.
“If that’s a core capability, then you don’t need a contingency.”