As we learned earlier this week, listed infrastructure offers income, growth, and diversification from typical stock-bond portfolios, yet it only forms a small part of most investors’ portfolios. It should come as no surprise then, that there are several widely held beliefs about the asset class that just don’t stack up to scrutiny. As senior figures within the infrastructure teams at major asset managers, the contributors to this Collection run into these myths every day. So they’re better equipped than just about anyone to teach us which of our beliefs about this asset class might require rethinking.
Response come from Warryn Robertson, Lazard Asset Management; Ben McVicar, Magellan Asset Management; Andrew Greenup, Colonial First State Global Asset Management; and Tim Humphreys, Ausbil.
Never forget The Golden Rule
The biggest misconception I often hear is that because bond yields are low, P/E’s should be higher. This is a misconception in equities generally but is a real problem in infrastructure. The problem with that thesis is that it breaks a golden rule of markets, which states that nominal GDP growth, which is the key driver of earnings, should be linked to nominal risk-free rates. Which is the key driver of multiples or discount rates.
Recently, what has happened in investment markets is investors have had low discount rates that they have applied high multiples and low costs of capital to but have assumed a return to trend growth levels. The nexus is therefore broken.
By breaking this rule, investors can now reasonably own U.S utilities that are trading on 20 times earnings. This is a particular problem for utilities, because there are direct linkages between allowed returns and interest rates. Many companies in the infrastructure sector are explicitly or implicitly regulated using a regulated asset base approach. Under this approach, the regulator allows the company to charge a tariff that covers all its agreed expenses (including depreciation) and achieve a ‘fair’ or ‘market-based’ return from the assets. Interest rates are obviously a key component of this calculation.
As a result, over the long-term, allowed returns should correspond to the level of interest rates. If you are applying low rates into perpetuity, but maintaining above trend growth, it is easy to see how extravagant multiples become the norm.
However, eventually there must be a reckoning, either the earnings or the discount rate must come down. This process could be very painful for some stocks, infrastructure companies included.
3 myths that should be forgotten
Ben McVicar, Magellan Asset Management Limited
Unlisted infrastructure is lower risk than listed infrastructure
At a fundamental level, there are limited differences between listed and unlisted infrastructure. The quality of the assets available in the listed markets is very high. They are often ‘crown jewel’ assets such as the Paris airport system or the dominant toll-road provider in countries such as Australia or some of the largest utilities in the US. However, we think the issue of perceived risk stems from the mark-to-market risk that is occurring live for listed infrastructure assets but is more periodic (such as quarterly) for unlisted infrastructure.
While investors in unlisted infrastructure gain control over assets and can direct cash flows, we note the significant undrawn unlisted infrastructure capital waiting for investment, whereas in the listed markets we find significant liquidity available daily and a large investment universe, which we believe compensate for this exposure.
Additionally, there are circumstances where illiquidity adds material risk to the investment. This was most recently highlighted by the UK utility industry when the opposition Labour Party adopted a policy to nationalise all utilities at significantly less-than-fair market value should it be elected. While an investor in the listed companies can sell out to avoid the risk, unlisted investors face a significant challenge to find a buyer given the uncertainty.
Listed infrastructure stocks act as bond proxies
We hear this one a lot. The consensus view is that infrastructure is highly sensitive to changes in interest rates. And certainly, in the short term the knee-jerk market response has been to sell infrastructure stocks when interest rate expectations increase. However, the impact on the businesses themselves is less significant. If a rise in inflation expectations boosts bond yields, then some or all this inflation is a pass-through for most infrastructure and utility businesses. Further, for most utility businesses, the cost of doing business (including interest costs) is largely a pass-through. Rising interest rates can even lead to higher allowed returns on the capital invested in the business; that is, the asset’s earnings go up.
Infrastructure companies carry too much leverage
Understandably, investors looking at infrastructure are often concerned about the levels of debt, especially after the experience for some Australian investors in the last major crash. What we find interesting in today’s world of low interest rates is that most infrastructure companies are not significantly increasing their debt. In fact, at a portfolio level, the ratio of net-debt-to-enterprise value is flat or falling, while interest-coverage ratios have improved in recent years due to the reduction in interest rates. We see that many companies are taking advantage of this access to debt markets by increasing the duration of their balance sheet, increasing the portion of debt that is fixed versus floating rate, and spreading maturities to avoid excessive refinancing risk in any one year. While there are always exceptions, the general reaction by a lot of management teams has been one of de-risking balance sheets while credit is easier.
No lack of opportunities in the listed sector
Haven’t I missed this given how well the asset class has done? Isn’t the sector expensive?
No. The asset class has performed well, in part aided by low interest rates, but that does not in itself make the sector expensive relative to other investment opportunities. Global infrastructure is delivering strong earnings growth which, when combined with lower discount rates (from falling interest rates), means that intrinsic asset values have also increased meaningfully. Despite delivering a double digit returns for the last decade, dividend yields for global listed infrastructure have remained in the 3%-4% range and are underpinned by reasonable payout ratios (~70%) and robust company balance sheets. In fact, in the last quarter alone, pension funds and unlisted infrastructure funds have aggressively bid for listed infrastructure firms and assets (Buckeye Partners, El Paso Electric, Genesee & Wyoming, Ausol) at prices well above where the listed sector is trading.
Isn’t infrastructure just a low growth, bond proxy investment?
No. Infrastructure assets offer defensive, non-cyclical growth opportunities from a variety of areas. These include:
(1) investment-driven earnings from the build-out of new transmission and distribution assets by electric, gas and water utilities
(2) clean renewable energy replacing carbon emitting, coal-fired electricity generation
(3) increasing equipment on mobile phone towers, to cope with growing data usage on smartphones
(4) rising traffic volumes on toll roads, as a result of urban congestion
(5) structural growth in global travel driving more passengers through airports and
(6) new energy pipelines and storage infrastructure being built to facilitate the world’s changing patterns of energy supply and demand.
To be clear, global listed infrastructure is an interest rate sensitive asset class (and I don’t profess to know the future direction of rates) but it also has defensive growth attributes.
Don’t I get exposure to global listed infrastructure via my global equities allocation?
A little bit - but not very much. We estimate that listed infrastructure companies account for between 2% and 4% of global equity portfolios. Hence, if you decide global listed infrastructure suits your investment needs, then you need to make an explicit allocation in your investment portfolio in order to gain a meaningful exposure to the asset class.
Opportunities for structural growth over the long term
The most common misconception I hear is that infrastructure companies are “low growth bond-proxies which are solely correlated to interest rates, and if interest rates rise, these companies will get smashed!”
There’s a lot to unpack here, but every time I hear this I have to smile as it reminds me how misunderstood listed infrastructure is and how supposedly savvy investors are still conditioned by pre-conceived misconceptions rather than reality. This misconception provides a huge opportunity for patient investors to take advantage of the long-term compound growth essential infrastructure offers, and that’s what really excites me about talking to investors today.
Clearly there are some areas of infrastructure that can be classified as “low growth”, and therefore by extension a “bond proxy”. However, there are many areas of infrastructure where the growth is extremely attractive and secular for many years to come. Gas distribution companies who are embarking on a 20-year process to replace their cast iron (and therefore leaking) pipeline system with modern, safer, polyethylene pipes are thereby providing a 20-year growth opportunity to grow earnings by mid-single digits per year for the next 20 years. In today’s low-growth environment, I can’t see many “growth stocks” that offer this level of growth with such high visibility over such long periods of time.
Airports would be another obvious area of unrecognised growth. As a higher number of consumers from the developing world can afford air travel, we are seeing a significant increase in passenger numbers and the amount spent at airports. This phenomenon is not cyclical but structural and secular in its nature. And it plays out in growth and income returns over time.
Bond proxies? Come again?
Despite the differences in their responses, it seems like one thing that just about all our contributors agree on is that listed infrastructure is not just a bond proxy. Warryn Robertson’s response, however, serves as an important reminder that what you don’t own is every bit as important as what you do own. In this recent podcast, I spoke to Warryn in more depth about some of the issues raised in his response.
In part one of this series, our contributors shared their top reasons for investing in global listed infrastructure.
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