Why the best opportunities from the energy transition may lie in infrastructure

For every buyer, there is a seller. For every bull, there is a bear. And in the case of ESG investing, for every supporter, there is a sceptic. Many investors believe in the Milton Friedman approach to investing, which in short, says that companies need to do whatever it takes to provide returns to its shareholders. 

But in recent years, ESG investing has scuttled this view as market participants embraced the idea of sacrificing returns for the good of the planet, marginalised communities, and other noble causes.

Then, just as the war in Ukraine was beginning, the anti-ESG crowd began to make a lot of noise. Their argument has been that warm feelings and noble goals aside, green investment valuations are just too high and their return potential too long in the tooth to realise. At one point in 2021, ESG investments accounted for more than a third of all assets professionally managed by banks and investment funds globally. 

But that bubble has now burst, and in the eyes of Brad Frishberg from Macquarie Investment Management, creates an opportunity for companies that can maintain a reasonable valuation and demonstrate the capital discipline required to grow sustainably. 

In this edition of Expert Insights, Frishberg tells us how infrastructure investing can provide a shelter against inflation and what he looks for as an investor in potential holdings.

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Edited transcript:

Through what mechanisms do your infrastructure protect against inflation?

Infrastructure is the best equity asset class from the perspective of direct, formulaic inflation linkage. There are two broad mechanisms that exist in our space. 

Either concessions or contracts can include a mechanism that directly links the price of the service to inflation – good examples here are toll roads or European cell phone towers that often have their prices adjusted by a formula that includes inflation. Or there are some utilities with regulation that adjusts the company’s asset base, on which they are remunerated, by inflation. This is more common, for instance, with European regulated utilities. 

I note that in all of these cases, the formula is driven by actual inflation as opposed to a “fixed rent riser” which while very powerful does not actually change with observed inflation.

Some investors associate the timeline for the energy transition with the time timeline for investment returns. Is that misguided?

I think the key focus for investors needs to be the net present value created by investments made by their companies’ managements. 

To the extent the investments are creating positive risk-adjusted returns over the long term, then the stock prices should reflect that increased value over time. 

Just participating in energy transition isn’t enough – detailed analysis of existing investments as well as future investments and the cash flows that those will generate should be the key drivers of future returns.

Are we still in a ‘green investment bubble?’

The confluence of higher long-term interest rates and substantial inflation has led to a meaningful reality check in the space. 

 Based on our experience and analysis, the “green investment bubble” that seems to have existed in late 2021 does look to be behind us. 

However, the key is what happens next. As I discussed earlier, the opportunities for investment will be enormous. But the winners and losers will likely be determined by those companies who maintain capital allocation disciplines and do not grow just for growth’s sake.

What do you look for in companies?

We are attracted to companies that will produce stable and growing cash flows over time. If their assets include inflation linkage, all the better. 

 Finally, we like to find those names that have the above characteristics but are also trading at a reasonable valuation relative to the future free cash flow we expect them to generate. 

Fortunately, the market tends to overreact to short-term fundamentals so we are often given opportunities to invest in great long-term franchises that may be out of favour in the near term.