7 golden rules of investing in infrastructure

Ageing roads, outdated railways and undersized airports: the already massive infrastructure challenge facing countries of the world is now gargantuan – a US$5.5 trillion problem, according to a McKinsey study.

COVID-19 lockdowns have blasted the revenue sources needed just to support existing programs, let alone invest in future expansion. Developing Asian countries alone need US$1.7 trillion a year in infrastructure spending for at least the next decade to maintain growth and tackle poverty, says KPMG.

The world has a $5.5 trillion problem. Image: McKinsey Voices on Infrastructure

And as governments divert revenue to critical healthcare services and economic stimulus, demand for private sector investment in infrastructure will balloon. At the same time, listed infrastructure assets – traditionally sought for their defensiveness, enhanced yield potential and predictable, resilient cashflows – are more appealing than ever due to extreme equity market volatility and historically low bond yields and cash rates.

In part one of this three-part series, I ask three listed infrastructure fund portfolio managers to flip open their rulebooks for investing in this diverse, often complex asset class.

Responses were provided by:

• Gerald Stack, head of infrastructure and portfolio manager, Magellan Financial Group
• Tim Humphreys, head of global Listed infrastructure, Ausbil Investment Management
• Sarah Shaw, chief investment officer, 4D Infrastructure

Sometimes boring is beautiful

Gerald Stack, Magellan Financial Group

Perhaps the most important rule is that if infrastructure is framed as a separate asset class, it can provide the benefits of diversification to a broader investment portfolio. This in turn means the risk and return characteristics of infrastructure assets should be quite distinct from other assets.

Investors have typically defined infrastructure by virtue of its physical characteristics – that is big, typically ugly pieces of capital equipment that provide services essential for the efficient functioning of communities. We think this is on the right track in that capital-intensive assets that provide essential services are likely to benefit from predictable demand for their services. 

But we believe that the magic of infrastructure lies in its investment characteristics, rather than its physical characteristics.

Because infrastructure assets generate reliable earnings and cashflows, investors seeking the portfolio diversification benefits of the category should embrace “boring”. As an asset class, infrastructure generates predictable long-term returns for investors with low levels of risk. The magic of investing in infrastructure is not in getting rich quick, but in growing wealth in a predictable manner over the long-term.

It pays to stay on the fairway

Tim Humphreys, Ausbil Investment Management

1. Stay on the fairway: It’s easy to be tempted by industries and companies that are on the fringe of infrastructure – by following either a trend or a crowd, or by chasing returns where share prices have done well or industries are growing.

If a company or industry doesn’t satisfy your well-defined criteria, move to the next. The characteristics of your portfolio will be the product of all the investments it contains. If each of the companies you invest in exhibits these characteristics, you can be reasonably certain these same attributes apply to your overall portfolio. This increases predictability and reduces risk.

For example, the market insists data centres are infrastructure assets because they provide base storage infrastructure for communications. But we view them as much closer to real estate than infrastructure, due to their shorter-term contracts and ability to expand available floor-space.

2. Be conservative and focus on quality: If I can find a stream of cash flows that gives me good upside from the current share price – even using bearish assumptions – then that’s a great starting point in infrastructure. The more aggressive and ambitious you have to be in your financial models to get a decent upside, the greater the risk of disappointment and loss.

Infrastructure valuation is a highly technical undertaking, and small changes can amplify over the longer-term. Supposed infrastructure experts have pitched me financial models for a toll road that assumes a 16-lane highway in each direction at the end of 30 years in order to prop-up returns! You need to be realistic in your assumptions and understand the limitations of the assets and their true capacity over the long-term.

As important as high quality infrastructure assets are, it’s equally crucial not to sell high-quality names at the wrong time. Some examples include NextEra (NYSE: NEE), American Water Works (NYSE: AWK) and American Tower (NYSE: AMT).

3. Think about terminal values: When you build a financial model for the next 30 years, you have to think about what the assets will be worth at the end of that timeframe.

Infrastructure investing is a whole-of-lifecycle investment approach. This distinguishes it from the earnings-multiple driven world of general equity investing. A great example is the current frenzy over the energy transition from fossil fuels to renewables and a decarbonised world. What will this look like in 30 years, and how will the current assets of a company be affected? If in doubt about the true terminal value, see rule number two above.

Finding the sweet spot

Sarah Shaw, 4D Infrastructure

We're currently experiencing a unique period whereby infrastructure is in a true global "sweet spot" of investment opportunity.

As an index agnostic, active investor in global listed infrastructure assets, the following points underpin our philosophy and key rules by which we invest.

How we define infrastructure: Known as a defensive asset class, infrastructure offers long-term, resilient and visible cash flows that underpin a yield or growth. Given investors are looking for this defensiveness, as a starting point we must properly screen a broad universe of stocks for the necessary “infrastructure” characteristics that facilitate this earnings resilience – such as stocks with monopolistic market positions or high barriers to entry; earnings underpinned by contract or regulation; and inflation hedges. If a stock doesn’t meet our definition, it doesn’t make the 4D universe.

Active management: We fundamentally don’t believe in index-relative investing – we want to give investors the best investment ideas globally, not the relative best ideas. Given the diversity of sub-sectors and regions within infrastructure, with active management we believe a portfolio can be positioned to take advantage of the long-term structural infrastructure thematic as well as near-term cyclical events such as COVID-19.

Integrated top down/bottom up approach: As active managers, understanding the economic environment at a global and domestic level is very important. As such, we have brought economics in-house, and our process includes an in-depth analysis of countries before we even get to their underlying stocks. 

Events like the GFC, and now COVID-19, have shown us that countries have real risk. We must understand this if we are investing in long-dated assets.

Our country analysis involves an assessment of fiscal, economic, political and ESG factors to determine whether a country is an acceptable investment destination. If it passes this litmus test – which we conduct before we even start looking at stocks – we might then start looking at specific assets in that country.

In conclusion

A laser-like focus on the types of infrastructure for your portfolio is key, given the diversity and complexity of the universe of listed assets. And there may be some merit to a non-benchmark approach versus tracking a global infrastructure index, given two of the three fundies we spoke to are benchmark agnostic – but that doesn't rule out the value of an index. And finally, don't sweat the small stuff – the magic of infrastucture lies in its investment characteristics, not physical appearances or attributes.

Stay up to date

Don't forget to follow my profile to read the upcoming wires in this three-part series, and give this article a like if you enjoyed it. The next instalments look at what lies ahead for infrastructure and how COVID has shifted portfolios and three fundies' top stock picks of global infrastructure.