Inside this inflation-beating asset class (and Warryn Robertson’s preferred plays)

Railways, roads, airports, and waterways are the backbones of modern society and when securitised, the assets are prized by investors seeking stable returns and income.

When Warryn Robertson, one of the pioneers of global infrastructure investment in Australia last appeared on Rules of Investing, he nominated the infrastructure asset class as one of the best places to invest during an inflationary environment.

That was in June 2022, when the inflation rate was more than 6% and the RBA cash rate was still at a now almost unthinkable 0.85%.

Fast forward more than 18 months and while inflation remains elevated it seems likely that RBA Governor Michelle Bullock’s job has been done and the local interest rate has peaked at 4.35%.

In Robertson’s latest appearance on the podcast, Livewire’s James Marlay asked whether infrastructure has delivered as he expected.

“On the whole, I think it has,” Robertson says. However, he also notes investors need to be cautious about assuming all infrastructure investments provide inflation protection, "because some provide it, and some don’t.”

“They’re set up for decent returns over the next 12-18 months, but you need to be selective. There are certain assets we think are running ahead of fair value and others that are trading below fair value – they’re the ones you want to own,” Robertson says.

How does the inflation outlook affect infrastructure?

Based on the widely held view that interest rates have peaked, Robertson is positive on infrastructure from here, though emphasises that some parts will do better than others.

He divides the asset class into those that carry “patronage risk” and those that don’t. The first type is those that help people move around – think railroads, toll-ways, airports – all of which were locked down during the pandemic.

On the other hand, there are power and water utilities. 

“Utilities didn’t have that negative effect from COVID. We stayed home, we turned the lights on, we still brushed our teeth and turned the gas on to cook,” Robertson says.

“But the patronage risk assets are recovering, and I think they’re set up for what looks like decent growth prospects in the next 12 to 18 months.”

Robertson also emphasises the nuance in how inflation adjustment occurs across different types of assets. For example, revenue streams might be secured by long-term contracts or government regulations for assets such as motorway tolls or airport landing charges.

“Where it’s explicitly inflation-protected – that happens in Australia, the UK and Europe – [infrastructure assets] have done incredibly well,” Robertson says.

What you need to know

Robertson says infrastructure assets are quite simple in some ways, but there are important details investors need to understand, particularly regulation. He uses US utilities as an example because their profit is regulated by the government. In accounting terms, this comes back to how much return on equity the companies are allowed to earn on shareholders’ funds.

“So, in the US, 51 regulators in total will sit there and make a judgement call about what they think is the right return on equity that a US utility should receive on its historical cost asset base,” says Robertson.

In the years before the latest interest rate tightening cycle began, the return on equity of US utilities had drifted lower. Since then, the rise in bond yields has made US utility stocks more attractive because the risk-free rate of return is higher.

As rates have risen, the return on equity from US utilities has remained relatively flat, “but the bond yield has started to rise back up to where we've seen it today, four going towards 5%, and we think in a world with a 5% bond yield, an ROE of 10 to 10.5% is appropriate,” Robertson says.

The valuations of utilities since then have pulled back to around 14x earnings, from around 20x – as bond yields have risen and investors rebalanced back toward bonds.

But what the market hasn’t adjusted for is that the higher interest rate environment meant these firms – which carry high debt loads – needed to use more “exotic” structures such as hybrid debt securities or holding company debt.

“Now interest rates have gone back to more normal levels, suddenly, getting those hybrids or convertible preference notes away at attractive rates is much more difficult. And that's the second phase of what we think will be a prolonged downturn for US utilities,” Robertson says.

What are the risks?

In a broader sense, Robertson regards infrastructure as appealing, with very low credit risk driven by steady demand, which means banks are happy to keep lending to companies in the space.

“You’re less likely to see issues come forward for those types of assets, as long as they’re appropriately leveraged,” Robertson says.

But again, it’s in utilities where he sees the greatest risk, given the elevated debt levels:

“The canary in the coal mine for us is the holdco debt for US utilities.”

That said, he emphasises there are no bank funding issues across most assets in Lazard’s portfolio.

Australia’s disappearing infrastructure

The same favourable attributes also make such assets appealing targets for M&A activity and acquisitions by superannuation funds and private equity – which we’ve seen in Australia. Our universe of large, listed infrastructure assets, those with market capitalisations of $1 billion plus, has shrunk to around 14 now.

Of those, only four tick Lazard’s boxes in being “preferred infrastructure". The key attributes Robertson and his team look for are:

• monopoly-like businesses,
• protected infrastructure revenue streams or returns, and
• manageable debt profiles.

Three of these are:

• Transurban (ASX: TCL),
• Auckland International Airport (ASX: AIA) and
• Atlas Arteria (ASX: ALX).

TCL gets the nod because Robertson and his team like Australia’s regulatory arrangements, the firm earning 90% of its revenue from here. He also likes the firm’s ownership of long-term concessional toll roads, which include Melbourne’s CityLink and Sydney’s WestLink M7.

Atlas Arteria is also locally listed but derives around 50% of its income from each of its North American and French toll roads.

A five-year stock pick

Asked to name a company he would buy and hold in the unlikely scenario that world markets closed for half a decade, Robertson named Ferrovial (BME: FER)

A Dutch-headquartered Spanish multinational company, it operates assets including highways, airports, and energy infrastructure. Its toll roads are predominantly in North America, this market providing around 80% of its value. For Robertson, one of the most exciting is the Ontario Highway 407.

“If I had to close the world for five years and only own one name, it would be that one because in five years, it will have paid you a massive dividend return.

Managed Fund

Lazard Global Listed Infrastructure Fund

Alternative Assets

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