Building the world

Sovereign and institutional investors have sought to relieve their income quandary by getting involved in large infrastructure projects around the world. In many cases, cash flows are guaranteed by governments and linked to inflation, so the attraction for long-term investors with fixed liabilities (pension funds, for example) is clear. Private investors, who have less scale and shorter time horizons, need to be mindful of liquidity (whether investments can be sold quickly at a fair price) as well as management and political risks for infrastructure projects. Unless investing for a massive fund, the simplest route to access the asset class is typically through listed investment trusts and companies, so all the usual concerns when buying equities apply. That said, the price volatility of infrastructure shares is lower than for whole stock markets and, in a world of low bond yields, the steady stream of dividends has appeal.

Adding balanced infrastructure exposure to your portfolio

Utilities fall firmly into the category of defensive income-paying stocks that have become bond proxies in the low-return environment. In the past, defensive stocks have demonstrated a tendency to deliver above-average total returns thanks to the income and, partly, because reliable yields have made investors slower to sell out in downturns. In addition, their boring profile relative to ‘lottery’ stocks with a more glamorous growth potential also meant a value premium often existed.

Now that investors are paying more for income, we might expect value-driven price gains to account for less of the total. If capital return premiums vanish, however, it becomes even more important to evaluate whether dividend growth in sectors such as utilities is underpinned by improving cash generation. When equity markets get to an expensive stage of the cycle, as many people would argue they are now, there is a risk bond proxies will see greater price volatility than in the past if dividend announcements disappoint.

Investing in infrastructure is about more than buying a few traditional defensive or income stocks and the objective should be to build a portfolio with risk spread across different sectors. Infrastructure can be thought of as any long-life, cash-generative fixed asset or project with strategic economic value and substantial barriers to entry. This is the definition used by the recently launched M&G Investments Global Listed Infrastructure Fund (GB00BF00R704) – ongoing annual charge of 0.75 per cent – which has three broad categories (Economic, Social and Emerging) for its investments. 

Economic infrastructure is subdivided into utilities, energy and transport. Companies in these sectors are expected to make up between 65 and 75 per cent of the M&G fund’s investments at any given time. For private investors wishing to make their own stock selections, it is possible to buy companies on European, Canadian and US exchanges as well as UK-listed shares. Deciding what constitutes a true infrastructure stock requires some clarity. Taking energy as an example, the manager of the M&G Fund, Alex Araujo, doesn’t consider oil majors to be appropriate. He reasons that although these companies own vast infrastructure, their core business is the sale of refined hydrocarbon fuels. It is a different matter, however, for companies which make most of their money from the long-term lease of pipelines, terminals or liquid natural gas facilities.

Economic Infrastructure:

Social infrastructure is a second distinct category. These are investments in education, health, prisons and social services. Involving private money in the provision of essential public services is highly charged politically. At the recent Labour Party conference shadow chancellor John McDonnell expressed intentions to bring private finance initiative (PFI) schemes entirely back under state control. The concern of Mr McDonnell and his party leader, Jeremy Corbyn, is that PFI puts profit before the needs of patients and students, who rely on public services, and the wellbeing of workers who provide them.

Social Infrastructure:

Finally, the third class identified by M&G is the evolving infrastructure of the global economy. This includes communication (data centres, telecoms towers, satellites, optical fibre); transactional technology (payments and exchanges); and royalty investments.

Royalty investments are the guaranteed cash flows from leasing drilling or mining concessions. So, although this is related to energy and mining, once again future cash flows aren’t dependent on pricing in commodities markets.

Many of the technology companies driving innovation in the global digital economy are more typically growth stocks. The dividend profile is different to economic and social infrastructure stocks but the outlook for payouts is still an important part of the longer-term investment case, as these businesses should have potential to increase payments over time, regardless of what stage the economic cycle is at.

As with economic infrastructure, in the evolving class there is a distinction to be made between large businesses where infrastructure is the enabler of profits, as opposed to being the direct source of earnings. For example, a company such as British Telecom (BT.A), which owns a significant proportion of the UK’s infrastructure, is a different type of investment. Despite the importance of its Openreach division, which contributes significantly to cash profits, the value of revenues from service-oriented parts of BT means the former state telecoms monopoly is not a pure infrastructure play. Were Openreach a separate company, then it would surely meet the infrastructure stock definition as competitors in the laying of new fibre-optic cables, still need to plug into its dark cable network.

Some of the best emerging infrastructure investments are where secure holds on aspects of digital expansion can be accessed in isolation and not as part of a sprawling legacy business. One such area is data centres. Companies such as Nasdaq-listed Equinix  US:EQIX) benefit from structural growth driven by e-commerce, Big Data and cloud services. They also have barriers to entry owing to client interconnections and captive digital eco-systems. Revenues also derive from long-term contracts with high-quality customers.

The last point opens up an intriguing route for income investors to access the cash flows generated by some of the richest digital companies. Amazon might not pay a dividend but its business also floods data centre suppliers with cash and these companies may be happier to distribute to shareholders (Equinix’s dividend yield is still below 2 per cent but it has grown the payout in the last year).

Evolving Infrastructure:

Listed infrastructure – a low-volatility, high-yield equity factor?

Investing in listed companies to access infrastructure themes is really highlighting a sub-asset class within the equities universe. Infrastructure shares in the more traditional economic category have characteristics, such as stable dividends and low volatility, which historically have been a precursor to outperformance. Factor or style investing has been very much in vogue over the past few years, so it would be unsurprising to see an exchange traded fund (ETF) emerge that tried to isolate listed infrastructure equities.

Overlaying return factors with an investment theme is a step beyond the purely passive smart beta strategies and probably would fall into the category of an actively managed ETF. It is possible to replicate some of the existing infrastructure benchmark indices but these tend to have a heavy weighting towards utilities, so there would be little additional value to an investor compared with holding a few utility stocks within their portfolio. 

Aside from the companies that provide the commodities, technologies and services that enable infrastructure growth and management, there are investment trusts that give exposure to the cash flows governments expect (and indeed underwrite) on major projects. The management charges for these funds are expensive – the investment trusts analysed by a recent Canaccord Genuity survey have annual charges ranging from 95 to 148 basis points, but they have proven to be reliable income generators.

With such demand for income, infrastructure investment trusts are trading at premiums (where the value of the market capitalisation of shares exceeds net asset value under management), although since the Labour Party conference these have lessened for the trusts with most exposure to UK PFI contracts in politically sensitive projects relating to schools and hospitals. Whether this represents fair value or not depends on the continuing ability of the funds to generate cash flows. The relative value of infrastructure compared with other sources of income also needs to be considered. Thanks to the long-term nature of concessions managed, however, the valuation of infrastructure portfolios should be thought of differently to other investment trusts and they are continually adding exposure to new projects, pushing the timeframe of future secure cash flows further out.

The Canaccord Genuity Listed infrastructure Chartbook shows, through charts and tables, several valuation and key performance indicators of four major UK investment trusts BBGI SICAV SA (BBGI), HICL Infrastructure (HICL), International Public Partnerships (INPP) and John Laing Infrastructure Fund (JLIF). These funds are not highly geared but they use revolving credit facilities with banks to quickly access cash to buy into projects. They then tap equity markets to raise capital and pay down the debts.

Credit facilities are much smaller than the total equity capital raised (the four trusts raised £1,043bn in aggregate 2016-17) but credit provides a good indication of how rapidly trusts are investing in new projects. HICL and INPP have the largest credit facilities, each around £400m, but at the end of September 2017 had only drawn £153m and £57m, respectively. Investments are overwhelmingly in operational projects with long-running concessions. There is a high concentration of UK exposure and many of the investments are in politically sensitive projects. The structure of deals should be noted – most are public private partnerships (PPP) or the controversial PFI deals which came under fire in shadow chancellor John McDonnell’s Labour Party conference speech.

Main projects for UK-listed infrastructure investment trusts 

Source: Company reports, data compiled by Canaccord Genuity

Political risk cannot be ignored, especially as the four largely UK-focused trusts, also hold investments in regulated infrastructure such as water companies, gas and electric transmission and rail projects such as HS1. These are all areas that will be massively affected by the large-scale nationalisations promised by a Labour government led by Jeremy Corbyn. The team at Canaccord acknowledge the possibility of disruption but are not in a rush to reduce their exposure to UK infrastructure investments. Responding to Mr McDonnell’s conference speech, the note they published on 28 September was sanguine. Canaccord pointed out that although PFI contracts would be subject to review, the wording of the Labour Party’s press release was that they would be brought back in house “if necessary”, which implied some process beyond just an ideologically motivated cull of PFI. They also highlighted the practicalities of nationalising PFI schemes, such as the drawn-out process of agreeing compensation to investors. These include, among others, pension funds that need the PFI income streams to meet future liabilities. Canaccord’s summation was: “While we don’t believe a UK general election is likely in the near term, one cannot fully discount the possibility of a left-wing government; however we question how high up the list of priorities nationalising PFI contracts would be for a new administration.”

This viewpoint may be wishful thinking. The Conservative government has a wafer-thin mandate and is toying with the hand grenade of delivering Brexit. If the warring Tory factions pull the pin, Jeremy Corbyn’s prospects of winning office are far from remote. Buoyed by the euphoria of such a triumph, Mr Corbyn’s commitment to deeply held principles should not be underestimated and rolling back Thatcherite privatisations and increasing the role of the state is surely a cherished aim.

That said, there is no clamour from a vote-weary public for another election. If fears of nationalisation can be kicked into the long grass, at least until 2020, there are plenty of reasons to share Canaccord’s enthusiasm for infrastructure trusts. Principally, the generous dividend yields, all covered at least 1.2 times by cash flows, keep the sector attractive. With the average discount rate (the implied forward rate of return of projects invested in) of listed infrastructure investment companies above 7 per cent, in financial terms, the prospects of maintaining expansive dividend policies are fair. What’s more, the correlations of returns with inflation offer further protection. When set against the record low return on 10-year gilts (UK government bonds), the political risk seems worth taking with at least a portion of portfolio funds.

A truly international asset class

There are many international opportunities for investors in infrastructure and diversifying geographically reduces the risks of political or regulatory upheaval in any one country or jurisdiction. It is also often the case that the best examples of certain types of infrastructure occur outside of the UK. Companies that offer exposure to these projects might be listed in these countries or be subsidiaries of conglomerates listed on some other exchange. This does mean that it can be more expensive to trade some of the best infrastructure stocks, but in terms of accessibility many online brokers enable trading on the US, Canadian and European markets where some of the most interesting companies are to be found.

Concessions to run toll roads are a very reliable source of revenue and they also have elements of pricing flexibility (fast route lanes that charge more). Aside from a few famous examples, such as Birmingham, there are few such projects in operation in the UK, let alone investment opportunities. This type of road-use pricing model is much more widespread in North America, however, and there are companies with such concessions as part of their asset base. Spanish-listed Ferrovial (Sp:FER), which also owns and operates Heathrow airport, is a leading player in North American and European toll road operations.

Of course, the main Spanish index, the Ibex, may face volatility with the Catalan secession movement creating constitutional uncertainty in Spain. The index lost 4 per cent of its value between close on Friday 29 September and Thursday 4 October, following the 1 October vote for independence. The index had recovered much ground by the middle of October and, although there is much further for this story to run, it is possible that any volatility will just create buying opportunities for companies such as Ferrovial whose revenues are dependent more on overseas economies and assets. 

The effect the Spanish political situation could have on the Ibex highlights the market volatility or beta risk of using listed equities as a vehicle to access infrastructure returns. As with the nationalisation risk for British concessions, this reinforces the case for international diversification. Arguably, however, the beta risk is less of a concern than any political or regulatory changes that may alter future cash flows from an investment.

Another important factor to beware of when buying infrastructure is the risk of assets becoming stranded. This can occur in geographies prone to natural disasters, with a good example being the Fukushima nuclear plant in Japan. Here, the major earthquake and tsunami in March 2011 not only knocked out the plant’s productive capacity but created a political will to rethink the entire national energy strategy. The M&G Fund makes hard exclusions to nuclear and coal-fired power due to the substantial political and stranded asset risk and gives environmental, social and governance (ESG) an important role in its selection process.

Concessions for infrastructure are long term, so it makes sense to screen for sustainability issues in order to pre-empt any future risks. Asset bases need to be assessed for age and whether they need replacing, their risk of stranding and ethical considerations that might give rise to future regulation or nationalisation. If companies can pass such an examination, then, combined with robust cash generation and natural barriers to competition in the spheres they operate within (what Warren Buffett calls moats), the returns from infrastructure can hopefully provide some ongoing stability to portfolios.

Yes, Minister… Trusts focus on operational projects with good reason

As well as high level political risk, the way in which government projects are managed should concern investors. In the case of the investment trusts UK investors can buy, the vast majority of projects are operational and generating cash flows. When investing in companies that depend largely on government infrastructure contracts, there needs to be an assessment of projects. The progress reports by departments, certainly in the UK, are woolly to say the least. The risks to companies are not just that projects may not complete. There is also the danger that projects overrunning swallows up valuable capacity and limits productive assets such as plant, labour and equipment being put to use and generating revenue elsewhere.

In Britain, the speed and rate of project completion is not impressive. In its 2016-17 annual report, the Infrastructure and Projects Authority (IPA) reviewed the status of the 143 current projects on the Government Major Projects Portfolio (GMPP). Spanning 17 departments, the total value was £455bn as of September 2016. The portfolio is somewhat bloated and although 36 projects left the GMPP since the previous year, the same number of new ventures have been taken on.

The IPA report includes Delivery Confidence Assessment (DCA) ratings, which are a traffic light scale of whether time and budget targets are likely to be met. These are just estimates but only 68 per cent have a rating of amber to green. This is spun as a success by the IPA but still means that nearly a third of activities aren’t going to plan, which is not necessarily good news for the companies with working capital tied up. When projects leave the GMPP they just go back to departmental oversight in their latter stages but, highlighting the risk of failed projects or changing government priorities, six (one sixth) of those leaving the GMPP last year were simply dropped. Long term, of the 76 projects set to be completed by 2020 18 are rated at red/amber, 39 are amber and 18 are amber/green, which means less than a quarter are going really well. Therefore, investors in companies that are involved in government projects need to ask themselves: what contractual protection the companies have in terms of projects overrunning? What is the exit strategy when things go bad? How do companies manage reputational risk?