'Cities grow quicker than economies do'

Many infrastructure trusts listed in the UK are relatively conservative with steady cash flows, a nice yield and a bit of price growth. But beyond the developed world, infrastructure is a way to tap into some of the trends that make emerging markets exciting. Utilico Emerging Markets Trust (UEM) invests in infrastructure and utilities in these regions, offering exposure to their growth potential but with less volatility. 

However, greater potential for growth still means greater risk. As the chart shows, Utilico Emerging Markets' share price dropped dramatically at the start of the Covid-19 pandemic and took a while to recover. It held up better than many other trusts in 2022 and had a solid 2023 until recently – its share price was down 5.9 per cent over the month to 26 October, although is up 2.5 per cent in the year to date. The MSCI Emerging Markets index, which the trust uses as a point of reference though not a formal benchmark, is down 3.4 per cent so far this year and the trust has outperformed it both over the medium and long term.

Emerging market economies grow faster than developed market economies and tend to have expanding middle classes. The trust's manager, Charles Jillings, argues that infrastructure is a good way to tap into this trend. “What makes emerging market cities special is that urbanisation is still taking place," he says. "Cities grow quicker than the wider economy. And the middle class in the cities grows quicker than the cities. That dynamic feeds into the performance of infrastructure assets.”

Emerging markets’ growing urban middle classes need better infrastructure such as larger airports and better roads. For some cities in the region, this can be easier to deliver than in developed markets because there's no legacy technology to contend with. “Take telecoms – a lot of emerging market countries have simply skipped copper infrastructure and moved directly to mobile, so their architecture is really leading edge," says Jillings. "It gives investors a lot of opportunity.”

Jillings and his team try to take advantage of this by investing predominantly in listed and operational assets across emerging markets. “We focus on listed companies because we want to receive regular information, have a relationship with managements and be able to sell through the market if we change our minds,” he explains. And they consider visiting assets and challenging their management teams an important part of their investment process.

Utilico Emerging Markets' policy is not to have more than 10 per cent of its portfolio in unquoted companies. As of March 2023, it actually had 10.8 per cent in these, partly because Petalite, a UK electric vehicle charging infrastructure company in which the trust invested a small amount in 2020, has grown very quickly and become the trust’s second biggest holding. Utilico Emerging Markets doesn't have to sell its unlisted holdings if their value goes above its limit, but cannot make any new illiquid investments when this happens. Petalite’s valuation was subsequently reduced by 12.9 per cent in September to reflect the “softening share prices” of listed peers and as of 30 September accounted for 4.7 per cent of the trust's assets.

Brazil vs China

Utilico Emerging Markets' managers pick investments on the basis of their individual merits rather than because of the industry sector they are in, so its portfolio looks quite different to the MSCI Emerging Markets index. For example, Brazil is by far the trust's biggest country exposure, whereas China is this index's largest country exposure. The trust’s two largest Brazil-listed holdings are electricity company Alupar Investimento (BR:ALUP11) and waste treatment company Orizon Valorizacao de Residuos (BR:ORVR3).

Jillings argues that investing in infrastructure in emerging markets is not profoundly different from doing so in developed markets, and says Brazil is a good example of why this is the case. Infrastructure investors need to look for good management teams, and monitor the political and regulatory environment but political turmoil doesn't necessarily impact the assets. “In Brazil, there was lots of noise around Lula and his presidency, and what he's looking to achieve but underneath the institutions are strong enough to stand up and say no,” Jillings says. “The regulatory environment is particularly strong. So we can have confidence in investing in infrastructure and utilities there.”

For example, Orizon is well positioned to take advantage of the current regulatory environment after Brazil introduced a plan to improve its waste management practices in 2022. The trust's managers increased its position in the company by almost 70 per cent in the year to March 2023. 

Jillings is less enthusiastic about China, the trust’s second-largest country exposure. “China is challenging at the moment,” he explains. “It’s hard to understand if it is going to return to stronger growth, where the growth is going to be and whether it is going to be rejuvenated by a shift back to supporting housing, which doesn't look likely.” The trust might invest more in China in the future, but for now it's difficult to find investments with the right ris/reward profile, he adds.

Infrastructure trends

Utilico Emerging Markets focuses on four main areas: energy transition, digital infrastructure, global trade and social infrastructure. Jillings says that from a global trade perspective, tensions between the US and China are pushing companies to improve the resilience of their supply chains and that this has resulted in a shift from investing in China to investing in countries such as Mexico and Vietnam. 

Mexican airports in particular are benefiting from the reshoring trend as its mountains make travelling by road more difficult. “We didn't have many airports [and] sold out of airports at the beginning of Covid," says Jillings. "More recently, we've invested back into airports because we can see the recovery. And that's been a good decision.” But he adds that travel in China hasn't recovered to the same degree as in other countries, and that a slowdown in China could have an impact on surrounding countries such as Korea and Vietnam. “But at the end of the day, our investments are not about the global economy," he says. "Our investments are generally about local economies and local dynamics.”

Jillings likes Vietnam’s growth prospects but says that local knowledge is especially important when investing in this country and it isn’t easy to find investments that tick all the boxes. So Utilico Emerging Markets gets some of its exposure to Vietnam via London-listed VinaCapital Vietnam Opportunity Fund (VOF).

The trust’s biggest direct company holding in Vietnam is FPT Corporation (VN:FPT), which is also its biggest digital infrastructure holding. FPT’s business model is a slightly odd mix: it’s an information technology and telecommunications business, but also runs a network of schools and a university. And it operates data centres, a key area of growth within digital infrastructure which the artificial intelligence boom is likely to boost further.

As of September 2023, the trust classified 37.2 per cent of its assets as “energy transition” investments. The past couple of years have been very volatile for the energy sector and Jillings admits that it has “produced some challenges, depending on the regulatory framework.” But the trust’s focus has been on renewables and energy transmission rather than energy generation assets, which are somewhat less exposed to power prices.

The trust’s biggest investment in the sector is India Grid Trust (IN:INDIGRID), a fund listed on the Bombay Stock Exchange which owns power transmission assets in India and is run by alternative asset manager KKR. This fund’s share price was down about 6 per cent over one year, as of late October.

Discount

The war in Ukraine hit emerging markets in different ways to the way it affected Europe and the US. In Asia, inflation didn’t increase quite as much and Latin American central banks managed it down faster. So Jillings isn’t quite as worried about interest rates, although keeps an eye on the leverage of the trust’s companies and any potential mismatch. "If a company is earning its income in Brazilian real but borrowing in US dollars, we think that's high risk and we would avoid it,” he explains.

The trust was trading on a 17.1 per cent discount to net asset value (NAV) as of 26 October. Jillings argues that low demand for it is a reflection of low appetite for emerging markets in general and investors are not “differentiating". The trust is a different way of getting exposure to the region but in the current environment it may be a while before demand recovers, and its proposition is more niche than that of other emerging market funds.

Utilico Emerging Markets is growth-focused but pays a dividend and had a 4.1 per cent yield in late October. Jillings says that this is because its investments generate regular cash flows and he considers paying dividends a useful discipline for the management of the trust’s holdings. Generating income “is not a driver but it is an outcome,” he says. 

Jillings is hopeful for the next few months albeit with a “degree of caution". He points to the resilience of the US economy and the trust's holdings' good results, which haven't always been reflected in the share price, and concludes: “You have to be an optimist to be an investor.”