News & Views

Infrastructure for the Long Term9 March 2018

Infrastructure assets have provided investors with a volatile backdrop over the past 6-12 months. As with many aspects of cyclical defensives, infrastructure has come under some pressure due to pricing, over optimism and investor sentiment. 

Delving a little deeper into these issues, infrastructure as an asset class had a large pick up in 2016 from the election of Donald Trump, synchronising global growth and the end of quantitative easing on the horizon. Many investors flooded into this asset class to access alternative sources of income. However, the Trump effect and the need for governments to spend has not materialised and many short-term investors have flooded out of the asset class and put pressure on valuations. Many investors continue to hold quality growth stocks, and cyclical assets including infrastructure have therefore struggled. 

The outflows of investment and the increasing strength of sterling over the past twelve months has provided a negative backdrop for what is a large thematic weighting in the lower risk areas of our models. 

From peak to drop the funds used have lost between 8-12% for investors which for a defensive type equity is large and we believe overdone. We still believe the asset class has positive long-term drivers for outperformance and this should lead to mean reversion in the performance of the funds and a pick up over time. 

Timing any investment is extremely difficult which is why investors must have a long-term view on the assets they hold and the reasons why these are invested into.

What are the reasons for investing in infrastructure? 

Firstly, there is a need for massive amounts of spending, not just in emerging economies, but also many developed nations. The long term need for further infrastructure spending is a factor we believe will run for many years to come.

Secondly the income generated from infrastructure is stable and displays inflation protection. This is key as inflation continues to increase in many western economies. For lower risk investments having inflation protection is something that is hugely important to create a positive total return. 

 

The graph above shows how one of the funds currently utilised with a yield of close to 4% has paid over 16% of income in distributions for investors in 4 and a half years. This income generation and pay-out is extremely important and helps to lessen the risk of capital losses over time. This income generation is extremely healthy compared to other income generating assets including cash and government bonds which are generating extremely low income for investors. 

Finally, infrastructure can provide equity type returns with lower risk and correlations to equity markets.

 

 

The table above shows how one of the infrastructure assets held in the models has provided better risk adjusted returns with a low correlation to markets (beta). Having a beta of 0.65 means that the fund moves less than the market in both up and down markets. So, in rising markets the fund will participate in 65% of the returns. However, in down markets the fund has only participated in 65% of the falls. This relationship is key to providing diversification to investors over time. 

The risk adjusted returns also highlight a positive reason for holding infrastructure over the long term. The Sharpe and Sortino ratios highlight this outperformance. Over the past five years the fund has generated greater return per unit of risk taken compared to global equity markets. Having this alpha generation plus lower volatility and lower beta in all should be positive for investors. 

Short term volatility will be present and losses can be made as shown by the maximum drawdown, but over time infrastructure assets should outperform due to the risk adjusted returns available. 

This is highlighted by the graph below which shows the total return of the Lazard Global Infrastructure fund over five years. 

 

In conclusion:

After reassessing all the funds, and the reasons for holding them for long term benefits for lower risk investors, the initial reasons still stand. As investors we cannot predict timing the markets correctly, but we can provide clarity of the reasoning for holding an asset class over time. Infrastructure has provided negative returns, but these are slowly reducing over time and holding for the long term will be a benefit for investors. We continue to monitor the individual funds and external issues including currencies, political risk and sentiment and as always, if there is need to reduce or increase the holdings we will do so for the long-term benefit of our clients. 

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Below are some brief comments from the infrastructure managers highlighting the factors that have provided a negative backdrop for investors.


Legg Mason IF RARE Global Infrastructure Income Fund 

The Legg Mason IF RARE Global Infrastructure Income Fund (X Income Class) returned -9.1% over the 6 months to 31 January 2018; a period in which Fund performance was impacted by a number of negative return drivers. The first of these was the currency impact of strengthening sterling in light of progress in the Brexit negotiations between the UK and European Union during the timeframe, which impacted performance by c.3.5% (the currency hedged X Income Class returned -5.5% over the same period).

The 6 months to the end of January 2018 was a period in which the portfolio’s Western European satellite exposure detracted significantly from performance, through SES (the world’s second-largest commercial satellite operator) and Eutelsat (a leading European satellite operator focused on broadcasting/communications services). The weak performance followed underwhelming Q3 results and lower guidance for revenue growth for both companies, which were in part driven by satellite launch delays. Alongside this we have seen a weaker supply/demand market for satellite capacity than had previously been expected, and both currency and inflation headwinds for the companies. Whilst the short-term outlook remains challenging, we expect both companies to generate significant growth in Free Cash Flow during 2018, which will underpin their balance sheets and dividend payments. In addition, we have recently seen a number of successful satellite launches from both companies as well as SES having its credit rating re-affirmed by both S&P and Moodys; factors which have brought some confidence back to market participants. We see current valuations as attractive for both stocks, and have conviction in the longer-term story for the companies and the industry, awaiting key catalysts (such as consistent revenue growth for SES) which we expect to drive a return to value.

The Fund continues to be positioned in a globally diversified portfolio of regulated assets (such as the electric, gas, and water sectors), combined with more growth-exposed user pay assets (such as toll roads, airports, and communications assets). Regionally, our largest allocation is to Western Europe (44% of the portfolio), where we expect the continued accommodative monetary policy to provide an attractive investment environment for select European regulated assets, as well as supporting economic growth in the medium-term (which we expect in turn to support the valuations of user-pay assets). We hold 27% of the portfolio in North America, where we have sold out of core-defensive utility plays in the US (in light of the increasing interest rate environment), however have the capacity to re-enter the market at the right valuations and timing, alongside the more-growth orientated companies that we hold. Alongside this we retain a 13% allocation to Australian regulated energy networks, and a 15% allocation to emerging market opportunities, including those within the Brazilian electric sector, combined with select opportunities in the Thai electric and Chinese toll road sectors.

Summary:
The recent pull-back in the Fund’s performance has been driven in a large part by the select stock names noted above, as well as a 3.5% currency impact for the unhedged share class. We believe that the underlying fundamentals and investment case for these companies – which include SES, Eutlelsat and Enbridge – remain positive. We continue to monitor the short-term outlook for these stocks, however believe this could provide a good opportunity to take advantage of the short-term market noise and to add on weakness.

 

Lazard Global Infrastructure

Despite the poor performance so far this year of our European satellite, US utility and U.K. utility positions, there has been no new information that would cause us to downgrade our intrinsic value for these stocks. The satellites have fallen on concerns over disruption from OTT alternatives, per Sky’s recent announcement. Yet Sky do not see OTT as a substitute for satellite, rather as a complement and a means to monetize the billions they have spent on content. I would refer to our most recent monthly commentary here. The satellites remain very cheap in our view, trading at material discounts to replacement cost. 

We have increased our positions in both PCG and EIX, both of which have fallen due to concerns over liabilities arising from the northern and Southern California wildfires. The shareholder liabilities implied by their price falls are far in excess of the actual insurance claims being reported for the fires; moreover, there is no information yet as to the cause of the fires nor whether the utilities were imprudent in their fire safety management, both of which are necessary for shareholders to be held liable. It is also worth pointing out that historically only 8 pct of California wildfires have actually been caused by electrical equipment. 

As for the U.K. utilities, they are falling on concerns of tougher regulation and possibly nationalization. We have always assumed lower allowed returns for the U.K. utilities, so this does nothing to change our valuation. Most importantly, we value them at RAB (replacement cost), which is almost certainly the valuation they would be given in the event of nationalization, which we still believe is a low probability scenario. We have increased our weights to the U.K. utilities in the recent sell off and will likely continue to do so should they fall further. 

Given our relatively concentrated, benchmark unaware approach, periods of underperformance like this are to be expected from time to time. 2008 and 2011 for example come to mind. In such situations we have used these types of sell offs to buy cheaply and stick to our discipline of focusing on long term intrinsic value.  Historically those situations have produced excellent subsequent returns for our clients. 

 

Miton Global Infrastructure

One macroeconomic factor which weighed on performance during January was the widespread global rise in sovereign bond yields. During January the yield on the 10-year US Treasury rose from 2.41% to 2.71%, the yield on 10-year UK Gilts rose from 1.19% to 1.51% and the yield on 10-year German Bunds rose from 0.42% to 0.69%. With infrastructure stocks, and particularly regulated utilities often viewed in equity markets as so-called “bond proxies”, the valuation of stocks fell in tandem with government bonds through the month. 

There are two ways in which we would argue that the fundamentals of the fund’s holdings will not be negatively impacted by the rising yields. In fact, we believe that the prevailing macroeconomic conditions may well be more supportive of earnings and dividend growth for our stocks than the equity market is anticipating. Firstly, we would flag that assessing levels of debt and gearing ratios is a crucial element in our stock selection process. We analyse these metrics very closely as experience tells us that one of the main reasons for a decline in fundamental earnings, cashflows and dividends and ultimately the capital value of infrastructure stocks is excessive gearing. Therefore, as interest rates rise we will try to avoid stocks where a rising cost of debt will jeopardise these fundamentals. 

Secondly, we believe that a simple read across from bonds to infrastructure equities ignores the potential for earnings and dividend growth from our stocks; put simply bond coupons are fixed, but equity dividends can grow. The major driver of recent sovereign bond yield increases and the underlying rate rises from central banks has been inflationary pressure, and we would flag that, in fact, many infrastructure stocks have inbuilt regulatory or contractual frameworks, which mandate that revenues grow in line with the prevailing local inflation rate. Therefore, unlike many other industries, where there may be issues passing through inflationary price increases to customers when inflation is increasing, for many infrastructure stocks this revenue uplift is guaranteed. We estimate that approximately two-thirds of the aggregate revenues from the stocks in our fund have this automatic inflation linkage.

 


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