Think local, go global - From IMAP Independent Thought

By IMAP Team

As global economies go through unparalleled development surges, infrastructure is playing an increasingly important part in the overall diversification of portfolios. John Julian (AMP Capital), Chris McAlpine (Context Capital Consulting), Tim Murphy (Morningstar), and Trent Koch (First Sentier Investors) discuss the challenges and opportunities of real assets.

It’s hardly surprising that investors face a challenging time over the coming years, as they navigate an investment environment that is likely to be characterised by high inflation, increasing interest rates, the risk of recession, ongoing geopolitical issues, and lower growth prospects over the next few years.

Yet despite this market uncertainty, John Julian - Managing Director, Global Infrastructure Equity at AMP Capital - is confident that infrastructure can play a significant role in portfolios, particularly during times of volatility. He refers to past recessions and periods of market stress, where many investors turned to infrastructure for its defensive capabilities.

John says this is primarily because, as providers of essential services, infrastructure businesses tend to generate cashflows that are less sensitive to economic conditions, compared to those generated by more mainstream industrial assets. This can allow infrastructure to deliver consistent yields to investors. 

Speaking at the IMAP Independent Thought Conference in Sydney, John believes infrastructure has an important role to play in investor portfolios, particularly during this current volatile period. However, he adds that infrastructure is not a ‘one-size-fits-all’ asset class and cautions that the prevailing environment could impact different categories of infrastructure in different ways. In his view, traditional ‘core’ infrastructure is likely to be more resilient in a low growth inflationary environment, than more speculative ‘core plus’ infrastructure assets.

According to John, infrastructure assets are ideal for helping investors navigate challenging environments. It does this in three ways:

1. Provides steady returns through market cycles with lower volatility. That’s because these are essential services assets that people use on a daily basis, like electricity distribution networks.

2. Provides stable long-term yields. Infrastructure asset revenues are often underpinned by regulation or long-term contracts, which provides a high level of certainty around the cashflows that these assets can generate for investors.

3. Diversification. Low correlations with other asset classes reduces the overall risk to portfolios.

Trent Koch - Portfolio Manager at First Sentier Investors - agrees that infrastructure can play an important role in a client’s portfolio, particularly in respect to income, growth, and reduced volatility.

“As an asset class, infrastructure will give your clients a reliable and stable yield of about 4 per cent per annum. It also provides structural growth that is less dependent on the economic cycle. The resilience of the earnings of these companies, whether regulated or long-term contracts, means investors have good visibility on the earnings,” he says.

“And importantly, infrastructure assets provide lower volatility to a portfolio. They’re almost like a defensive equity. If you look at the returns this year, global equities are down about 15 per cent, but infrastructure is up by around 1-2 per cent. Infrastructure provides downside protection to clients in more volatile markets.”  

According to Chris McAlpine - Co-founder/Consultant at Context Capital Consulting - the biggest implementation issue he has encountered when adding infrastructure to a portfolio is the lack of suitable funds available for retail investors.

“Generally, building portfolios in a retail setting means we are largely confined to Australian domiciled liquid funds. So, the universe is quite narrow because we really don’t have access to unlisted assets,” says Chris.

“Therefore, the biggest implementation challenge would be the lack of availability of suitable funds for retail portfolio structures, which means you are fundamentally playing a different game to the superannuation funds because of the structures you can access.”

John agrees that when it comes to listed infrastructure companies on the ASX, there aren’t many to choose from. Instead, he advises retail investors who are looking to implement a well diversified infrastructure portfolio to invest globally.

He suggests investors could invest directly in global listed infrastructure stocks, but warns that this tends to be time-consuming and challenging. Instead, he says there are a number of listed infrastructure vehicles available in the market that provide good diversification across global markets.

It’s a view supported by Trent: “Investors wanting to invest in infrastructure need to think global. The U.S. is about half of our portfolio, but the U.S. is like 50 separate countries. Every state has its own utility, and often multiple utilities. There is a huge opportunity there, so if you are thinking about investing in infrastructure, you need to think beyond the very limited Australian market.”

John acknowledges that the performance of different infrastructure assets can be impacted - both positively and negatively - by a range of economic factors, including inflation, interest rates, and the level of economic activity. As such, the net impact on infrastructure cashflows depends on how these positive and negative impacts balance out.

He explains: “Impacts can vary widely depending on the type of infrastructure asset. For example, growth linked assets, such as airports and toll roads, are both positively and negatively impacted by inflation. On the upside, patronage increases in a growth environment and service charges can increase by inflation. While on the downside, operating costs increase with growth and inflation, with a potential increase to the cost of debt, which can be possibly mitigated through hedging arrangements.”

Some other risks that apply to infrastructure assets that advisers need to be aware of include correlations and company debt, says Tim Murphy CFA - Director of Manager Research - APAC at Morningstar.

“Given the more consistent nature of the cashflows of many of these companies, they tend to carry much higher debt levels than other comparable listed companies,” says Tim. “And from a portfolio construction perspective, correlations aren’t stable through time. Being aware of that and the drivers of change are important to understand when building a portfolio.

“Listed infrastructure has held up well this year in the downturn, but that hasn’t always been the case in other periods of drawdown. So, correlations can and do vary, which advisers need to be conscious of when putting together a portfolio.”    

Another aspect of infrastructure that advisers need to be aware of is what appears to be infrastructure on the surface, may in fact not be investable infrastructure.

When AMP Capital looks at infrastructure businesses, there are certain common characteristics that the manager looks for. These include:

• The asset needs to provide essential services, which helps to provide resilience through market cycles;
• It should be a natural monopoly or enjoy a very dominant market position; and
• It must have consistent and predictable long-term cashflows with inflation linkage.

However, John adds that advisers must be cognisant that infrastructure consists of a very broad range of assets, and some of those assets don’t actually possess those characteristics, which does not make them investable infrastructure.

“If you look at any of the broad-based infrastructure and utilities indices in the market, they all contain companies that we would not consider to be infrastructure. Examples include companies that have their revenues heavily influenced by commodity prices, or it might include energy generators that sell their product into the market at spot market pricing,” he says.

“That’s not the kind of consistent, reliable and long-term cashflow profile, which is underpinned by a regulatory framework or a long-term off take contract, that we would typically look for in an infrastructure asset.”

Undoubtedly, one of the biggest trends unfolding over the next few decades is decarbonisation. After a patchy and inconsistent start, the transition to a low carbon environment is gaining speed globally.

“The ‘race to net zero’ will be one of the biggest trends of our time, which will take place over a multi-decade timeframe,” says John. “A huge level of infrastructure investment will be required, which will drive investment opportunities, and as this theme plays out, we can expect to see more and more investment opportunities come to market.”

AMP Capital is bullish on renewables and has already made a number of investments. However, John concedes it still is an evolving area of the infrastructure market.

“Consequently, we continue to be selective about the opportunities we pursue in this space. That’s because there has been a lack of coherency and consistency in the regulatory environment, where renewable assets operate across a number of jurisdictions. However, we do expect this will be resolved over time,” he says.

“There has also been a significant weight of capital pursuing renewable opportunities, which has driven up the pricing. As a result, we’ve seen a number of incidences where some renewables are transacting at prices that are commensurate with the prices we’ve seen on other infrastructure opportunities that have a lower risk profile.”

Nevertheless, decarbonisation is a theme John expects will continue to play out over the long-term. It’s an area that AMP Capital is particularly excited about, which will require a massive amount of infrastructure investment over the coming decades. As that occurs, it will drive more infrastructure investment opportunities.  

Tim agrees that infrastructure in the ESG and renewables space is still in its infancy. However, he adds that most fund managers are now talking about these assets, including how they incorporate them in their investment capability.

“The reality for most managers building fund-to-fund portfolios is that there are limited building blocks to use with ESG aligned real assets,” he says. “There are plenty of ESG equity funds and an increasing number of bond funds, too. However, real assets is certainly an area where we are seeing more discussion around incorporating ESG into existing processes, but at the moment, it remains a challenge.” 

With decarbonisation shaping up as one of the biggest thematics playing out in infrastructure over the next 10-30 years, Trent encourages advisers to think carefully about how they will gain exposure to this thematic in their portfolios.

“In Australia today, we only have about 2 per cent of new car sales being electric vehicles, while globally that’s at 9 per cent. In parts of Europe, it’s over 20 per cent. The biggest inhibitor to the take up of electric vehicles both here and elsewhere, is the infrastructure that is needed behind it.

“So, when investing in that thematic, you can either invest in the car manufacturer or you can invest in the utility that will spend many billions in capital expenditure, put it back into its rate base, and then earn a regulated return on that capex going forward. It’s a different way of investing,” says Trent.

“In our view, utilities are lower risk with a stable return of about a 4 per cent dividend yield, and 6-8 per cent earnings growth each year. We think utilities will be very attractive to investors going forward.”   

John Julian is Managing Director, Global Infrastructure Equity at AMP Capital;

Chris McAlpine is Co-founder/Consultant at Context Capital Consulting;

Tim Murphy CFA is Director of Manager Research - APAC at Morningstar;

and Trent Koch is a Portfolio Manager at First Sentier Investors.

They spoke on ‘The role of property and infrastructure in portfolio management’ at the IMAP Independent Thought Conference - Sydney.

The session was moderated by Marius Wentzel - Head of Client Solutions and Distribution at AMP Capital.