Pension funds have been increasing their allocations to infrastructure since the GFC to build robust portfolios for the long term. So how have the defensive aspects of this asset class held up under the turmoil caused by COVID-19?
Infrastructure is an asset class that seems to be naturally aligned with the investment horizons of pension funds. It provides a steady and transparent income stream, often backed up by regulations and government support, which makes it less susceptible to economic shocks.
It is, therefore, unsurprising that investors have increased their allocation to this asset class since the global financial crisis.
But now that markets have been disrupted by the onset of COVID-19, have these defensive qualities of infrastructure played out?
4D Infrastructure (4D), a Bennelong Funds Management boutique, is an asset manager specialising in global listed infrastructure stocks.
“We talk about infrastructure as being a defensive asset class and that is because of its defensive fundamentals. However, in reality it is still an equity, so when we have markets haemorrhaging like we’ve had recently, then we will be sold off too,” Sarah Shaw, Global Portfolio Manager & Chief Investment Officer at 4D says in an interview with [i3] Insights.
“The March selloff was indiscriminate – fundamentals did not drive the selloff. As equity investors we are not immune to these times of extreme market volatility,” she said
Whilst markets can be volatile in the short term, the question is whether the disruption has changed the ability of infrastructure as an asset class to provide defensiveness over the long term?
“The asset class has defensive, long term fundamentals and importantly within the asset class you have distinct and economically diverse sub sectors, which means that, when the dust settles, you can position an infrastructure portfolio to capitalise on the prevailing economic conditions.
The market was irrational following the global contagion of the virus coupled with a sudden commodity shock. But in terms of underlying earnings drivers and value upside, a diversified infrastructure portfolio can be positioned for both short term cyclical events, as well as the long term, structural opportunity that is infrastructure
“I am not necessarily talking about short term market moves, because the market was irrational following the global contagion of the virus coupled with a sudden commodity shock. But in terms of underlying earnings drivers and value upside, a diversified infrastructure portfolio can be positioned for both short term cyclical events and the long term, structural opportunites. We are looking for a demographically and asset diverse portfolio of high quality infrastructure assets supported by strong management teams and robust balance sheets”, Shaw says
4D divides the asset class into two distinct subsectors: User Pay assets and Utilities. Each sub sector has its own risk profile, Shaw says.
“One is the essential services, so that is your gas, power and water utilities. These are the assets that from a fundamental earnings perspective, are relatively immune to economic shifts as a function of them being a basic need as well as the structure of their regulatory environment.
“In weak economic environments, in which we could be over the next few quarters, the earnings of these assets will hold up relatively well. They are really good assets to hold in weak economic conditions, because you can still see earnings growth supporting an attractive income yield.
“On the other hand, we have what we call ‘User Pay’ assets, which are airports, ports, roads, rail and communications infrastructure. Now, these assets are correlated to economic conditions; economic growth will drive volumes and inflation will drive tariffs or tolls.”
“So, while you still get the defensive characteristics of infrastructure, such as monopolistic assets, inflation hedges and contracted earnings, you are exposed to volume driven metrics. These are the assets that you want to be exposed to in buoyant economic environments such as the last couple of years.
“These are also the assets you want to own when countries are recovering from the COVID-19 shock and we are seeing an economic rebound,” she says.
Establishing 4D Infrastructure
Shaw first got involved in the infrastructure asset class in London, where she spent seven years researching communication assets across developed and emerging markets, before moving back to Australia.
“In 2005, I returned home to Australia and I was really looking for the next opportunity. I was quite keen on communications and I was very keen on the emerging market opportunity. The characteristic I really liked when analysing communication stocks is that real assets define their earnings stream.”
“At that time in 2005, the sector that we now call ‘listed infrastructure’, was very new. It was in its infancy and I had the opportunity to get involved at that infancy, and take the experience I developed in communications to all other forms of infrastructure, whether it was a toll road, an airport or a utility.
“These asset values are all fundamentally driven by monopolistic market positions or ones with high barriers to entry, earnings under pinned by contract or regulations, very long asset lives with high upfront capital investment but then very low maintenance requirements and scale advantages driving long term earnings profiles.
“These characteristics support long term cash flow profiles and I very quickly developed a real love for the sector,” Shaw says.
Shaw launched 4D Infrastructure in 2015 with business partner Greg Goodsell, who is the Global Equity Strategist.
“There was a lot of work behind the scenes by Greg and me before we became a Bennelong boutique. Firstly, we had to establish whether listed infrastructure was the place to be, or whether we were too late to the party.
“We decided quite quickly that, while we might not have been the first mover in the listed infrastructure space, there was still a huge opportunity set here and we were definitely not too late to build a successful business.”
“At the time, our universe of potential stocks was about US$2 trillion, but there was only around US$50 billion in the hands of dedicated infrastructure managers globally. As of January this year, our infrastructure stock universe had grown to approximately US$4 trillion.”
As a strategist, Goodsell does detailed in-country analysis, before 4D even looks at companies operating in that country, to determine whether the conditions are right for infrastructure projects to flourish.
“We look at a country, the way other people would look at a company,” Shaw says. “This is Greg’s area of expertise. He assesses a country based on financial, economic and political risk as well as ESG factors. A detailed research paper is compiled on each of 4D’s focus countries and updated as things change. His work determines whether the country is an acceptable investment destination,” Shaw says.
In the US utility space, there is a huge need for replacement spend, as well as investment in the energy transition, which will drive asset returns for a very long period of time. These returns are further supported by the incredibly low interest rate environment. We expect this low interest rate environment to stay low for longer
Goodsell has developed a simple traffic light system to reflect the assessed risk in each country. Green is an acceptable investment destination, while Red is completely uninvestable at that point in time. Amber rated countries are either improving or deteriorating.
“They are not completely a slam dunk in terms of the investment proposition; they are still investable, but warrant a higher risk assessment,” Shaw says.
A further component of the country analysis is to identify the directional shift of that country: is it moving in a positive trajectory or more negatively?
“Depending on its traffic light assessment, we then ask the question whether we want to be in User Pays in that country, or is it a weaker economic environment and do we want to be in the more economically immune, regulated Utilities?”
This analysis is also supported by investable themes, such as the energy transition that is taking place around the world or the emergence of the middle class in developing economies.
“Once we’ve got that country analysis in place, it gives us direction as to where we want to focus our stock analysis,” Shaw says. “When we are looking at a company, we want it to capitalise on the opportunity set in its country. We want it to recognise the thematics that are driving infrastructure need and investment.”
“From a stock perspective, we are judging companies both on a quality basis, including how well they are positioned in their market, their asset class, their management team, as well as the value proposition.
“So we look to build a portfolio of stocks which offer both quality and value. Pre-COVID-19, while we could definitely find quality in utilities, we struggled to find the value in certain regions of the world. Post the selloff, our opportunity set has expanded as we see both quality and value available.
“For example, in the US utility space, there is a huge need for replacement spend, as well as investment in the energy transition, which will drive asset returns for a very long period of time. These returns are further supported by the incredibly low interest rate environment. We expect this low interest rate environment to stay low for longer,” she says.
4D specialises in global listed infrastructure, which is more volatile than its unlisted cousins. However, it also means it has much better liquidity than unlisted assets and in times of stress this can become important.
“Unlike in the unlisted space, where you buy an asset and are locked into this asset, in the listed space we can position our portfolios to capitalise upon the prevailing economic conditions. We can also capitalise on the volatility to add to over-sold positions adding alpha over an investment cycle,” Shaw says.
“Before COVID-19 became a pandemic, we were positioned for 2020 to be a relatively solid year, economically. We were talking about a growth environment, slower than the last few years, but still a growth environment.”
“Inflation certainly wasn’t getting out of hand, and interest rates remained low. All of that was very supportive of infrastructure as an asset class,” she says.
“We went into the crisis overweight User Pay assets and overweight Europe and emerging market assets. Part of the reason why we were underweight Utilities is not only the economic positioning, but also the fact that we believed they were overvalued in a lot of jurisdictions. US utilities, for example were trading at all-time highs.”
“Our portfolio positioning was the result of not only our economic outlook, but also of the need to find value. If we couldn’t find the value in Utilities, I wasn’t going to own them just to own Utilities. That obviously shifted in March and we now see significant value everywhere,” she says.
But that doesn’t necessarily make picking assets an easy task, Shaw says.
“At the moment we see real value and real quality globally in many sectors and sub sectors and we are now spoiled for choice.
“One of my biggest concerns now is that pension funds or unlisted infrastructure funds with cash piles will look to the listed equity market for opportunities, as stock valuations are depressed both in absolute terms and relative to unlisted infrastructure valuations. As these investors have a much longer term view and they know the quality of these assets, they might think that this is the ideal time to sweep them up.”
While a one-year earnings hit will impact this valuation [of an airport], for 50/60/75-year duration assets, a one-year hit does not justify a 35 per cent drop in value. Our view is premised on the fact that this is an event-driven earnings shock, not a long-term structural industry shift.
For those funds that want to ensure their portfolios are a bit more conservatively positioned, Utilities are currently the space to be in, Shaw says.
“In this environment, with a few quarters of weak economic growth ahead, I would increase my position in Utilities given their now attractive value proposition. However, we are still longer term value investors, and some of the User Pay assets have been completely oversold and, as such, we won’t be selling out of these assets at these depressed price levels.
“We are working to balance near term economic threats with long term value opportunities to create a diversified portfolio of high quality, global listed infrastructure equities.”
“I’ll use an example of airports in this environment. The grounding of flights has an immediate impact on revenues and, given airports are a high fixed-cost business, the impact to the bottom line is even greater.
“This impact is clearly real and warrants a correction in valuations. What should that correction be? 4D (along with other infrastructure investors) values these assets using a long-term, discounted cash flow methodology to determine an intrinsic fair value for the stock.
“While a one-year earnings (cash flow) hit will impact this valuation, for 50/60/75-year duration assets a one-year hit does not justify a 35 per cent drop in value. Our view is premised on the fact that this is an event-driven earnings shock, not a long-term structural industry shift.
“We believe that while COVID-19 is causing significant disruption and earnings impacts globally, it will resolve and life will return to a new normal. We also believe the long-term structural opportunity for airports remains intact and traffic will recover and with it, earnings,” Shaw says.
This article is paid for by Bennelong Funds Management. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.