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Listed Infrastructure: The anatomy of defensive returns

Listed infrastructure has offered investors attractive risk-adjusted returns and lower correlations to traditional asset classes. This outcome has been achieved by delivering steady outperformance during periods of equity market weakness. First State Investments | 28.07.2016 10:25 Uhr
©  Fotolia.de
© Fotolia.de
Fund holdings in most infrastructure sectors outperformed during falling equity markets. Utilities and mobile towers proved particularly resilient. Pipelines, railroads and ports were less defensive than utilities but held up better than global equities due to robust business models and strong market positions. Listed infrastructure consists of real assets that provide essential services, often backed by contracted or regulated earnings. Stable demand and a relatively low sensitivity to the broader economic cycle tend to support infrastructure earnings at times when more cyclical businesses can struggle.

The overall beta of listed infrastructure compared to global equities has been around 0.75 over the long term. Broken down, this has translated to beta of around 0.9 in rising markets, and under 0.6 in falling markets, as illustrated in Chart 1. In essence, delivering most of the upside in rising markets, whilst falling by significantly less than global equities during periods of decline.


Analysing the 15 discrete months when global equity markets fell the furthest, since the Fund’s inception in October 2007, allows a more detailed assessment of how this outcome has been delivered to investors.

The following data compares the performance of global equities during those 15 months with the returns of the Fund. This period encompasses a broad range of market conditions, including the 2008-9 Global Financial Crisis; Eurozone volatility between 2009 and 2011 and concerns about slowing China economic growth rates and rising US interest rates between 2012 and 2016.

Fund performance in falling markets

Table 1 shows the performance of the Fund during those months, ordered by the magnitude of MSCI World declines.

The Fund outperformed global equities on 11 of these 15 down months, resulting in outperformance, on a simple average basis of 1.1% per month.

These details highlight three main points:

-) Sometimes sell-offs can be indiscriminate. In 2008, markets were shocked by the collapse of credit markets and the risk of deep recessions around the world. The flight to safety and the need for liquidity saw equity markets tumble. Fund performance relative to the market in September and October 2008, for example, illustrates that few distinctions were being made between higher and lower quality stocks.

–) As active stock pickers running conviction portfolios, we don’t always get it right. During other months (June 2008 and February 2009) fund positioning counted against us. Our holdings in those months included companies with high quality infrastructure assets such as Transurban and Macquarie Airports. However their debt levels and payout ratios were revealed to be unsustainably high, teaching us a valuable lesson. 

–) Most of the time, listed infrastructure’s underlying characteristics, combined with value-adding active management, enabled the Fund to preserve capital in falling markets. While this outcome is expected, it is encouraging to note the magnitude of outperformance during these periods of very worst market conditions, when investors seek a safe haven.

Chart 2 shows the dispersion of these down markets chronologically, illustrating the difficulty of predicting when they may arise, and emphasising the value of maintaining defensive exposures within a portfolio.

 

 

Performance in falling markets by sector

We can look in more detail at the underlying sectors delivering this outperformance by comparing the average performance of the MSCI World during these 15 months (-6.7%) with the simple average return of the Fund’s holdings, categorised by infrastructure sector, over the same time periods.

For example, the Fund’s tower holdings – the most defensive sector over the sample period as a whole - delivered a simple average return of -1.8% during those 15 months; 4.9% better than the average return delivered by global equities during those months.

Chart 3 shows listed infrastructure sector performance, relative to global equities, during severe market downturns (most defensive to least defensive).

Underlying drivers of performance

The most defensive sector during these 15 down months was towers. Structural growth drivers have insulated these stocks from the ebbs and flows of the broader global economy. The proliferation of smart phones over the past decade has dramatically increased the usage of mobile data, in turn driving demand for mobile tower services. Planning restrictions on tower sites represent effective barriers to entry. Long-term contracts tend to provide for annual price escalators of around 3%, and help to minimise technology risk.

Utilities also held up well. American and British water utilities, which dominate the listed water sector, operate within highly mature markets. They are typically allowed to earn a small premium to their underlying cost of capital, resulting in minimal volatility in each company’s returns throughout the regulatory period.

Gas and electricity utilities delivered significant outperformance. These stocks have very predictable patterns of steady demand underpinning their business models. Transmission and distribution networks tend to be monopoly suppliers of electricity and gas. Pricing is usually set by formal regulation of returns on equity, giving very clear visibility over future earnings streams.

The multi-utilities sector includes companies with power generation segments as well as electricity transmission, gas production/storage and retailing activities. Power generation markets are less regulated and more competitive, which can result in a higher variation of return outcomes, relatively volatile earnings profiles, and potential vulnerability to weaker demand in power markets.

Energy pipelines share prices have lagged since mid-2014 as lower oil and gas prices have impacted the ability of some operators to meet aggressive growth forecasts. However as this analysis illustrates, the sector has traditionally offered effective defensive exposure during broader market downturns. Prices tend to keep pace with inflation while volumes are supported by long-term, take-or-pay contracts.

Railroads, toll roads, ports and airports are hard assets with high barriers to entry and demand profiles that make their customers relatively insensitive to price increases.

North American freight rail companies are unique and valuable franchises. Their wholly-owned track networks are high quality infrastructure assets which can never be replicated. They typically operate under duopoly market conditions, with significant numbers of captive customers such as grain, chemical and auto producers giving them strong pricing power over long haul routes. Improving operating efficiency provides further scope to grow earnings. Trucks represent competition over shorter distances, and volumes are linked relatively closely to economic growth.

Sea ports have historically delivered strong volume growth, reflecting the globalisation of trade. Volumes today are directly linked to global GDP growth rates; with port operators typically demonstrating high operating leverage. Significant trade routes include the import of bulk commodities to Asia and the subsequent export of containerised finished goods. Consolidation in the shipping industry has tilted the balance of power away from port operators to a certain extent.

Airports tend to operate under long-term leases and are subject to some form of regulation. Driven by globalisation, increased wealth and declining real airfares, passenger volumes have historically grown at multiples of GDP. Revenue from privately owned airports is typically well diversified with income from aeronautical, retailing and property services.

Toll roads are typically operated under long-term leases. Revenues tend to be robust, with consistently high operating margins of between 60% and 80%, and can match GDP growth over the long-term.

Price increases are typically linked to inflation, with negotiated compensation for additional capital expenditure.

Airports and toll roads are the only infrastructure sectors that did not outperform global equities during these months. The nature of their businesses gives them some sensitivity to economic growth rates. However, both sectors delivered strong gains during rising markets.

Consistent outperformance through time

Splitting the data into three distinct periods (2007-early 2009; late 2009-2011 and 2012-2016), the same pattern is shown as illustrated in Charts 4-6. This highlights the broad consistency of these defensive characteristics, regardless of the underlying triggers of equity market weakness.

Looking ahead

Global listed infrastructure looks well-positioned to continue to hold up in falling markets. Listed infrastructure companies are in sound financial positions. Dividend payout ratios overall are conservative at around 60% and borrowing levels are reasonable, with average net debt/EBITDA ratios of between 3x and 4x. Debt refinancing at low interest rates has enabled infrastructure operators to reduce rates, lengthen maturities, spread refinancing risks, and diversify funding sources.

The cash yields of infrastructure sectors are higher than dividend yields (see Chart 7) implying ample scope for payout ratios to be raised. This is especially the case for freight rail, toll roads and mobile towers. This balance sheet strength suggests many companies have the potential to carry out share buy-backs, or to engage in M&A activity in order to boost earnings and dividends. Current valuation metrics are also likely to be supportive, as shown in Chart 8.

 

Simple average of 240 stocks in universe. Source: Bloomberg, FSI as at 31 May 2016.

We believe that toll roads, mobile towers and freight rail operators offer exceptional value today. Although this is offset to a certain extent by some stocks, notably in the airports sector, that look expensive on fundamental measures, current valuation levels overall are attractive compared to long-term averages. These metrics are likely to support listed infrastructure’s ability to deliver similar patterns of performance during periods of equity market weakness in the future.

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