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Infrastructure is used to describe a wide range of real assets. However, at its heart, the term refers to the set of long-duration assets, such as schools, hospitals, roads, power transmission systems and water pipes, that are critical to the operation of a region or economy.
Given their nature, these assets often have monopoly characteristics and are highly regulated. Equally, because of their importance, asset builders/owners tend to be paid based on the availability of the asset, rather than its usage. For example, a hospital needs to be open and fully functioning whether it has one patient or one hundred at any one time. The operator is compensated to reflect this – being paid not on the level of demand, i.e. the number of patients who pass through in any period, but rather on the extent to which the building and services are available.
This is a very important point for the investment case. It is this revenue stability that really decouples infrastructure returns from those of broader financial markets, which tend to be more correlated to the health of the economy and aggregate demand levels. It is what gives core infrastructure assets their diversifying qualities.
Whilst potential returns will clearly vary from asset to asset, our long-term return expectation for the infrastructure asset class is currently 2.75 per cent p.a. over cash1. This positive return arises for two main reasons. First, infrastructure has tended to be a nominal return asset class, with investors requiring at least 6 – 8 per cent to be interested and, as cash rates have fallen, the premium this represents over cash has increased. Second, and perhaps more persuasively, there is a substantial need for infrastructure expenditure and a resulting requirement to attract adequate private capital to facilitate the completion of key projects. This explains why governments allow these high returns to be earned by investors.
Our expected return number for infrastructure has evolved over time. For example, three years ago in June 2016, our long-term expected return for infrastructure was 4 per cent p.a. over cash. The lower expected return we have today is because investors have allocated more capital to the asset class, thus pushing valuations higher over time. Despite these higher valuations, we believe the infrastructure space remains attractive given the substantial need, globally, for infrastructure expenditure.
This demand for infrastructure is high as a direct consequence of underspending over the past few decades. The OECD economies have, in aggregate, decreased real public spending on infrastructure from around 4 per cent of GDP p.a. in the 1970s to around 3 per cent over the 2000s. This lower spending has resulted in a substantial amount of ageing infrastructure, most of which now requires replacing. In fact, the American Society of Civil Engineers gave America’s infrastructure a ‘D’ grade in its latest report card. Further, we are also seeing high demand for new infrastructure from emerging markets and more generally across all countries as a stimulus; it is now widely recognised that spending on infrastructure delivers many ancillary benefits and so a high economic return.
Although demand for infrastructure is high, the supply of capital to fund infrastructure projects, at least from the public purse, has been falling. Governments around the world find themselves increasingly strapped for cash as they look to de-leverage and maintain more austere budgets. Consequently, projects and regulations have often been designed to tempt private capital in, with returns set at attractive levels and risks reduced as far as possible.
For example, US electricity network operators are typically allowed to make a return on equity of 11 per cent by their federal regulator, whilst a recent trend towards decoupling in state power markets explicitly removes the sales volume risk, effectively enabling utilities to make their allowed return whatever the level of power demand in their markets. Provisions to allow the pass through of inflation and any increase in contractor or debt costs have also become more commonplace.
Our Infrastructure Performance – adding value through active selection
Source: Baillie Gifford & Co and S&P. Data to 30 September 2019.
Diversified Growth infrastructure asset class returns v S&P Dow Jones Brookfield Global Infrastructure index returns.
Rebased to 100.
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1. As at 30 September 2019. These are on a passive basis, net of access costs.
As noted earlier, the term infrastructure can be used to describe a wide variety of real assets. Some of those will have the core diversifying, yet high return, characteristics that we are looking for, while others will not. For example, the DJB Global Infrastructure index contains a large number of oil and gas storage as well as airport service companies, which are typically more volatile and offer less diversification2. We focus on a subset of that index, which we think of as core infrastructure.
Holdings by Geography
Holdings by Sector
As at 30 September 2019.
Since our Multi Asset strategies are open ended and offer daily liquidity, and because we wish to be able to change our allocation to the asset class quickly if valuations and conditions demand it, we access core infrastructure by investing in shares of listed infrastructure funds and companies that offer a pure exposure to those real assets. In particular, we have identified a set of 200–250 funds and companies around the world, with a combined market capitalisation of £1.5 trillion, which have both the attractive return and diversification characteristics that we are looking for, as well as good liquidity.
We use quantitative analysis to reduce this core infrastructure universe down to a focus list of around 50 funds and companies, which we follow closely and whose management we seek to meet with regularly.
We research these companies carefully, focusing on the regulatory environment in which they operate; the quality of both their assets and their management; and their current valuation. This research allows us to build a bespoke infrastructure portfolio.
How attractive infrastructure is as an asset class, and whether there are particular stand out valuation opportunities, will determine the number of infrastructure names we seek to own at any one time. However, we would typically expect to hold 20–30 names within our infrastructure allocation. We do not require substantial diversification amongst these names because they are being held as just one part of portfolios that are themselves very broadly diversified across a range of asset classes. However, these names would tend to reflect a mix of different countries and sectors, as the charts on page 8, which shows the current split of infrastructure holdings within our portfolios.
2. These sectors represent 45 per cent of the index and have a 30 year beta of 0.7 and 1.1 respectively. This is significantly higher than our historic infrastructure portfolio beta of 0.2.
The nature of both the real assets and the regulatory contract with the sponsoring government gives infrastructure diversifying qualities which are very attractive to our Multi Asset portfolios. The removal of certain risks, particularly those that bring economic sensitivity, such as volume risk, very clearly reduces the correlation of infrastructure with other economically-sensitive asset classes such as equity or property; whilst the high level of cash flow generated typically means these assets are resilient during downturns.
Investing in infrastructure has many benefits for a multi-asset portfolio in terms of returns and diversification. As investors looking to achieve returns with low volatility however, we must also assess the potential risks of this asset class.
Infrastructure is often perceived to have an implied duration or interest rate risk. The theory goes like this: any move up/down in interest rates is expected (all else being equal) to result in lower/higher valuation. Most infrastructure assets are quite heavily geared (on average between 30 per cent to 90 per cent debt/EV)3 and higher bond yields may also increase the cost of borrowing for infrastructure companies.
In practice, the evidence for a correlation between government bond yields and infrastructure returns is patchy at best. There is no clear directionality in the relationship between yields and infrastructure stocks returns, and past rate cuts have sometimes been accompanied by positive returns for a selection of infrastructure stocks. At other times, the direction of the relationship changed to negative.
Higher interest rates do not always lead to higher debt costs for infrastructure companies (at least not immediately). Infrastructure companies typically manage their debt pretty well and have staggered maturities to help manage refinancing, as well as use derivatives to hedge out the interest rate risk.
For the wider infrastructure universe (as opposed to the kind of infrastructure we own), economic growth is a significant driver of underlying revenues (e.g. cash flows for airports and toll roads will benefit from higher economic growth4). In the case of core infrastructure (the assets we own), higher growth is not an underlying diagnostic factor (i.e. we get paid if hospitals and schools are available for use). Inflation, on the other hand is one to watch. If interest rates are rising, that’s probably because inflation is rising, and up to a point, core infrastructure cash flows should be ok given the explicit and implicit inflation linkages that underpin the revenue generation.
3. At project level. The degree of leverage varies by the nature of the asset. Most investments are structured in such a way that this leverage is appropriate and based on security of future income.
4. The average toll road project cash flow beta to GDP growth is about 0.7x.
Investment in renewable energy is instrumental in achieving global decarbonisation targets. On top of that, there is a clear need for renewable energy generation to balance out the aging fleet of conventional and fossil fuel power generation networks. These factors contribute to a clear demand for renewable energy infrastructure and underpin attractive returns to those investors willing to put in the capital required to make the necessary investments. Stable and attractive returns for investors were underpinned initially by subsidies and increasingly now by long-term corporate power purchase agreements that are a clear testament of the increasing cost-competitiveness of renewable power operators.
PFI funds’ core investment proposition is their underlying assets’ generation of predictable, inflation-adjusted cash flows year in and year out, regardless of the overall health of the economy. Aside from the compelling returns on offer (about 4 per cent p.a. over cash), it is this stability that makes PFI investments a valuable diversifier for multi-asset portfolios. This is not to say that PFI projects are risk-free. Rather, the risks involved in owning such assets – operational and political risks in particular – should be lowly correlated to traditional economically sensitive asset classes such as equities and property.
The views expressed in this article are those of James Squires and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved on the stated date and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
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Annual Past Performance to 30 September Each Year
Diversified Growth Composite Net (%)
Source: Baillie Gifford & Co. GBP.
Past performance is not a guide to future results. Changes in the investment strategies, contributions or withdrawals may materially alter the performance and results of the portfolio.
Ref: 42022 INS WE 0503
James is an Investment Manager in the Multi Asset Team and a member of the Investment Risk Committee. He became a Partner in 2018. He joined Baillie Gifford in 2006, initially working in our North American Equity and Fixed Income Teams. James has been a CFA Charterholder since 2010 and graduated BA in Mathematics and Philosophy from the University of Oxford in 2005.