Infrastructure's game plan

PORTFOLIO POINT: There are three good reasons why infrastructure assets and utilities should be part of your portfolio, particularly if you're not fond of listed property.

When Lizzie Magie Phillips created the game Monopoly in 1904, she did so to warn society about the dangers of concentrated ownership of assets. While competition has found its way to Park Lane, it hasn’t reached most utilities, railroads and other types of infrastructure. This natural monopoly is what underpins the attractiveness of infrastructure as an investment, especially for retirees. Here we’ll explore this asset class and explain the 'what’, 'why’ and 'how’ of investing in utilities and infrastructure.

The 'What’

Infrastructure and utilities are assets (generally listed as the companies that own and operate them), which provide essential services such as distribution of water, electricity and gas; enable transportation (including toll roads, railways and ports); generate and sell energy; support communications; and, in some countries, house people, including prisoners. They are generally long-life assets and enjoy some form of monopoly protection. In exchange, their revenues can be regulated by government, although they are often indexed with inflation. Some assets, such as transportation, operate on a user-pays model, and thus earn more revenue during periods of economic growth. Of the 40,000 or so listed company securities in the world, about 1,000 would be considered infrastructure companies. Locally, there are 34 companies (and some funds) classified by the ASX as belonging to the utilities sector, and a further 26 companies in transport. However, not all of the latter would be considered infrastructure – for instance, ports and railway operator Asciano would be, but airline Qantas wouldn’t.

If you are a highly diversified, growth-style investor, then you might already have a 1% exposure to these assets and not know about it. However, many professional investors go out of their way to increase this allocation. As examples, the benchmark industry super fund Australian Super has more than a 10% allocation and the Future Fund allocates 5%, including timber land.

Infrastructure comes in at least three types: mature, developing and greenfield. The returns from mature assets, which make up the majority of the market, are the most stable and offer the lower risk. Investors in greenfield projects take on the most risk and aren’t always rewarded for it (this includes, for instance, super funds that invested in the Sydney Cross City Tunnel and retail investors in BrisConnections.

The 'Why’

There are at least three reasons to invest in infrastructure and utilities:

1. To improve the defensiveness of your portfolio. While not immune from economic conditions and sharemarket movements, infrastructure and utilities generally fall less in a down market. Conversely, in boom times, don’t expect people to flush their toilets twice as often (meaning share prices won’t move as fast other companies’).

The graph below shows that global listed infrastructure has outperformed international equities and international listed property since the GFC (all currency hedged). In the panic of 2008, global listed infrastructure fell less than shares and listed property (by 6 and 12%, respectively) and in the down market of 2011, it rose 3%, versus shares falling 2% and international property rising 2%. Including dividend income, a dollar invested in global infrastructure at the start of 2007 would be worth the same amount five years later, versus 87 cents in global and local shares and 76 and 45 cents in international and Australian listed property.

Growth of $1 invested in global listed infrastructure, shares and listed property (all currency hedged) since January 2007.
2. To increase income. Global listed infrastructure offers about twice the income of other listed equities. With an extra boost from currency hedging (see Hedging's little extra, February 24 2012), they deliver the same sort of 6-8% income you get from listed commercial property.

3. To improve inflation protection. Most utilities offer a natural hedge against inflation, which can ravage portfolios, especially those funding a pension. Earlier, I included an allocation to utilities in my imaginary Inflation ETF (see How to prepare for inflation, March 24 2010).

Previously, many investors considered property as a prudent diversifier to shares and bonds. Listed property has indeed shown it behaves differently, but unfortunately not necessarily defensively. If you don't believe that past issues with excessive gearing and stapled funds management/property development activities have been repaired, than you should look at infrastructure and utilities as an alternative.

Of course, not all infrastructure assets are defensive. The GFC and its aftermath pose challenges for some to refinance debt. Also, while there has always been regulatory risk, the threat of climate change and carbon taxing needs to be considered, investment by investment.

The 'How’

Infrastructure assets can be owned directly or, where listed, bought on the sharemarket. Your choice creates a trade-off between greater price stability and liquidity.

Many large institutional investors prefer to invest directly in unlisted investments, as the day to day value of these assets don’t change, unlike assets listed on the sharemarket. In falling or volatile markets, this can help reduce the overall decline in a portfolio’s value, and smooth returns. It’s not that the value of these assets doesn’t fall, but that you choose not to know about it until you sell or revalue the asset. It is also true that sharemarkets overreact, which is the price you pay to guarantee nearly 24/7 access to your money.

Investing in higher-risk developing and greenfield projects is usually only possible through unlisted assets, however BrisConnections was an exception – and one probably not to be repeated. Like unlisted commercial property, investments in unlisted infrastructure investments cannot be redeemed in difficult times.

Retail investors can more easily buy companies trading on local and international stock exchanges, or invest in a fund that does so.

There are at least half a dozen specialist retail infrastructure funds available to Australian investors. Those from Lazard, Macquarie and RARE have a five-year track record, with the latter outperforming the S&P Infrastructure index by an impressive 3.6% annually since 2007. The other three funds are offered by Colonial First State, Magellan and Vanguard. Vanguard offers the only index fund option, but has chosen – unusually for its track record – to track a proprietary lower volatility index. Hoping to offer better down-market performance, it shuns eight of the 12 utility and infrastructure sub-sectors. As of yet, there are no Australian listed infrastructure ETFs.

Table 1: Australian global infrastructure fund returns to end of February 2012.

Most funds hold about 30 to 50 stocks. Interestingly, across these six funds, only one in four of the top 10 holdings are common, which suggests they have very different views about where good value lies in this space. Accordingly, few would consider these managers 'index huggers’. A common strategy is to alter the utility stock mix 'up’ in difficult times, and 'down’ in boom times. Another value-add from a professional fund manager may be to de-select those firms excessively re-engineered by Babcock & Brown and Macquarie Bank prior to the GFC. A summary of the top-10 holdings is shown in Table 2.

Table 2: Recent top-10 shareholdings of six Australian global infrastructure funds and number of
funds holding that issue in common, ranked by average % holding.

UK-listed electricity and gas distributor National Grid Plc wins the popularity contest as the most desirable global infrastructure company (in the top 10 holdings of four of six local specialist funds). It is followed by Australian, Italian and European toll road operators Transurban, Atlantia and Vinci. Next are TransCanada, a well-regarded energy pipeline operator, and Southern, one of America’s largest electricity generators.

Despite these funds being run out of Australia and obvious franking benefits with local company investing, only six Australian companies made it into the top 10. They are:
· Transurban – owner of eight toll roads in Australia and the US;
· Spark Infrastructure Group – which part-owns three Australian electricity distribution companies;
· ConnectEast – recently taken over by institutional infrastructure specialist CP2;
· DUET Group – owning a major Western Australia gas pipeline and Melbourne gas and electricity distributors;
· Sydney Airport – earning nearly $1 billion annually from travellers and car parking; and
· Asciano – Australian ports (formerly Patricks) and Australian railway operator.

Earlier Roger Montgomery (ValueLine: Infrastructure, December 1 2010) warned that many Australian infrastructure companies don’t stack up on value metrics, lending support to the idea you should invest part of your allocation offshore. If you don’t want to be an owner of infrastructure, for less risk and return you can instead “a lender be”. Table 3, kindly provided by FIIG securities, shows a sample of fixed-interest rate, floating interest rate and inflation-linked bonds offered by infrastructure suppliers. Allowing for current pricing and assumptions about inflation for those bonds, the yield-to-maturity of these bonds ranges from 6-8%. The higher yields are available should you be willing to lend your money for longer, or to a perceived less-creditworthy borrower. While infrastructure companies are generally considered to be low-risk borrowers, backed by protected assets and long-term income streams, you’ll need to do your own research to confirm that.

Table 3: Sample of Australian bonds issued by infrastructure suppliers.

-Issuer	Maturity/call date	Coupon	Trading margin	Coupon type	Capital structure	YTM	Running yield	Face value
DBCT Finance Pty Ltd (Dalrymple Bay)	9/06/2016	6.25%	2.14%	Fixed	Senior Debt	6.60%	6.33%	$50,000
DBCT Finance Pty Ltd (Dalrymple Bay)	9/06/2016	0.25%	2.40%	Floating	Senior Debt	6.84%	5.20%	$50,000
DBCT Finance Pty Ltd (Dalrymple Bay)	9/06/2021	0.30%	2.70%	Floating	Senior Debt	7.47%	5.76%	$50,000
DBCT Finance Pty Ltd (Dalrymple Bay)	9/06/2026	0.37%	3.51%	Floating	Senior Debt	8.48%	6.62%	$50,000
Envestra Ltd	20/08/2025	3.04%	3.01%	ILB	Senior Debt	7.95%	3.74%	$60,695
Southern Cross Airports Corporation Pty Ltd	20/11/2030	3.12%	3.26%	ILB	Senior Debt	8.25%	4.18%	$58,630
Southern Cross Airports Corporation Pty Ltd	20/11/2020	3.76%	2.85%	ILB	Senior Debt	7.60%	4.01%	$62,505
CitiPower I Pty Ltd	28/02/2013	0.68%	2.87%	Floating	Senior Debt	7.16%	5.26%	$500,000
ElectraNet Pty Ltd	20/08/2015	5.21%	2.92%	ILB	Senior Debt	7.22%	5.07%	$712,850
SPI Electricity & Gas Australia Holdings Pty Ltd	25/09/2017	7.50%	1.35%	Fixed	Senior Debt	5.93%	6.99%	$500,000
SPI Australia Finance Pty Ltd	12/08/2015	7.00%	1.26%	Fixed	Senior Debt	5.58%	6.71%	$500,000
United Energy Distribution Pty Ltd	23/10/2014	0.28%	2.45%	Floating	Senior Debt	6.68%	4.89%	$500,000
$3,094,680
*Current face value on inflation-linked bonds represents the inflation-adjusted face value.

Source: FIIG Securities

For many years, US investors considered utilities to be the perfect “widow and orphan” stocks, because of their regulated business operations and steady dividends. Local market, post-GFC debt complications and possible concerns about climate change (and in Australia, carbon taxing) means that some of the shine has been taken off this asset class. However, I’m sure there is still a case for having in your portfolio utility and infrastructure holdings – equity or debt – which promise above-average income, and inflation and down-market protection. They should prove a safer holding than your technology stocks, despite the fever over Apple Inc at the moment.

Doug Turek is the principal adviser of executive and family wealth advisory firm Professional Wealth.

Financial products mentioned here are referenced for education purposes and don’t constitute an investment recommendation. Please undertake your own research before investing.