Thematic Investing: Infrastructure

There is no denying that infrastructure is a big deal these days: Developed countries desperately need to restore aging systems, and emerging markets need to actually build theirs. As with alternative energy, government stimulus funds can only add to the attraction of this sector. Infrastructure investing can offer an appealing opportunity to pursue long-term, stable, inflation-protected cash flows along with potential diversification of a traditional portfolio.

An infrastructure story will be a recurring theme associated with emerging markets, but infrastructure development is literally and figuratively the road that leads a country to prosperity, no matter the status of one's economy.

What are Infrastructure Investments?

Infrastructure assets are the physical structures, networks, and other facilities that provide services essential to economic productivity. Traditionally, these have included transportation assets (roads, bridges, tunnels, railroads, seaports, airports) However, the definition has become broadened in recent years to go beyond the heavy weighting towards utilities and transportation and include communications assets (radio, TV towers, wireless networks, cable systems, satellite networks), regulated assets (electricity transmission, utilities, water systems), and social assets (schools, hospitals, prisons, courthouses) and even financial services.

Today, the real infrastructure story is in the emerging markets; emerging markets and infrastructure go hand in hand. What we take for granted in the developed world is currently in high demand in the emerging world. The most basic essential services such as access to nourishment, education, higher end consumer goods and health care are necessary before an individual can become a part of a vibrant middle class. For such an environment to exist, they need a place to live and the means to get to and from work. Jobs in the public and private sectors will expand and this will result in greater energy demands to keep operations running. For the society to be truly enhanced there will need to be a technological infrastructure in place to keep up and potentially compete within the broader globalized world. This tapestry of sectors being pulled together starts and ends with infrastructure.

For investors, tangible nature of infrastructure makes it an attractive category to add to portfolios. In times like now where risk aversion is high, investors do not simply limit their greed in favor of fear. Rather, they prefer something more real and tangible. Investors need a simpler reason to invest. Infrastructure is about development at the most basic level and in a way that is visibly more constructive for the individual and for the society overall.

Infrastructure as an Asset Class

Asset classes and categories are currently being redefined. Questions are being asked like, what is the equity risk premium forecasted for US stocks as an asset class altogether? What are the long-term yields for fixed income for developed? How does one define hedge funds and is it an asset class? Where does gold fit (dollar hedge, inflation hedge or Armageddon hedge)? Investors need categories that are simple to understand, make intuitive sense and allow for capital appreciation, yield enhancement and some sense of security in order to construct portfolios for today's environment.

Infrastructure investing has exploded since the early 1990's starting with some Western European countries and added strong interest from Australia and Canada. Infrastructure is often considered as the new, long-term, inflation-linked asset class that parallels real estate and private equity. It can also be considered a key alternative asset to complement traditional stock and bond holdings. The idea of infrastructure investing is not new. Historically it has in fact raised entire nations and can be considered one of the oldest forms of investing. Today, the reasons for interest in infrastructure are also plentiful:

• visible long-term earning streams
• natural inflation hedge since it is a real, tangible asset
• government sponsored projects means a solid partner leading to an investment displaying monopoly/oligopoly characteristics
• highly uncorrelated to other asset classes

The Market

The global infrastructure market is roughly $20 trillion worldwide. Interestingly, the private portion of this market remains quite small. Current estimates put the global value of privately owned or privately controlled infrastructure projects at $200 billion, or 10%, at most. This may be due to the fact that governments wish to limit foreign dominance in infrastructure which is obviously a key sector. However, with the outstanding demand in emerging markets due to its demographic backdrop, the reality is that there are too many infrastructure needs for the growing populations entering the global middle class. This is a middle class that may not be buying multiple flat screen TVs but they are buying their first mobile device. They're actually purchasing their first car as opposed to downsizing vehicle size and numbers here in the United States. Think about the mobile phone towers and roads that need to be built just for these two examples. Then consider how increased paychecks turn into improved diets and healthcare -- again the extrapolation possibilities for infrastructure are enormous.

At the beginning of this document, I suggested that infrastructure can include other industry sectors. Consider telecom and a recent cover story from The Economist (The Power of Mobile Money, Sept 24, 2009):

"Once the toys of rich yuppies, mobile phones have evolved in a few short years to become tools of economic empowerment for the world's poorest people. These phones compensate for inadequate infrastructure, such as bad roads and slow postal services, allowing information to move more freely, making markets more efficient and unleashing entrepreneurship."

Clearly, like water sanitation systems and roads, a mobile device for many in the world (emerging or developed market citizen) is a necessity and in fact the systems that facilitate communications are a key part of a society's infrastructure. This article further explores the future of financial services through the mobile device. They are truly emerging markets when the sophistication of banking services for the ordinary consumer is at par (or above) those in the developed markets:

"Across the developing world, corner shops are where people buy vouchers to top up their calling credit. Mobile-money services allow these small retailers to act rather like bank branches. They can take your cash, and (by sending a special kind of text message) credit it to your mobile-money account. You can then transfer money (again, via text message) to other registered users, who can withdraw it by visiting their own local corner shops. You can even send money to people who are not registered users; they receive a text message with a code that can be redeemed for cash."

Without the effective movement of cash and credit, a society cannot effectively operate. Thus, this convergence of telecommunications and financial services provides a key infrastructure need for the growing and highly educated consumer class of the developing world. In fact, there's good reason to limit the use of the term "developing" for these regions. In many ways, they are quite highly developed. Normally, infrastructure projects are so massive that the government's tax revenues need the support of outside investors who are sophisticated enough to understand the various risks associated with the long-term nature of such investments. Thus, those involved with financing private equity funds and the large pension plans have traditionally been the key players in financing infrastructure projects. These investors have time horizons that better match the length of time needed to plan and execute complex projects especially given the uncertainties related to population shifts, economic growth patterns and the simple supply/demand curves as a result of this.

Obstacles & Opportunities

Although the global infrastructure market is sizable (~ $20 trillion), the private portion of this market remains modest. Current estimates put the worldwide value of privately owned or privately controlled infrastructure projects at $150-$200 billion. However, given that the overall infrastructure market remains small, highly fragmented, and complex, investors should keep in mind that successful execution may depend on the combination of very costly resources with highly specialized expertise.

Opening infrastructure projects to private investment or "P3s" (Public-Private Partnerships) clearly supports the funding gaps that governments are often left with. They also provide the means to extend funding dollars as many projects get extended in terms of time and money.

Opening infrastructure projects to private investment or P3s (Public-Private Partnerships) clearly supports the funding gaps that governments are often left with. They also provide the means to extend funding dollars as many projects get extended in terms of time and money.

Infrastructure investments tend to be less sensitive to interest rate risk and are less prone to being affected by gyrations in the equity markets. Of course, a slowdown in the economy will have an effect on infrastructure spending. However, when considering key services these cuts often occur last. Furthermore, in times of great distress, infrastructure spending aligns well with Keynesian monetary policy and is what we see happening today in both the US and China. Therefore, compared with real estate, they are less sensitive to the economic cycle, with limited fluctuation in the underlying asset's value. Historically, there are three forms of infrastructure investments.

Private Equity

This is the most common and offers investors a return premium (and diversification benefits) due to the illiquid nature of such long-term oriented investments

Publicly-Listed Equity Investing

This has increased in popularity in the past several years. Typically, greater liquidity relative to private markets generally results in a lower expected return versus private equity; however, given the illiquidity lessons of 2008, it may be a price many investors are willing to accept.

For example, in 2007, Brazil launched a four-year plan to spend $300 billion to modernize its roads, power plants and ports. The development of modern infrastructure and middle-class amenities has helped Brazil establish credibility as a progressive nation and future economic leader.

Now comes the important part, how to capitalize. One way would be to move to Brazil and invest in a textile plant or soybean farm. That actually sounds like a lot of fun, but might not be realistic for most of us. Here is an easier way; buy Brazilian stocks.

There are plenty of great Brazilian stocks that trade as American Depository Receipts (ADRs) on American exchanges, providing a nice dose of transparency and regulation to a less familiar investment destination.

The ETF Approach

An indexed approach via an Exchange Traded Fund (ETF) provides the liquidity, transparency and diversification many investor classes likely require for entry into a new asset category. Since ETFs are usually listed on the largest exchanges and have underlying market makers who are compensated to provide ongoing liquidity, they are useful portfolio management tools in the infrastructure space.

Large pension plans make considerable investments in infrastructure projects. Their unique size gives them clout that comes with such size; they can access infrastructure projects ahead of other investors and have the means (manpower, dollars) to execute. For investors with less than $50 billion in investable assets, infrastructure investing means something else. The problem for investors lies with the lessons of 2008. Not being able to exit a strategy can truly kill an investment plan. Like hedge funds, infrastructure funds can have parameters that wouldn't allow investors to exit when they may want to. Furthermore, many investors simply don't have the means to build the experience and brain-trust needed to execute a proper infrastructure sub-portfolio. Hence, the benefit to infrastructure investing via an ETF.

Debt Instruments

This is also a very common method for funding infrastructure projects (think about  municipal bonds and their purposes). Such issues can have measures that allow for the yield and security of the instrument to be tied directly to performance of the project. Furthermore, many instruments can have enhanced features to sweeten the deal for investors. For example, a privatized toll road can have returns dependent in some manner on traffic flows. Given whether it is stability of capital value, inflation-linked cash flows, low correlation with other asset classes or differentiated risk factors, infrastructure investing makes sense in a robust portfolio. Of course, when considering the differentiated risk factors, investors must realize that infrastructure introduces new and unique risks not common with other asset classes such as project risk, political and regulatory risk specific to a particular country as well as illiquidity risk. The upside is that infrastructure assets can be both return enhancing and risk reducing at the same time.

We look to inclusion of infrastructure in our clients' portfolios as they are designed to generate stable, long-term returns. Infrastructure assets have a long economic life and offer low-risk, reliable returns linked to inflation in order to help pay "dividends" for decades. We look for businesses and opportunities in regulated industries that will provide stable returns with low risk. We find good investment opportunities in jurisdictions that have a fair and transparent regulatory framework, creating a strong environment for private investment. Additionally, we realize there is a need to provide returns in a low yield (cash/bond) world means gaining higher than normal exposure to equity markets and real assets to recoup losses from the devastation of 2008.

Conclusion

Recently, the International Olympic Committee announced that Rio de Janeiro, Brazil had won the right to host the 2016 Summer Olympic Games. Using history as a guide, we can see how Japan, South Korea and China have used this event to fast track their infrastructure agenda and push their economies into the modern age. Unlike other investments, infrastructure and the emerging markets are both long-term stories providing investors the potential to ride a long wave of prosperity.

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To learn more, read our Introduction to Thematic Investing. We strive to identify global themes that we believe are most likely to be important long-term drivers of the global business environment. Then we use intensive fundamental research and a wide array of quantitative tools to invest in companies that stand to benefit as these themes unfold. We believe this approach we help us to steer clear of trouble and stay focused on what's working, and making money.

Green Valley Wealth Advisors | Nov. 19, 2009

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