Infrastructure has become one of the most sought-after asset classes in recent years. In a world of low and even negative interest rates, infrastructure investments provide stable cashflows that are often linked to inflation.
However, the very definition of ‘infrastructure investment’ is shifting. Historically, listed infrastructure companies were heavily regulated utilities that enjoyed monopolies in their respective markets. But over time, investors have expanded the definition to include more exotic businesses, most of which have been unregulated and have therefore offered the potential for higher returns. The downside of this expansion of the definition is that these companies also typically have more volatile business models and consequently are riskier investments.
The distinction between ‘core’ infrastructure in the strictest sense and infrastructure in a wider sense is accordingly a very important one. In order to qualify as a core infrastructure investment, a company should have:
- consistent and predictable cashflows, often arising from long-term contracts and regulated revenue streams; these cashflows should be inflation-linked, either through regulation, contractual arrangements or pricing power within the area of its operations
- high operating margins and low operating leverage in order to not be too dependent on economic and market conditions
- a natural monopoly, either through regulatory guarantees within a region or country or through a dominant market position.
As a result, the company’s earnings should be non-cyclical and have a low correlation with overall economic activity.
In contrast with this, companies that are typically included in common infrastructure indices and the wider definition of listed infrastructure include:
- power producers and power retailers that are operating in unregulated markets and are thus subject to substantial price volatility
- contracting and concession businesses that are reliant on debt financing and subject to shorter contract maturities, and thus exposed to higher share price volatility
- logistics and shipping companies, which are considered to be industrials rather than infrastructure and often operate with low margins in a cyclical environment
- bus and railway companies that own the rolling stock but not the tracks; the contract lengths for these operators are typically shorter, which exposes them to more volatile cashflows
- companies operating in emerging markets where operational, regulatory and environmental, social and governance risks are higher
- data centre operators and telecommunications service providers that do not have real monopoly positions and are subject to market competition.
The companies classified above as non-core infrastructure have higher stock price volatility than the core infrastructure businesses. This shows that a strict definition of core infrastructure can be an effective means of reducing investment risks.
With all the talk about the reduced volatility of core infrastructure stocks, one might wonder if we are not putting too much emphasis on the ‘risk’ side of the coin while ignoring the ‘return’ side. Traditional finance theory predicts that in order to achieve higher returns, an investor must accept higher systematic risks. Accordingly, the higher beta of non-core infrastructure companies should be compensated by higher returns in the long run. However, over the last couple of decades it has become clear that there are systematic deviations from the predictions of traditional finance.
Sweet and low
One such deviation is the low beta or low volatility factor. Historically, stocks with lower volatility or lower market beta have outperformed stocks with higher volatility. Since 2010, Hedge Fund Research has calculated the performance of a systematic approach to investing in low volatility stocks. Since its inception, the yearly performance of the low volatility stocks has been 4.5 percent higher than the performance of the MSCI World benchmark.
This anomaly can also be observed in the listed infrastructure market. Since 2009, the more defensive FTSE Core Infrastructure index has persistently delivered higher returns at a lower level of volatility than the broader S&P Global Infrastructure index.
A strict definition of what is and is not ‘core infrastructure’ provides two main benefits. Firstly, by restricting the investment universe to companies with stable, inflation-linked cashflows and natural monopolies, the investor can generate stable returns in a portfolio and suffer lower drawdowns than with stock markets overall – as well as more conventional approaches to infrastructure investing. Secondly, by exploiting the low volatility anomaly in stock markets, the investor has the potential to generate higher returns than would be the case with conventional infrastructure investments.
Core infrastructure investments are clearly superior to non-core and worthy of serious consideration for investors trying to diversify existing equity holdings.
Ursula Tonkin is head of listed strategies and portfolio manager of the Listed Core Infrastructure Fund at Whitehelm Capital.