(Revises energy weight to 23 percent in fifth paragraph.)
As inflation expectations climb, many investors are looking to buttress portfolios with assets that can hedge against that risk. Publicly traded infrastructure companies can be as effective a hedge against inflation as commodities and real estate, say the growing number of fund managers specializing in such companies. There's one catch: The chosen companies must own and operate toll roads, bridges, or regulated power plants under long-term concessions, rather than merely build them or supply materials for them.
While the fortunes of builders and companies supplying such materials as cement are tied to the ups and downs of economic cycles, owners and operators of core assets such as toll roads enjoy high barriers to entry, stable cash flow in all economic climates, and the ability to increase prices in line with a measure of inflation or economic growth. Many of the companies also offer above-average dividends—the average is about 3.5 percent for companies in the iShares S&P Global Infrastructure index (IGF). That's nearly double the dividend yield for the average company in the Standard & Poor's 500-stock index. Long an investing option for institutional investors through private equity deals, funds focused on global infrastructure have gone mass market in recent years. More than half of the 13 global infrastructure mutual funds that Morningstar (MORN) identifies have been around less than three years. Four launched last year.
Infrastructure as an asset class has underperformed other inflation hedges over the past year, which presents an opportunity, says Aaron Visse, co-manager of the Forward Global Infrastructure Fund (KGIAX). The Standard & Poor's Global Infrastructure index was up 6.9 percent for the year ended Mar. 31, vs. a 34.9 percent gain nfor the S&P GSCI Commodities Spot index and an 18.2 percent rise for the S&P Global REIT index. According to Visse, the infrastructure index's 41 percent weight in European companies was largely to blame for its underperformance, given worries about governments' "ability to finance infrastructure in the age of austerity." Visse says investors forget that a lot of assets are already owned in the public markets and don't depend on government spending. If budget constraints slow government-sponsored projects, it means less competition for existing assets in the foreseeable future, he adds.
Net Inflows Since October 2010
Retail investors seem to be coming around to Visse's view. After experiencing cumulative net outflows from all infrastructure-related funds, excluding utility funds, from March 2010 to September 2010, the funds started reporting net inflows last October. Inflows were up to $563 million by February 2011, according to data from EPFR Global, a Cambridge (Mass.)-based data provider. Money flows into infrastructure exchange-traded funds show a similar shift in investor sentiment. Net inflows averaged $20.5 million from January 2010 through August 2010, jumped to $117.3 million in September, and peaked at $232.7 million in December, according to TrimTabs Investment Research of Sausalito, Calif. Net inflows slowed to just under $120 million in January and rebounded to $154.6 million in March.
A key aspect of an infrastructure company's appeal today is a revenue model linked to the local country's consumer price index or gross domestic product. Two-thirds of the stocks in Virtus Global Infrastructure Fund (PGUAX) benefit from inflation-linked or similar cost pass-through mechanisms, says Connie Luecke, who manages the fund with Randle Smith. Energy represents 23 percent of the portfolio. Four of the top five holdings—Enbridge (ENB), Williams (WMB), Spectra Energy (SE), and TransCanada (TRP)—focus on pipelines that transport shale gas under long-term contracts, with revenues shielded from commodity-price and economic swings.
One Obstacle: Fear of Volatility
Investing in infrastructure isn't without controversy. Institutional investors have largely avoided listed infrastructure companies in favor of private equity funds because of concerns about the stocks' greater volatility. That volatility stems from headline risk, which can prompt sell-offs whenever investors get nervous. This leads to a higher correlation between listed infrastructure and global equities, which may make it a less-reliable diversification strategy, says David Kaposi, global head of the alternatives area at Mercer Investment Consulting, which advises pension funds on portfolio construction.
Brad Frishberg, who oversees $3.1 billion in global infrastructure assets as chief investment officer at Macquarie Investment Management, says that equity-like volatility over the short term in publicly traded infrastructure companies is compensated by the better risk-adjusted returns they provide over global equities in the long term. During the past decade, returns on the S&P Global Infrastructure index averaged 11.6 percent per year, compared with 4.7 percent for the MSCI World index. That's because in rising markets infrastructure stocks fully capture upside gains, while in down markets their losses are just 70 percent of those of the broader equities markets, due to lower cyclicality and stable cash flows, he says.
Forward's Visse likes countries that face deadlines for infrastructure spending. He sees opportunity in Brazil's need to build new airports and highways in time to host the 2014 World Cup and the 2016 Olympics. He holds shares in Cia de Concessoes Rodoviaria, or CCR SA (CCR03:BZ), the owner and operator of a toll road network and one of São Paolo's subway lines. The ability to raise tolls to keep pace with inflation—as well as limited wage pressures, due to a move toward electronic tolling—can boost toll road operators' profits, he says.
China's Car Boom Will Feed Tolls
China is another area with a lot of opportunity, says Frishberg. Toll road revenues will rise, not on the potential for tariff hikes, but through increases in traffic volume now that China is the world's biggest buyer of new cars, he says. He likes Jiangsu Expressway (177:HK), which owns and operates a major highway between Shanghai and Nanjing, which—along with all the roads that stem from it—serves an area of more than 30 million people.
Wireless towers are a favorite of Robert Becker, co-manager of the Cohen & Steers Global Infrastructure Fund (CSUAX). Becker believes the towers stand to benefit most from growing demand for data-intensive devices such as smartphones and tablets. His top holding is American Tower (AMT), whose long-term contracts provide predictable cash flows. American Tower has lots of spare capacity on its towers, which Becker expects to prove increasingly valuable to such wireless carriers as AT&T (T) and Verizon Wireless as they build out their networks.
While most infrastructure fund managers try to avoid cyclical plays, there are exceptions. Some find room for stocks with greater exposure to economic swings if they can be involved in the massive rebuilding to be done in Japan after the country's devastating earthquake and tsunami. Josh Duitz, manager of the Alpine Global Infrastructure Fund (AIFRX), is trying to figure out which cement and other building-materials makers are most likely to benefit from demand. Some companies' stock prices spiked the day after the earthquake, and Duitz doesn't want to overpay. "[Reconstruction] is going to be a several-years process and we want to make sure the names we own are fairly valued," he says.