Low rates emphasise the virtues of long-term assets

This column does not stray Down Under too often, barring an occasional foray into the world of mining, but the A$6.3 billion (£3 billion) bid for Asciano from a consortium trying to head off a rival Canadian approach catches the eye. The potential target is an Australian rail and port operator and in an era of low growth and record-low interest rates it is easy to see why the Qube-Canada Pension Plan Board-Global Infrastructure partners grouping is keen to swallow it whole and elbow Toronto's Brookfield Asset Management out of the way at the same time.

Infrastructure assets come with almost guaranteed demand and while pricing tends to be tightly regulated, this at least provides a fair degree of predictability to the steady cash flows on offer. These characteristics are potentially very attractive, as those cash flows can either:

• fund dividends or coupons and provide yield to investors, private or institutional
• be used to meet potential liabilities for financial buyers and provide steady returns to income-starved pension funds
• fund the cheap debt that can be used to pay for the deal, in the case of trade buyers seeking diversification or expansion of their asset base

The potential on offer is not going unnoticed. According to data from IJGlobal, 2015’s merger and acquisition (M&A) activity in the European infrastructure arena – defined by the consultants as transport, telecoms, water and social and defence – looks set to match or even surpass the record levels of 2007. Nineteen deals worth $17.1 billion were struck in the first half of this year, compared to 17 deals valued at $32.4 billion across the whole of the peak year.

Infrastructure M&A boom

Source: IJGlobal

Investors can view this rash of activity in two ways:         

• They can accept this as a strong indicator that the infrastructure sector still offers good value and seek ways to access it, especially as pension funds, sovereign wealth funds, insurers and financial investors mean there is no potential shortage of buyers at the moment.

• They can adopt the opposite stance and argue the bid frenzy is a sign of an overheated market, where record-low interest rates helping (or obliging buyers) to take on more risk than is ideal in a reach for yield.

Whatever their views, investors will recognise that infrastructure is a long-term investment and one that is perhaps best suited to a mandate that focusses on income. Anyone seeking access at least has plenty of options. There are around half a dozen OIECs from which to choose, although they do not all have a five-year history, while clients can also assess the merits of seven specialist investment trusts and a quintet of Exchange-Traded Funds (ETFs). Note the investment trusts tend to invest in actual projects while the ETFs and OIECs buy stakes in quoted companies that specialise in infrastructure. The investment trusts have, in some cases, offered superior performance and come with good yields, too, but they tend to come with higher fees and in some cases some very chunky premia to net asset value (NAV).

Best performing Equity Infrastructure OEICs over the past five years

Source: Morningstar, for Sector Equity Infrastructure. Where more than one class of fund features only the best performer is listed.

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Best performing Infrastructure investment companies over the last five years

Source: Morningstar, The Association of Investment Companies, for the Sector Specialist: Infrastructure category.

* Share price. ** Includes performance fee

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Best performing Equity Infrastructure ETFs over the last five years

Source: Morningstar, for the Equity Infrastructure category.

Where more than one class of fund features only the best performer is listed.

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Rate of return

One issue to note is the role of interest rates, especially now that October’s bumper American employment figures leave the US Federal Reserve with few if any credible excuses not to raise headline borrowing costs when it next meets on 15-16 December.

Long-term, cash-generative assets such as infrastructure stocks are well suited to the valuation method known as the discounted cash flow. This forecasts future cash flow over the long-term (at least 10 years) and then establishes the present value of those prospective returns by discounting back using a weight-adjusted cost of capital (WACC), which attributes a cost of equity and debt and the mix of them used by a firm to fund itself.

The calculation is sensitive to the interest rate used to help establish the WACC. Low interest rates mean higher valuations for the infrastructure provider and higher rates should therefore in theory mean lower valuations.

A Fed rate hike on 16 December could therefore be a negative for infrastructure funds but the tricky bit is finding decent historical data to back this up, as the last interest rate in the UK and US came in 2006 and the last upward turn in a rate cycle came in 2004. None of the OEICs, investment trusts or ETFs listed in the performance tables above ETFs has a history which goes back that far.

It is possible to use the FTSE All-Share’s Electricity and Gas, Water & Multi-Utility sectors as infrastructure proxies, albeit in the knowledge other factors will have influenced share prices and valuations, notably the UK’s regulatory structure and the regular pricing reviews. The charts below look at 10-year Government bond yields to try and account for how the market will anticipate an actual rate rise from the Bank of England.

The results are inconclusive although a rise in bond yields in 2015 does look to have put on the brakes on for both gas/water and electricity stocks.

The relationship between bond yields and UK utility stocks ….

Source: Thomson Reuters Datastream

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

…is far from clear-cut, over a 20-year period.

Source: Thomson Reuters Datastream

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Investors looking for a long-term source of income and cash flow may therefore take some comfort from these charts, especially as any increases in the UK base rate are likely to be well-flagged in advance and come in small, incremental steps, although divining exactly how markets may respond to the first tightening of monetary policy in a decade remains an art rather than a science.

Russ Mould

AJ Bell Investment Director