This article appeared in the June 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Five key reasons the sector's fortunes have turned.
By Nathan Bell, Intelligent Investor
For years, Intelligent Investor avoided Australia's listed infrastructure funds. As with the listed property sector, although the underlying assets were sound they carried too much debt and, all too often, oppressive fee structures and management contracts that encouraged all the wrong behaviours.
While distributions were increasing, many investors, to their cost, overlooked these risks. Then in 2008 when the credit crunch became a fully fledged global financial crisis, everything changed. Distributions were cut, banks forced over-leveraged infrastructure players (with too much debt) to raise capital at deeply discounted prices and the ensuing panic triggered a 53 per cent fall in both the S&P ASX 200 Utilities Index and the ASX 200 Index from their peaks.
Investors with a strong constitution were offered a great buying opportunity. Funds added to Intelligent Investor's buy list at the time included essential infrastructure owners Spark Infrastructure and Challenger Infrastructure Fund, and airport owners MAp Group and Australian Infrastructure Fund.
Investors did not need to pick the bottom for these investments to pay off. But from the market lows in the second week of March 2009, on average they have returned 46.9 per cent, which compares favourably with the 21.6 per cent return of the Utilities Index; the ASX 200 Index has returned 51 per cent.
Using the analytical framework laid out in our special report, The Case For Essential Infrastructure (you can download it free here), weighing up price and value helped to reduce the interference of an emotional response to such turmoil.
The recovery in security prices across the sector shows that infrastructure investments are no longer out of fashion. But there some bargains left.
Intelligent Investor believes that, combined in whatever weighting suits your own portfolio preferences, the infrastructure sector currently makes an excellent income-producing opportunity for up to 10 per cent of your share portfolio.
The infrastructure sector's reversal of fortune is due to five key factors:
1. Less debt
After capital raisings and debt repayments, gearing (debt to equity) levels have fallen. Infrastructure stocks are now safer, on average, but the distributions, while more sustainable, are lower.
Infrastructure funds tend to carry huge amounts of debt. Expanding an electricity network, for example, costs billions of dollars. But without this debt, the returns would be miserable. That does not mean conservative investors should automatically rule out these investments but it is something worth bearing in mind.
2. Better fee structures
Some of the management contracts for infrastructure funds have been redrawn. External management contracts created a conflict of interest between security holders and managers, who typically received a base fee and astronomical performance fees. The foolish use of debt was contractually encouraged, to say nothing of the fees related to (often overpriced) acquisitions. 'Heads management wins, tails you lose' is no longer the norm for many infrastructure funds.
Spark Infrastructure recently internalised management after paying its external managers a one-off $50 million fee. It now has its own management team.
Macquarie Group set its offspring MAp Group free in 2010, but not before receiving $345 million.
3. Reappraisal of recurring income
Third, investors have rediscovered the joys of toll roads, airports, pipelines and power stations. Many of these assets are natural monopolies and subject to some form of government regulation. Cash flows are predictable and defensive in nature. And there is often an opportunity to increase returns by increasing non-regulated revenue. Anyone who has parked at Sydney Airport will understand how this plays out.
Currently, these attributes have a particular poignancy. The global economy is still de-leveraging as consumers pay down debt, and corporate profits are being artificially boosted by unconventional monetary policies. That may change. Having a few highly dependable businesses in your portfolio may be no bad thing.
4. Regulatory certainty
Some funds offer regulatory certainty for many years. With the Australian Energy Regulator recently agreeing on electricity charges for the next five years, Spark Infrastructure security holders can rest until negotiations resume in 2015. In 2009, MAp Group also agreed on airline charges for five years.
5. Takeover appeal
In Intelligent Investor's view, many infrastructure funds are takeover targets. Others have already been taken over. Ordinarily, takeover is not something we would be prepared to bet on. But lower security prices and debt levels, more sustainable distributions and the removal of onerous external management contracts, have triggered a rash of takeovers. There are, however, a few listed assets where, at current prices, it makes more sense for them to be in other hands, such as the Future Fund.
Are you suited to infrastructure?
Because infrastructure funds are usually "stapled securities' - which means there is a trust component in their structure to avoid paying corporate tax - they pay out most of their earnings as unfranked distributions. High yields and reliable cash flows have historically made them the sole preserve of income investors.
Provided the share price compensates today's investor for the higher debt levels compared to other sectors, infrastructure investments should still appeal to conservative income-focused investors. In fact, one reason there are still some bargains around is that many investors find infrastructure stocks boring - even though there is nothing boring about reliable, higher distributions and the prospect of some capital growth.
About the author
Nathan Bell is research director of Intelligent Investor. You can access a free trial.
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