Wednesday 07 Jun 2023
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This article first appeared in Wealth, The Edge Malaysia Weekly on July 25, 2022 - July 31, 2022

Having largely been under the radar over the past two years, infrastructure companies are now back on centre stage, thanks to inflation and rising interest rates, says Ajay Dayal, director and client portfolio manager at ClearBridge Investments. Infrastructure companies are defined as those with technical experience and expertise in infrastructure development.

ClearBridge is a fully-owned investment business of Franklin Templeton, with US$190.7 billion in assets under management (AUM) as at March 31.

“This year, as markets come down, people are starting to recognise the uncertainty risk of rising inflation, higher interest rates and possibly slower demand by the end of the year. They are starting to pivot to companies with predictable growth. Where do you find them? In the infrastructure space,” says Ajay.

“Compared to technology and high growth stocks, a lot of these companies are quite boring. But now, investors once again realise that boring pays. Boring is attractive, especially in a very uncertain world.”

He says ClearBridge has had an infrastructure investment strategy for more than a decade and it manages about US$4.5 billion of clients’ money worldwide. It aims to outperform the OECD G7 CPI Index plus a 5.5% annualised return over market cycles, typically five years.

While the firm’s performance may not be as exciting as that of technology companies when the pandemic was at its peak, its infrastructure investment strategy has done much better than the broader equity market this year. The strategy is currently down about 1% year to date, compared with more than 20% of the S&P 500 and equities globally, according to Ajay. The defensive nature of the infrastructure sector is the key factor that has started to attract more investors’ money.

Dividend distribution backed by predictable earnings is another strong factor, whereby ClearBridge’s infrastructure play aims to deliver 5% income through a market cycle, typically over five years, he says. 

However, not all infrastructure companies are cut from the same cloth. ClearBridge favours those in developed markets as well as those in the utility space with predictable earnings and physical operating assets.

Predictable earnings mean companies that provide utilities such as electricity and water to the public via long-term contracts signed with governments and corporations. They can also be companies involved in the business of energy distribution, instead of power generation, making them less sensitive to market supply and demand.

Top picks and those to avoid

National Grid plc, a British multinational electricity and gas utility company headquartered in London, is a good example, says Ajay.

The company, one of the top 10 holdings in ClearBridge’s infrastructure strategy, distributes electricity and gas through transmission lines and pipelines in the US and the UK. It is not involved in energy generation and is less affected by market supply and demand. It is also a profitable company with predictable returns, with revenue growing at about 7% a year, he says.

“The company has long-term strategic assets and has had a steady level of growth over time. [A return of] 7% a year may not seem a lot if compared with tech companies; it doesn’t look exciting. But in 10 years, the size will double [at that rate],” says Ajay.

He says the company’s assets, especially the transmission lines that distribute electricity, are strategic as the world consumes more electricity each year and more electric vehicles hit the road. Public transport such as trains is increasingly powered by electricity and households in developed nations are using it for their daily activities, such as cooking, instead of gas.

“The transmission lines to distribute electricity have to be strengthened and be more resilient. This is a big growth area, and National Grid is investing more in it over time,” he adds.

Ajay also likes companies with stable earnings and that are well positioned in the renewable energy space. Clearway Energy Inc, one of the largest developers and operators of clean energy in the US, is another that he likes. It is involved in developing, operating and distributing renewable energy, including wind and solar farms.

“It is a very big player in the US. We find that different parts of the US are demanding more renewable energy. Clearway has been effectively selling the thermal oil and gas parts of its business to other investors, thereby cleaning up its portfolio and making itself more attractive by using that money to build more renewable assets. Think wind and solar farms. This is a good stock as well,” he says.

Some investors shun infrastructure companies involved in the oil and gas sector as they consider these companies less green. But Ajay says this may not be the right strategy, especially since the Ukraine-Russia conflict started this year.

He explains that most EU countries have decided to stop using Russian oil and gas by the end of 2022, and these countries are scrambling to secure supplies from other parts of the world. The situation has provided new opportunities to companies in the US to expand their business in the traditional energy sector.

“Some companies we own, including one called Pembina Pipeline [Corp] based in Canada, are looking at extending and creating more pipelines. So, some of these oil and gas products can get to the EU. In many ways, recognising that Russia is not a trusted or accepted supplier for some countries has actually improved opportunities for global energy infrastructure players over the long term,” says Ajay.

“It is a balancing act. We want to be greener. We want to be part of the green evolution. And renewables are increasing over time. But at the same time, the world will not switch off its demand for oil and gas today.”

Meanwhile, knowing what to avoid is just as important as knowing what to invest in. Infrastructure companies that invest in cloud data centres have gained much traction since the pandemic started. But this is one sector that Ajay avoids.

For one, earnings generated by cloud data centres are not predictable as they usually do not lock in long-term contracts with their customers. Second, the barrier to entry becomes lower over time as technology advances and equipment cost falls quickly.

“We look at three things when investing. The service the company provides has to be essential. It needs to own and operate hard, physical assets. And it needs predictability in earnings,” says Ajay. 

“Yes, you can argue that more people are using the cloud, which is essential. Do they have hard, physical assets? Yes, as you need to build data centres with servers. But the issue we have with these is predictability. The contracts most of these companies have [signed] are relatively short term.

“The cost of building these data centres and cloud services has also decreased dramatically. The economics are eroding. If you build a cloud or data centre, your competitor can build another one next door at half the price, maybe after 12 to 24 months. The economics isn’t great as a business. So, although you may be selling what you’re doing right now [at a specific price], the profitability of those companies is unpredictable.

“Again, when we look for infrastructure companies, we want companies with long-term contracts and predictability. This kind of business does not have that, so we avoid them. Avoiding these companies is as important as picking the right ones.”

Infrastructure companies in the utility space are more attractive amid a potential recession. Against the backdrop of fast-rising inflation, especially in the US and Europe, market players are debating whether a global recession is looming or the world will experience slower economic growth. Ajay belongs to the latter camp.

“We are expecting a slowdown. Interest rates have risen strongly, and now the US Federal Reserve expects to raise its base rate to 3.5% at the end of the year. If this is the case, that’s going to slow down economic activities in the US. It is going to increase mortgages, slow down house purchases and investments [made by] some companies,” he says.

An economic slowdown will reduce business activities, with fewer people travelling worldwide and fewer vehicles on the road. The demand for goods and services will also decline. All these will affect the future profits of some infrastructure companies, including those involved in seaports, airports, railroads and telecommunications businesses such as cellular towers.

“You may want to take some profits off these companies,” says Ajay.

Meanwhile, he is investing more in defensive companies which are, again, infrastructure companies in the utility sector that are riding on major trends.

“Their earnings are predictable and their asset growth is based on big tailwinds, such as the decarbonisation trend. The world is moving towards more renewables and clean energy. These companies will be building those [renewable] assets for many years into the future,” he says.

“At the same time, there’s political intent to do so in the EU. Many other countries want to develop more renewable energy power too. They need to meet their net-zero commitment by 2050 or so. To do that, they have to start investing more now.”

The infrastructure sector is slow moving and does not garner much attention from investors. But because of this, there could be diamonds in the rough waiting to be discovered.

“It is slow moving. What’s interesting is that sometimes people look at these utility companies and assume that it is not changing. But if you compare what you assume with what is happening underneath, [you will find that] some of these companies are changing. They are getting rid of things they don’t like, closing down some [power stations] and creating renewables. And yet, the world is not really recognising them, as they are not as exciting,” says Ajay.

Meanwhile, investors who want exposure to ClearBridge’s infrastructure strategy can invest in Affin Hwang Asset Management Bhd’s Global Infrastructure Fund. The wholesale fund, which was launched in November last year, will feed investors’ money into a collective investment scheme, namely Legg Mason ClearBridge Global Infrastructure Income Fund, managed by ClearBridge Investments.

Accessible only to sophisticated investors, the fund has a minimum investment amount of US$5,000 and is offered in four currency classes, namely USD Class, MYR-Hedged Class, SGD-Hedged Class and AUD-Hedged Class.

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