As markets continue to throw out new challenges, risk management and diversification across both stock and infrastructure sub sector becomes ever more critical.
Unlike the previous two economic slowdowns in 2001 and 2008, infrastructure assets have had a higher level of dispersion in returns across sub-sectors during the COVID-19 downturn, forcing many investors to re-visit their underlying assumptions.
With distinct economic drivers often related to the regulated revenue streams, and a localised footprint for their asset base, infrastructure companies such as utilities, transport and telecommunication assets are typically considered to be a more defensive cohort of companies that have a greater level of immunity to local economic shocks.
Not so with COVID-19, where a shock to consumption-based demand tested this hypothesis.
Infrastructure sub-sector returns over March 2020 highlights greater underperformance among those assets exposed to discretionary travel - such as airports and toll roads - while utilities and telecommunication assets have held up well given that the underlying demand for these essential community services has not waned as the situation evolves. The following diagram shows the impact on return for the various infrastructure sub-sectors during the mid-March 2020 period which coincided with the largest drawdowns in equity market due to the COVID-19 pandemic.
Infrastructure performance has recovered since these lows however, this dispersion in the returns of infrastructure assets, or in other words risk, was a cause of concern for some investors. But risk is only one component of the investment equation. The other key aspect of the investment equation is return - both yield and growth. And this is driven by the underlying fundamentals and financial health of these companies.
Historically, the dividend stream that infrastructure assets have been able to generate has been a strong indicator of long-term valuation. The following diagram shows the historical growth in dividends of listed infrastructure companies over a 15-year period overlaid over the market price of the same securities. The figure highlights that the dividend stream of core infrastructure companies has remained reasonably stable, even through the 2008 financial crisis period, and emphasises the importance of these assets to their local market economies.
Given the impact of the recent crisis on the transport and pipeline sub-sectors of infrastructure, some cuts to dividends in these areas have already occurred. In addition, a small number of assets have returned to the listed market seeking to raise fresh capital in order to shore up their balance sheets and help sustain their businesses through this short-term downturn in consumer demand. This capital raising effectively dilutes the investor base which subsequently dilutes dividend distributions to all investors.
So, for some infrastructure assets, this effective decrease in dividend will have a considerable impact on short-term valuations, and the shape of the recovery in this metric will determine the impact on longer-term valuations. But, for the majority of infrastructure assets, such as household utilities, the impact to financials and dividends will be more muted due to the critical nature of the services they provide.
The abrupt economic slowdown as a result of COVID-19 saw central banks across most developed markets signal rates lower in an attempt to re-stimulate local demand in their respective countries.
This change in central bank positioning, coupled with recent price movements and changes to dividend expectations, highlights the importance of assessing the dividend yield of infrastructure assets in both traditional yield terms and also on an excess of cash rate basis.
In traditional yield terms, the dividend yield of global infrastructure assets has remained reasonably stable since 2009 despite having had strong price appreciation over this period. This stable dividend yield, highlights that this price appreciation has been supported by the ongoing growth in the dividend stream of these underlying assets.
Furthermore, assessing dividend yield in excess of local market cash rates allows investors to incorporate the impact of changes in central bank cash rates into the yield picture. By adjusting dividend yield for the cash rate in the country each company operates in, investors gain insight into the ability of these companies to generate cash distributions in excess of their cost of debt funding.
Following the recent downturn, excess yields are now at levels not seen since 2017. So, for investors, this means that having money invested in core infrastructure companies generates an income premium relative holding cash at bank and receiving interest payments. But this income premium comes at the cost of volatility – that is the uncertainty of market movement compared to the relative safety of cash in a bank account.
However, for those investors who are in a financial position to take on this additional market risk, there is the potential to capture price appreciation in the underlying assets in addition to the dividend stream that they generate.
When assessing the potential for price appreciation in infrastructure assets, identifying good quality assets with sound balance sheets, good management practices and that are financially well positioned is an important start. These companies are generally in a better position to maintain pricing power in times of economic stress and this is an important characteristic as investors think about the preservation and growth of their invested capital.
Hence, identifying good quality assets delivering essential service to their local economies is an important return consideration for investors. But as markets continue to throw out new challenges, the other important consideration is risk management. Ensuring appropriate diversification across both individual companies and the various infrastructure sub-sectors coupled with the regular monitoring of each company is critical. Incorporating both these elements allows investors to turn an insightful investment perspective into a well-balanced portfolio that helps preserve and grow the purchasing power of their investment for the long-term.
This document has been prepared by Redpoint Investment Management Pty Ltd (ABN 83 152 313 758, AFSL 411671) (Redpoint), the investment manager of the Strategy, in good faith (where applicable) using information from sources believed to be reliable and accurate and based on information that are correct and estimates, opinions, conclusions or recommendations that are reasonably held or made as at the time of preparation. All information is to be treated as confidential and may not be reproduced or redistributed in whole or in part in any manner without the prior written consent of Redpoint. GSFM Pty Limited (ABN 14 125 715 004, AFSL 321517) (GSFM), is an associate of Redpoint and is the distributor of the Strategy.
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