128. Why infrastructure investing is poised for great things

22 April 2021 (pre-recorded 19 April 2021)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Ryan Lightfoot-Brown (RLB): Hello and welcome to the Investing on the go podcast brought to you by FundCalibre. I’m Ryan Lightfoot-Brown and today I’m joined by Alex Araujo, the Elite Rated manager of the M&G Global Listed Infrastructure fund. Alex, thank you very much for your time today.

Alex Araujo (AA): Hi Ryan, good morning, pleasure to be here.

[INTERVIEW]

[0:19]

RLB: Now, your fund invests in three different types of infrastructure, they’re economic, social and what you call, evolving. If we could just go through each of those in turn, maybe a few examples to help bring that to life for our listeners? Firstly, what are the type of companies that are included under the economic category?

AA: Right. Well, Ryan, this is the broadest exposure and in fact, the largest exposure in the fund – it’s typically around two thirds of the overall exposure of our strategy and it spans three sub sectors. So just to make things slightly more complicated: utilities businesses, energy infrastructure and transportation infrastructure. So, think of the, sort of, for lack of a better term ‘old economy’ or real economy type infrastructure assets.

So within utilities, which is an extremely important area for us, you have everything from electricity generation to water to waste and recycling and so on. So an example there, and this is a global strategy, so perhaps I’ll give you an example of a sort of a faraway business, which would be a company we invested in last year, that’s listed in Hong Kong called China Gas Holdings, which is involved in making connections and distributing natural gas within China to industrial and household users, which is actually quite an interesting decarbonisation initiative because it displaces the use of coal.

Within energy infrastructure, you can think of pipelines, for example, not energy production, not the production of energy products, but the transportation, storage processing of these products. And then in transportation it would be things like airports, toll roads and public transit, for example.

[2:04]

RLB: Okay, thank you, so what about the social category of infrastructure?

AA: Well, this is an area that’s of course become extremely critical. It’s quite apparent that these are critical assets for the functioning of society. And you can think of things like hospital infrastructure, municipal buildings, schools, fire and police stations, university accommodation, courthouses, things like that. So mainly government sponsored or government contracted building infrastructure that is critical for the functioning of society. And I think, you know hospitals are a great example of this and one of the reasons this is such an attractive area and is one of the more defensive areas of this portfolio is that even if this infrastructure isn’t actually being used – so think of last year, for example, schools being closed, libraries being closed, and so on – the infrastructure owner, in which we’re invested, still receives the contracted revenues, which tend to grow at roughly the rate of inflation.

[3:14]

RLB: Sure. Thank you. And then finally, maybe we can look at the evolving infrastructure, is this sort of some of the new economy versus the old economy of the economic side?

AA: Yeah. In some ways it is, and it’s quite an exciting area because, as you can imagine, it is structurally growing. And so in the same way that last year, for example, and more recently, we’ve come to find social infrastructure quite critical. What about digital infrastructure? Everything that’s required to function in a digital economy to work from home, entertain ourselves from home, be connected to families and loved ones by a video and so on. So these are things like mobile phone towers, like data centres, without which the internet wouldn’t exist, or even optical fibre networks. And I think something else has become quite apparent is that this infrastructure has significant requirements for further investment to make it more robust, to address the demands on the need for data and connectivity.

I’ll give you an example of a recent holding. In fact, the newest holding in the fund, which we invested in very recently, is a German listed company called Vantage Towers. And this is actually the spin-off of the digital infrastructure towers from Vodafone. It’s something that’s been happening over the years where telecom service providers have actually spun off or divested their infrastructure assets in order to fund their ambitions in building out their networks and 5G and so on. And so these digital infrastructure assets are extremely attractive for us because they have very long lives, very long-term growing contractual cash flows and increasing opportunities around the need for 5G connectivity and so on. So it’s a very exciting area. And across these three categories, I should mention you have very different characteristics of the underlying businesses and holdings. They don’t actually necessarily move in the same direction at the same time, in the same manner in various markets. So they are quite complimentary and diversifying to one another.

[5:12]

RLB: Okay, well, so with that in mind, if they are all sort of quite different, what area do you think is the most exciting today for you in terms of the opportunities that are there?

AA: Hmm. Well, they’re all exciting. I should preface with that, but at the moment, in terms of valuation opportunities and potential upside, I would probably highlight the first category we talked about: economic infrastructure because in the midst of the global pandemic and economies voluntarily shutting down and so on you can just think of, you know, how empty airports and empty toll roads and so on would affect the.. these kinds of businesses, valuations have become extremely attractive. So some of the transportation infrastructure businesses and energy infrastructure for that matter look extremely attractive in terms of upside around reopening of economies. And the UK is early in that reopening, as we all know, but others will follow and increasingly people will become passengers again and will travel on toll roads and through airports.

The other very important area, as I’m sure we’re all aware, is this need for decarbonisation and the greening of recoveries. And that’s a huge initiative on the part of not just the European Union and the UK, but America under Biden’s new infrastructure plan, and emerging markets as well, including China. And so businesses in transition, particularly around energy generation, moving from less sustainable forms of energy generation towards more renewable and more sustainable forms of energy generation are extremely attractive, including those that are providing transition fuels like the example I gave earlier around using natural gas as a decarbonising measure, as an intermediate step where renewables aren’t yet available or the opportunity doesn’t yet exist.

[7:00]

RLB: Yeah because on that note actually, I noticed that in the portfolio, you recently sold a holding called Embridge because M&G updated its sustainability policy and this company no longer fit. What changed about that company in particular and what are the requirements of the companies in which you do invest and which areas you will exclude?

AA: Yeah, well that holding is a particularly interesting one and then we could talk for days about it I’m sure. It’s been held on the fund since day one. And there had been some controversy around a project in which the company was a minority joint venture participant. So unfortunately not in control of the processes. And we did initially go through a validation process to get that holding in the fund, we didn’t feel like the company should be excluded at the time and it was held for a little over three years. The policies around UNGC or UN Global Compact violations or allegations of violation have tightened up over time. And we needed to go to our independent governance committee again with this holding.

And I think it’s a good example of how a third party or independent validation and scrutiny of a holding is extremely important in the world of ESG. Rather than us just, you know, unilaterally dismissing an issue around a controversy. So it was quite a rigorous process, hundreds and hundreds of pages of a submission around it. And we were in fact unsuccessful in defending its position in the portfolio as a result of a vote, we did get some votes in our favor, but in the end it was it was determined that the violation or the alleged violation was serious enough that it should be divested for the time being, but that of course can change. And given the opportunity again, we would invest in that business because we do believe it is a very high quality well-governed sustainable business. It’s just that we had an internal debate around it, and it didn’t go our way in this case.

In terms of exclusions, just to your point, we exclude certain activities around sustainability considerations and so we put some strict limits on coal-fired power, for example, and nuclear power. And we still have some little bits of exposure – again, remember those transition businesses that are transitioning and are providing that huge opportunity. So we don’t completely exclude, but we put some strict limits and we also have some carbon intensity thresholds that we’re very, very vigilant on. And so again, all of this steering to sustainability for economic reasons, in order to avoid stranded asset risk, to avoid the loss of social license to operate, and therefore ensure the sustainability of the cash flows and preserve the capital for our investors.

So there’s a lot to it. It’s quite an involved and intricate process.

[9:53]

RLB: Okay, thank you. And just going back to sort of the social infrastructure bucket, you own an investment trust called Home REIT, which is all about combating homelessness and providing accommodation to vulnerable people across the UK. It doesn’t strike me as an area that you usually associate with making money or being a strong investment case. Obviously it does add value to society. Can you tell us more about the holding? Sort of why you’re able to sort of balance those two needs in there please.

AA: Yeah, well, this is, it’s an interesting one, and it’s analogous to other areas of social infrastructure, such as hospitals, for example, where a government sponsored provision of infrastructure and the services within them is a private and public sector partnership in many ways. So if you think of a hospital, yes, the NHS provides the services inside those hospitals, but it’s actually the infrastructure business or owner that actually owns the building and provides that building’s availability to that service. So we do have businesses like that. We have a holding for example called Hickle which is a UK listed closed ended trust, and that business owns the hospital, but doesn’t provide the services inside.

Home REIT is analogous in many ways because there is a need for accommodation for the homeless and that is provided by local councils, and it is certainly a public sponsorship, but those facilities aren’t actually owned by the local authorities. So regardless they have to pay somebody in the private sector to provide that accommodation. And then the services are then put forward by the local authority. So as long as that’s a requirement, where the local authority or the public entity doesn’t actually own the infrastructure, it ends up being privately held and its availability is paid for by that local authority to the benefit over time of investors. So it’s critical social infrastructure, and it’s a partnership between the private and the public sector.

[12:02]

RLB: And so now, just going to your portfolio as a whole, how do you sort of balance the need for some capital return, as well as generating some income for your shareholders for the fund, just talk talked through that maybe with the difference in the sort of economic, social and evolving cases as well?

AA: Sure. Well, we are resolutely focused, not on yield, but on the growth in the dividend stream, which itself comes from the growth in the cash flows that are backed by these physical infrastructure assets.

So there is a common perception that infrastructure businesses are high yielding and it’s true you can go and find high yielding non-growing infrastructure assets and businesses, but that’s not what we do. We happily take a slightly lower starting yield – it’s still very generous, it’s significantly higher than, than the global equity market at roughly 3.5%  at the moment – but where we then get the capital return is by way of the growth in the underlying dividends which we then translate into growing income to our own unit holders over time. So what you end up with is, in the current environment, a starting yield of roughly 3.5%, and then growth in the income stream of between 5% and 10% over time, which basically turns into your capital return for a total expected return in the high single digits with lower volatility and lower drawdown than the broader equity market.

And that’s, since we’ve launched three and a half years ago, roughly what we’ve delivered, it’s almost exactly, it’s exactly what we’ve delivered with all kinds of market environments and a global health pandemic thrown in for good measure. So that’s how it all comes together. But again, that resolute focus on growing dividends is key.

To your question around the three categories, it’s very true that the nature of the dividend growth or the profile of that dividend growth, is different. Economic infrastructure, as you’d expect, has a dividend growth rate roughly around the growth rate of GDP. Social infrastructure, as I mentioned earlier, roughly a growth rate of inflation, and then within evolving infrastructure, you get those higher structural rates of growth that are associated with some of the fastest growing areas of the economy, particularly around digital infrastructure.

RLB: Well Alex, that’s been super interesting, thank you so much for your time today.

AA: Oh it’s a great pleasure. We’re very excited about the asset class, and I do believe it’s poised for great things over the short, medium and long term.

RLB: Brilliant. Well on that excellent note we’re going to have to leave it there. For more information on the Elite Rated M&G Global Listed Infrastructure fund, please visit our website: fundcalibre.com and, for more from our Investing on the go podcast, please subscribe via your usual channels.