Anatomy of Defensive Returns

The anatomy of defensive returns

Listed infrastructure has offered investors attractive risk-adjusted returns and lower correlations to traditional asset classes. This outcome has been achieved by delivering steady outperformance during periods of equity market weakness.

This paper analyses the performance of our listed infrastructure Fund¹ in falling global equity markets. It concludes that the underlying characteristics of listed infrastructure, combined with active management, enabled the Fund to preserve capital in falling markets on most occasions. For long-term investors, this consistent pattern of capturing most of the upside but less of the downside has the potential to accumulate into material outperformance.

Fund holdings in most infrastructure sectors outperformed during falling equity markets. Utilities and mobile towers proved particularly resilient. Pipelines, railroads and ports were less defensive than utilities, but held up better than global equities due to robust business models and strong market positions.

Looking ahead, most listed infrastructure companies are in good shape, with prudent levels of debt and conservative dividend payout ratios. Valuations are reasonable. These metrics suggest that the sector remains well placed to continue to hold up during potential future periods of equity market weakness, although of course this cannot be guaranteed.

¹ First State Global Listed Infrastructure Fund. Fund performance is for the total portfolio in GBP, net of fees assuming an OCF of 0.80% pa, based on end of day market valuations and midday cash flow assumptions.

Cumulative Performance (% in GBP) to 31 November 2018

Annual Performance (% in GBP) to 30 November 2018

Introduction

Listed infrastructure consists of real assets that provide essential services, often backed by contracted or regulated earnings. Stable demand and a relatively low sensitivity to the broader economic cycle tend to support infrastructure earnings at times when more cyclical businesses can struggle.

The overall beta of listed infrastructure compared to global equities has been around 0.7 over the long term. Broken down, this has translated to beta of almost 0.9 in rising markets, and under 0.6 in falling markets, as illustrated in Figure 1. In essence; delivering most of the upside in rising markets, whilst falling by significantly less than global equities during periods of decline.

Figure 1: Global Infrastructure in MSCI World Up/Down Markets

Although the scale of these metrics appears relatively mild, this pattern of performance, combined with active management, has over time enabled the Fund to outperform global equities by a significant margin. It has delivered cumulative outperformance vs global equities of 55.7% since its inception in October 2007.

Analysing the 15 discrete months when global equity markets fell the furthest, since the Fund’s inception, allows a more detailed assessment of how this outcome has been delivered to investors.

The data in Figure 2 compares the performance of global equities with the returns of the Fund during those 15 months. This period encompasses a broad range of market conditions, including the 2008-9 Global Financial Crisis; Eurozone volatility in 2011; concerns about a slowing Chinese economy in 2015; and mounting trade tensions in 2017-8.

Fund performance in falling markets

Figure 2 shows the performance of the Fund during those months, ordered by the magnitude of MSCI World declines.

Figure 2: Performance of the Fund vs MSCI World

The Fund outperformed global equities on 10 of these 15 down months, resulting in outperformance, on a simple average basis, of 1.2% per month.

These details highlight three main points:

• Sometimes sell-offs can be indiscriminate. In 2008, markets were shocked by the collapse of credit markets and the risk of deep recessions around the world. The flight to safety and the need for liquidity saw equity markets tumble. Fund performance relative to the market in September 2008, for example, illustrates that few distinctions were being made between higher and lower quality stocks.
• As active stock pickers running conviction portfolios, we don’t always get it right. During other months (June 2008 and February 2009) fund positioning counted against us. Our holdings in those months included companies with high quality infrastructure assets such as Transurban and Macquarie Airports. However their debt levels and payout ratios were revealed to be unsustainably high, teaching us a valuable lesson.
• Most of the time, listed infrastructure’s underlying characteristics, combined with value-adding active management, enabled the Fund to preserve capital in falling markets. While this outcome is expected, it is encouraging to note the magnitude of outperformance during these periods of very worst market conditions, when investors seek a safe haven.
   

Figure 3 shows the dispersion of these down markets chronologically, illustrating the difficulty of predicting when they may arise, and emphasising the value of maintaining defensive exposures within a portfolio.

Figure 3: Chronological dispersion of down markets

Performance in falling markets by sector

We can look in more detail at the underlying sectors delivering this outperformance by comparing the average performance of the MSCI World during these 15 months (-6.8%) with the contribution to returns of the Fund’s holdings in each infrastructure sector², over the same time periods³.

For example, the Fund’s tower holdings – the most defensive infrastructure sector over the sample period as a whole – contributed -1.6% to returns on average during those 15 months; beating global equities’ equivalent average return during those months by +5.2%.

Figure 4 shows listed infrastructure sector performance, relative to global equities, during severe market downturns (ordered by most defensive sector to least defensive).

² Satellites have been excluded due to the small sample size. The Fund’s position during these periods was always less than 4% of the portfolio, typically in just one stock.
³ The contribution to return of each sector has been divided by the average portfolio weight of each sector to obtain a proxy comparison to global equities (and assumes a constant sector weight throughout the month).

Figure 4: Outperformance vs MSCI World during the 15 worst down months 2007 - 2018

Underlying drivers of performance

The most defensive sector during these 15 specific months was mobile towers. Structural growth drivers have insulated these stocks from the ebbs and flows of the broader global economy. The proliferation of smart phones over the past decade has dramatically increased the usage of mobile data, in turn driving demand for mobile tower services. Planning restrictions on tower sites represent effective barriers to entry. Long-term contracts tend to provide for annual price escalators of around 3%, and help to minimise technology risk.

Utilities also held up well. American and British water utilities, which dominate the listed water sector, operate within highly mature markets. They are typically allowed to earn a small premium to their underlying cost of capital, resulting in minimal volatility in each company’s returns throughout the regulatory period.

Gas and electricity utilities delivered significant outperformance. These stocks have very predictable patterns of steady demand underpinning their business models. Transmission and distribution networks tend to be monopoly suppliers of electricity and gas. Pricing is usually set by formal regulation of returns on equity, giving very clear visibility over future earnings streams.

The multi-utilities sector includes companies with power generation segments as well as electricity transmission, gas production/storage and retailing activities. Power generation markets are less regulated and more competitive, which can result in a higher variation of return outcomes, relatively volatile earnings profiles, and potential vulnerability to weaker demand in power markets.

North American energy pipelines have faced headwinds in recent years. Volatile energy prices, combined with slower than expected regulatory approval for several substantial projects, have raised concerns about balance sheet stability. However as this analysis illustrates, the sector has provided effective defensive exposure during sharp market downturns. Pipeline tariffs tend to keep pace with inflation over time, while volumes are supported by long-term, take-or-pay contracts. Railroads, toll roads, ports and airports are hard assets⁴ with high barriers to entry and demand profiles that make their customers relatively insensitive to price increases.

North American freight rail companies are unique and valuable franchises. Their wholly-owned track networks are high quality infrastructure assets which can never be replicated. They typically operate under duopoly market conditions, with significant numbers of captive customers such as grain, chemical and auto producers giving them strong pricing power over long haul routes. Improving operating efficiency provides further scope to grow earnings. Trucks represent competition over shorter distances, and volumes are linked relatively closely to economic growth. Japanese passenger rail companies are highly cash generative, stable businesses which operate some of the world’s busiest high speed rail lines.

Marine ports have historically delivered strong volume growth, reflecting the globalisation of trade. Volumes today are directly linked to global GDP growth rates; with port operators typically demonstrating high operating leverage. Significant trade routes include the import of bulk commodities to Asia and the subsequent export of containerised finished goods. Consolidation in the shipping industry has tilted the balance of power away from port operators to a certain extent.

Toll road revenues tend to be robust, with consistently high operating margins of between 60% and 80%, and the potential to match GDP growth over the long-term. Concessions are typically set over long time frames, with price increases often linked to inflation and negotiated compensation for additional capital expenditure.

Airports tend to operate under long-term leases and are subject to some form of regulation. Driven by globalisation, increased wealth and declining real airfares, passenger volumes have historically grown at multiples of GDP.

Revenue from privately owned airports is typically well diversified with income from aeronautical, retailing and property services. Ports, toll roads and airports were the only infrastructure sectors that did not outperform global equities during these months. The nature of their businesses gives them some sensitivity to economic growth rates. However, these sectors have delivered strong gains during rising markets.

⁴ A hard asset is a tangible or physical item or object of worth that is owned by an individual or a corporation. It is listed on the balance sheet as an asset and can be used by analysts to calculate a company’s value.

Consistent outperformance through time

Splitting the data into three distinct periods (2007-early 2009; late 2009-2011 and 2013-2018) results in the same pattern, as illustrated in Figures 5-7. This highlights the broad consistency of these defensive characteristics, regardless of the underlying triggers of equity market weakness.

Toll road revenues tend to be robust, with consistently high operating margins of between 60% and 80%, and the potential to match GDP growth over the long-term. Concessions are typically set over long time frames, with price increases often linked to inflation and negotiated compensation for additional capital expenditure.

Airports tend to operate under long-term leases and are subject to some form of regulation. Driven by globalisation, increased wealth and declining real airfares, passenger volumes have historically grown at multiples of GDP. Revenue from privately owned airports is typically well diversified with income from aeronautical, retailing and property services.

Ports, toll roads and airports were the only infrastructure sectors that did not outperform global equities during these months. The nature of their businesses gives them some sensitivity to economic growth rates. However, these sectors have delivered strong gains during rising markets.

Figure 5: Outperformance vs MSCI World during 2007 – Feb 2009 down months⁵

⁵ Freight rail sector excluded this period due to sub-1% portfolio weighting

Figure 6: Outperformance vs MSCI World during Oct 2009 – 2011 down months

Figure 7: Outperformance vs MSCI World during 2013-2018 down months

Looking ahead

Global listed infrastructure looks well positioned to continue to hold up in falling markets. The asset class consists of stable, long life assets, and continues to deliver a reliable yield of between 3% and 4% per annum although of course this cannot be guaranteed. Listed infrastructure companies are in sound financial positions. Dividend payout ratios overall are prudent at around 70% and borrowing levels are reasonable, with average net debt/ EBITDA* ratios of between 3x and 5x. Debt refinancing at low interest rates has enabled infrastructure operators to reduce rates, lengthen maturities, spread refinancing risks, and diversify funding sources.

Several infrastructure sectors are benefitting from structural growth drivers such as urbanisation (Tollroads) and the increasing mobility of communication (Towers). The US continues to consolidate its position as the world’s largest hydrocarbon producer, to the benefit of the pipeline sector.

The cash yields of most infrastructure sectors are higher than dividend yields (see figure 8) implying ample scope for payout ratios to be raised. This is especially the case for freight rail, toll roads and mobile towers. Current valuation metrics are also likely to be supportive, as shown in figure 9.

Figure 8: Infrastructure Yields by Sector

Figure 9: Global Infrastructure Price/Earnings x

We believe that toll roads and pipeline operators represent exceptional value today. Tollroads are the Fund’s largest sector overweight, owing to the appeal of their stable cash flows, high operating margins and effective barriers to entry. Energy pipelines are the portfolio’s second largest sector overweight. Investor concerns about earnings growth presented the Fund with opportunities to build positions in several companies with unique and long life energy infrastructure networks, at appealing valuation multiples.

Although this is offset to a certain extent by some stocks (notably in the airports and utilities sectors) that look expensive on fundamental measures, current valuation levels overall are attractive compared to long term averages. These robust metrics are likely to support listed infrastructure’s ability to deliver similar patterns of performance during periods of equity market weakness in the future.

Important Information

This document has been prepared for informational purposes only and is only intended to provide a summary of the subject matter covered and does not purport to be comprehensive. The views expressed are the views of the writer at the time of issue and may change over time. It does not constitute investment advice and/or a recommendation and should not be used as the basis of any investment decision. This document is not an offer document and does not constitute an offer or invitation or investment recommendation to distribute or purchase securities, shares, units or other interests or to enter into an investment agreement. No person should rely on the content and/or act on the basis of any material contained in this document.

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