Hello and welcome to our latest 4D Infrastructure podcast. My name is Jodie Saw, an account director with Bennelong Funds Management, and I'm pleased to be joined today by Sarah Shaw, portfolio manager and chief investment officer with 4D Infrastructure.
Welcome Sarah, it's great to have you here in person in Brisbane with us today.
Thanks, Jodie. It's lovely to be here.
Sarah, 2022 was a year of much macro influence. It was a period where central banks reacted to rising inflation, started tightening very quickly. Interest rates rises, we saw a major escalation of the war between Russia and Ukraine and continued lockdowns in China. So given all of these events, how has infrastructure performed both from an absolute and a relative perspective?
While 2022 and the start of 2023 has actually seen strong absolute performance and significant outperformance of listed infrastructure relative to general equities, we believe there is much more to go. The recent outperformance doesn't tell the full story, and if we look back further than sort of the 2022, back to say maybe the 2020 March selloff regarding COVID-19, listed infrastructure actually continues to lag general equities and we think this is unjustified. Listed infrastructure is an equity and will be caught up in market volatility like all other listed securities. And unfortunately we feel infrastructure wasn't really sexy enough to participate in what was a real cyclical or growth led market bounce and we ended 2021 as a sector significantly behind general equities.
So while we have seen that gap close over the last 18 months as defensive asset classes gained some favour, as you mentioned with the return of inflation and increasing geopolitical tensions, we still see a significant value disconnect between listed infrastructure and general equities. And if we take it a step further, when we separate the equity market moves from the investment fundamentals, the earnings of the listed infrastructure asset class have proven to be far more resilient through COVID than the share price selloff implied, and even better coming into that 2022 and 2023 periods that we're facing today.
So through a tumultuous 2020 and 2021, the asset class proved its defensive characteristics with solid positive earnings growth underpinned by very strong balance sheets. And then we get to 2022 with the reopening gaining real momentum and infrastructure EBITDA growth actually significantly outpaced general equities. And this period also saw significant growth opportunities through both stimulus package as well as the fast tracking of the energy transition as a result of the Russia/Ukraine crisis. Yet that equity market gap persists.
So I believe this current disconnect continues to present a very attractive investment opportunity for listed infrastructure despite the outperformance that we saw in 2022 and year to date. You still get defensiveness, you still get growth, and you still have the ability to actively position for both long-term fundamentals as well as the short-term cyclicals that you mentioned. And very few asset classes offers this diversity with such a big value disconnect at the moment.
So how are you positioning the portfolio for the current environment?
Just reiterating that infrastructure assets have a number of unique characteristics that make them an attractive asset class for investors across all points of the economic or market cycle. The macroeconomic outlook for 2023 does remain very uncertain. We have inflation currently still elevated. We have interest rates moving up and policy direction remains pretty unclear.
So how do we think infrastructure is to perform in this environment? Well, let's just highlight two of those characteristics that position it relatively well. We have investment returns that are underpinned by regulation or contract and we have inflation hedges in the asset's business models. What we believe then becomes relevant in positioning in this environment is within the asset class, how quickly does inflation and changes in interest rates pass through into earnings profiles. And that is what we are looking at when we're positioning infrastructure in today's environment.
On the one hand we have what we call user pay assets, and they have that direct positive correlation to economic activity through volumes and they have built-in inflation protection, which can see a positive impact on earnings and valuations due to the compound effect. This will ultimately be reflected in stock price and performance. So these type of assets represent a core portfolio holding for us in an inflationary environment. In contrast, we have the regulated utilities, and these can be more immediately adversely impacted by rising interest rates and inflation because of the regulated nature of their business. So, the speed at which inflation flows through to tariffs for these assets is dictated by whether the utility has a real return model where inflation is quickly passed through, or a nominal rate model where they must bear the inflationary uptick in certain costs until it has a regulatory reset. In our view, this distinction will see certain utilities weather this inflationary environment better than their peers, particularly over the shorter term.
So at 4D, we remain overweight the user pay assets and within the regulated utility sector are favouring those with the inflation pass-through. Saying all that, should the market overreact to the economic outlook and sell off in 2023, we would use it as a buying opportunity across all sectors. So while we're conscious of the economic backdrop and our position to make the most of it, we are also remain optimistic about the long-term fundamentals underpinning the infrastructure investment case, and are also positioning for that.
So just as a reminder, what are those key investment thematics? Firstly, we have the reopening trade, capturing the stimulus and the pent-up consumption around the world. 2023 should be China's year. We have the global need for infrastructure investment across every country as either they evolve or they replace very ageing infrastructure. We have the emergence of the middle class offering a significant opportunity within infrastructure, as it's both a driver and a first beneficiary of improved living standards. We have global population growth with changing demographics: the West is getting older, but much of the East younger and infrastructure is needed for both ageing as well as the growing populations. And finally we have the energy transition. We have significant environmental and climate challenges and that underpins the need for even more spend on infrastructure globally.
So at 4D we are positioned for both the short-term cyclical events as well as these long-term thematics.
So it sounds like you think investors should be increasing their allocations to listed infrastructure in this environment despite the recent outperformance that you mentioned?
Absolutely. We would argue strongly that there is a place for infrastructure and listed infrastructure in all portfolios and in all markets, it offers defensiveness with growth and sector and regional diversity, which means infrastructure can be fundamentally positioned for all points of an economic cycle. And we think allocations to the asset class should be more representative of this opportunity set. Maybe 20 years ago when listed infrastructure was only just being recognised as its own asset class, when we were still educating people on what it was and how it slotted into a portfolio, maybe then a small 5, 6% allocation to listed infrastructure was appropriate. But today when we have a 200-plus stock universe with a market cap of over 4 trillion US dollars with sector and regional diversity, when we have 20-year proven track record of long-term earnings growth above general equities with average yields above general equities and with long-term equity outperformance outpacing general equities, when we are talking long-dated assets which offer earnings resilience and an inflation hedge as proven through COVID and a subsequent inflationary spike, when we have a growth pipeline that is huge in offering exposure to some of the key investment thematics of the next 20 to 30 years – this is all within one asset class and it's offering you all of this and yet we're still talking about asset allocations of only 5 to 6% with a big bet being sort of 10%.
In my view, it's not market volatility or recent cyclical macro events that needs to be considered, it's actually the importance of an overall allocation to what is such an attractive asset class that needs to be talked about. Now we truly believe infrastructure is the fundamental investment theme of the decade and does warrant a jump in portfolio allocations.
So is there a case for increased allocations to listed over unlisted infrastructure?
I believe that the listed and the unlisted infrastructure asset managers are fundamentally investing in the same sort of assets. In some cases exactly the same asset. I believe we are working with the same or very similar definitions of infrastructure, with the end goal to capitalise on long-term visible and resilient cash flows and the growth thematics that are in play. The differences lies in how we gain exposure to these assets and we see listed and unlisted allocations very complementary to each other.
We believe having both listed and unlisted exposure increases asset diversity of an overall infrastructure portfolio, with certain assets and regions more prevalent in the unlisted opportunity set, such as social infrastructure. While there is arguably more opportunity in other areas for listed investors such as US regulated utilities, greenfield assets, or in some of those perceived riskier jurisdictions such as emerging market where listed operators have the liquidity to shift. Listed offers also greater liquidity and flexibility to move in and out of asset jurisdictions. But this liquidity comes with increased in-cycle volatility. Listed assets are re-priced daily. As a listed investor we see this volatility as an opportunity to add our FUM. An extreme example being the COVID response of the equity markets relative to the unlisted revaluations in the infrastructure space. In this instance, we believe our unlisted peers got it right in the valuation adjustments made to the long-dated infrastructure assets. The equity markets, by contrast, in our view completely oversold these assets and as listed investors, we saw this as a real buying opportunity.
There has long been discussion in the market about the relative volatility of listed infrastructure assets compared to their unlisted peers. Interestingly, over short timeframes, the correlation between listed and unlisted valuations can often be low. Keep in mind that we are talking the same type of asset if not the exact same asset. However, over the longer term the correlation has proven to be much higher, so investors can capitalise on value disconnect as and when it appears within the listed and unlisted revaluations and actually add alpha to an overall infrastructure portfolio.
For us, we believe you have to increase allocations overall to infrastructure, and we believe listed infrastructure should get a fair share of that allocation within an overall infrastructure allocation.
Sarah, you made an interesting point regarding emerging market exposure and that listed is the best way to gain that exposure. So can you elaborate on emerging markets and why you think it makes sense to include them in your portfolio allocation?
We think emerging markets are too important to continue to ignore in a global portfolio. Whether you have direct exposure or not at any point in time, that's another question. But you always must understand what is happening in these regions as they have significant ramifications for global growth and investment outlooks. We also believe that if an investor is looking for emerging market exposure, then infrastructure is an incredibly attractive way to gain this exposure. Infrastructure is 100% correlated to the in-country domestic demand story, while hedging against key emerging market risks including inflation and sovereign risk.
Finally, as we look at the key long-term infrastructure growth thematics that I've discussed, three of the four are directly linked to emerging markets. As a reminder, we have population growth with all the growth coming from the emerging world. We have the emergence of the middle class, this is a huge investment dynamic where infrastructure is both a first beneficiary and a driver of the evolution. And we have the energy transition. This is not just a developed markets story. Without the emerging world being on board with a cleaner environment than the world has no chance of achieving net zero, particularly in the timeframe that we're working towards. So as an investor, I'm keen to capitalise on these thematics and capitalise on superior demand outlook while mitigating key risks to emerging market investment, and infrastructure allows me to do this.
We have seen the emerging market infrastructure names do well over the last 12 months, but we expect further outperformance as the market starts to recognise the disconnect between share price and fundamentals, and we believe the opportunity set the emerging markets is offering is just too attractive to ignore when you're looking at a global portfolio allocation.
Thank you so much for another great update, Sarah. It's always great to chat with you. And thank you to everyone for joining today's podcast.
Thanks very much. It's always great to talk infrastructure.