Bennelong Fund Management - Actively Managed Investment Funds
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Infrastructure provides the basic services essential for communities to function and for economies to prosper and grow.

 Infrastructure assets share a number of unique characteristics that make them an attractive option across all points of the economic cycle, including investment returns that are underpinned by regulation or contract and inflation hedges inherent in the assets’ business models.

However, despite sharing these defensive characteristics, the infrastructure asset class offers two distinct and economically diverse sub-sectors – user pay assets and regulated utilities (essential services). This allows investors to capitalise on in-country economic cycles and gain exposure to domestic demand stories.

For us at 4D, these two broad asset categories allow us to actively manage our portfolio to capture the prevailing economic environment while also capitalising on long-term sector thematics.

Broadly, user pays tend to suit an environment of GDP growth and higher inflation, while in more difficult economic times regulated utilities offer a more defensive option as they are largely immune to the macro cycle.

Airport

User pay assets

Typical user pay assets are toll roads, airports, railways and ports, whereby the user pays to use the asset.

These stocks have a direct positive correlation with GDP growth (volumes) and often have built-in inflation protection mechanisms in their business models, which makes them well-suited to any economic environment. This can see a positive impact on earnings and valuations due to the compound effect, which should then ultimately be reflected in the relevant stock price and performance.

These types of assets should represent a core portfolio holding in a growth or inflationary environment.

gas-pipeline

Regulated utilities

In contrast, regulated utilities – such as electricity, water and gas providers – can be more immediately adversely impacted by inflation and rising interest rates because of the regulated nature of their business. While they are slower to realise the benefits of economic growth, at the same time they are less exposed to economic contraction and benefit from lowering interest rates.

 The speed at which inflation flows through to tariffs is dictated by whether the utility’s return profile is real or nominal.

  • If the utility operates under a real return model, then inflation is quickly passed through into tariffs, much like a user pay asset. This model limits the immediate impact of inflationary pressure, and can in fact positively boost near-term earnings and long-term values.
  • In contrast, if the utility is operating under a nominal return model, it must bear the inflationary uptick reflected in certain costs until it has a regulatory reset when the changing inflationary environment is incorporated into new tariff/revenue assumptions. These assets can be more ‘bond proxy’ in nature, particularly over the shorter term.

Therefore, utilities in a real model tend to weather inflationary spikes better than their nominal peers.

However, in terms of interest rates, the issues for both real and nominal models are consistent. For a regulated utility to recover the cost of higher interest costs, it must first go through its regulatory review process. While a regulator is required to have regard for the changing cost environment the utility faces, the process of submission, review and approval can take years. In addition, the environment surrounding costs, household rates and utility profitability can be politically charged. As a result, both the regulatory review process and the final outcome can be unpredictable.

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