Jan 30, 2020 Infrastructure

What makes infrastructure equities so compelling to investors?

Railways, fibre optic networks, mobile phone masts: the demand for infrastructure is growing worldwide. This creates opportunities for investors, even in difficult economic times.

  • Economic growth and prosperity depend on efficient infrastructure.
  • The focus in emerging markets is on construction and expansion, but industrialised countries need to renew their aging facilities too. This means the need for financing remains high.
  • Equities in the infrastructure sector are of interest to investors because infrastructure companies are less dependent on the economy’s ups and downs.
4 minutes to read

Technological advances mean many facilities quickly become obsolete - but there is often also not enough money to finance infrastructure projects.

Infrastructure facilities are usually large projects that require a lot of capital to build. A country's technical infrastructure includes all the facilities necessary for society’s functioning and development. Transport facilities such as roads, railway lines and airports are just as much a part of this as energy and water supplies, waste and sewage disposal plants and telecommunications networks. Social infrastructure ranges from schools and hospitals to sports and leisure facilities, as well as shopping centres. Companies themselves are dependent on efficient infrastructure, which makes this a key factor in their choice of location. And when companies set up in a particular region, this in turn impacts on the standard of living of the population there.

Investment backlog threatens industrial nations’ prosperity

Despite infrastructure’s huge importance to the standard of living in a society, investment in this area has tended to drop back, especially in highly developed economies. This is mainly due to the tight budgets in many countries. They simply lack the money to finance costly projects, and years of underinvestment mean an investment backlog has now built up. Technical advances also mean that mobile phone networks, for example, are quickly becoming obsolete.

According to a study by US consulting firm McKinsey,[1] around 2.3 trillion euros are invested worldwide every year in transport facilities, energy and water supplies and telecommunications. This corresponds to 3.5 percent of global gross domestic product (GDP). However, to keep pace with expected economic growth in the period to 2030, almost 3 trillion euros or 3.8 percent of GDP would need to be spent annually. But even the USA under President Donald Trump has not yet managed to push through the measures needed to renew its crumbling infrastructure – contrary to the rhetoric. The situation is similar in Europe.

Shares in infrastructure companies have special characteristics that make them attractive to investors.

The urbanisation megatrend is fostering infrastructure projects in emerging markets

In emerging markets, where a rapidly growing population, fast economic growth and the trend towards urbanisation make infrastructure expansion an urgent priority, things are going better than in developed markets. According to the McKinsey study, emerging markets account for about 60 percent of[1] global infrastructure investment needs. And indeed, China, which puts 8.8 percent of its economic output into infrastructure, invests more resources in this area than the USA and Western Europe put together.

Although there are currently only a few truly major infrastructure projects on the go – the new Silk Road to Europe that China is building is an example – investor interest is high. This is because shares in companies that are involved in infrastructure projects have very special characteristics. Infrastructure projects are usually planned over several years or even decades. Combined with fixed contracts, their long term nature, ensures that the companies involved have a relatively stable and predictable cash inflow.

Shares in infrastructure companies are generally also considered to be defensive because they are less susceptible to cyclical fluctuations. Listed infrastructure companies can therefore make an interesting addition to an equity portfolio.

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Conditions for infrastructure companies can change rapidly

Of course, the rule that there are no opportunities without corresponding risks applies to infrastructure stocks as well. It is possible for regulatory and political changes to alter an individual company’s business prospects radically overnight. German utilities discovered this when the country pulled out of nuclear power. Furthermore, as high fixed costs and market entry barriers create obstacles for new infrastructure companies, the state often intervenes directly in the market and sets conditions. Price caps on electricity and water or a requirement for telecommunications network operators to connect less lucrative regions to the mobile phone network can, for example, reduce earnings prospects and hit potential share price gains.

On the plus side for infrastructure investments, companies in this sector have historically offered investors opportunities in more advanced economic cycles with lower economic growth, such as the one we are experiencing at present. As these stocks generally combine predictable returns with organic growth, they have been able to deliver good returns for a reasonable level of risk, even during periods of economic weakness.

In addition, listed infrastructure companies’ dividend yield has been 1.15 percentage points[2] higher on average than that of the broad equity market over the past ten years. Although this difference has recently shrunk to slightly less than one percent, dividend yields are likely to remain one of the plus points for infrastructure stocks.

Political and regulatory changes pose the greatest risk to the infrastructure asset class.

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1. https://www.mckinsey.com/de/~/media/McKinsey/Locations/Europe%20and%20Middle%20East/Deutschland/News/Presse/2016/2016-06-15/160615_pm_mgi_infrastructure.ashx

2. DWS Research: GLOBAL LISTED INFRASTRUCTURE AND MACROECONOMIC ENVIRONMENTS, January 2020

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