There is no such thing as the perfect asset but if there was it would probably be infrastructure. There are a number of reasons for this.
For example, infrastructure can take many forms – from an airport to a water plant to a pylon carrying high voltage power lines to pipes regulating water flow in outback Australia – and can be defined in a multitude of ways. My favourite definition, however, is “For the Public Good”; society can’t afford not to have Infrastructure and will pay for it as part of the cost of being in a 21st century world.
Additionally, the characteristics of infrastructure assets give us an idea of why it is such a good portfolio asset:
- Infrastructure is key in the provision of essential services so must be built and maintained;
- Infrastructure generally has high upfront building costs, but generally low ongoing operational costs;
- There are invariably high barriers to entry due to the large amount of upfront capital and the monopoly rights that many of these assets enjoy; and
- Infrastructure has long-term, stable, predictable cash flows with a very low level of volatility.
- Generally speaking, there are three discrete forms of infrastructure, one of which has 2 sub-sets:
- Patronage, or “Pay as you go”;
- Social infrastructure; and
- Utilities, which can be divided into:
- Regulated; and
Social infrastructure includes “public” infrastructure such as schools, prisons, and hospitals – which have traditionally been the domain of governments – and more recent infrastructure such as retirement villages which are the domain of the private sector. As a rule, social infrastructure is not in our universe due to unreliable cashflows, competition issues, and the role of the state in so much of this space.
Utilities can be divided into regulated utilities – which we like – and unregulated utilities – which we don’t like. Unregulated utilities include electricity generators and retailers and they are subject to competition and commodity pricing, neither of which meets our definition of “pure” infrastructure so is not part of our universe. Regulated utilities, on the other hand, generally suffer no competition and are certainly not subject to commodity pricing. These would include electricity lines companies and water companies. Regulators ensure these utilities are able to “earn” a competitive rate of return on their assets and around the world this has almost invariably been 10.5% pa or thereabouts. This is very attractive from an investment point of view and provides a very good hedge against inflation as well.
The last group of assets are patronage infrastructure. These are assets people are not compelled to use but when they do use the asset are charged for their use (hence, “pay as you go”). Common examples of patronage assets are airports, ports, toll-roads, towers, and pipes and these are among our favourite infrastructure assets: this is because they are all “differentially advantaged assets”, the modern politically correct term to define monopolies. A monopoly is a terrific asset to own as an investor (but a terrible one to be a consumer of) because of its inherent pricing power. This one feature alone makes patronage infrastructure very appealing but there are others. Chief among them is the ability of a concession holder (an investor who owns or leases an asset like an airport) to charge fees that protect the concession holder from both inflation and deflation. This is because a typical tariff will be reviewed periodically and will have a clause allowing it to increase the tariff by the rate of inflation or by a fixed number (e.g. 2%), whichever is higher. This is investment nirvana.
The last issue with “pure” infrastructure is that the “elasticity of demand” appears to be almost infinite. What this means is that no matter how much a tariff is increased the public will tend to keep paying, providing the asset has the ability to take capacity.
So in summary, we like infrastructure as a core part of portfolios because it is both a growth investment that is tied into the success of our economies and a defensive asset that will continue to generate a very predictable cash-flow no matter what the prevailing economic conditions.