Understanding infrastructure
Infrastructure is the general term used to describe the essential services needed for our societies to operate on a day-to-day basis. These services range from roads and railways to telecommunications and include schools, universities, hospitals and water and sewage systems. In short, they're the services we use every day and are essential for our economy to function.
Investments in new infrastructure projects or improvements into existing ones helps stimulate long-term economic growth, creating a need for more infrastructure. Returns are relatively stable and generally immune to economic fluctuations caused by expansions and recessions.
As an asset class, infrastructure is less volatile than equities, and it can provide a high yield over the long term. That's why many companies, Clearwater included, like to invest in infrastructure funds because of their defensive characteristics.
The two types of infrastructure investments
From an investment perspective, infrastructure can be separated into two key areas: regulated assets and user-pays assets.
The benefits of regulated assets
A regulated asset is an asset owned by a utility company but controlled or regulated by a government regulatory agency. There's a range of regulated industries in Australia, including energy, water, telecommunications, media, transport, And natural resources, such as forestry and fisheries.
There are barriers to entering these regulated industries that prevent new competitors from easily gaining access to the sector. These barriers act as safeguards, protecting your investment and offering visibility regarding a company's cash flow.
Each industry has a regulator that determines how much a company should earn from its assets. If a company makes over this threshold, they're required to return some of their profits to customers by lowering prices. On the other hand, if a company reports that they have earned less than expected, they can increase their prices.
Regulated assets appeal to investors because they offer a steady cash flow over a long period. On top of this, the industry regulator will assess inflation in their determinations, which means that price increases will reflect the inflation rate, increasing returns and reducing risk.
The benefits of user-pays assets
User-pays assets are the kind of investments that depend on the volume of people who pay to use the asset. Examples include railways, airports, toll roads, ports, and energy infrastructure.
The beauty of user-pays assets is that as an economy grows, the need for user-pays assets increases. You'll see this in action when you consider the expansion of mobile communications towers across Australia, which adds capacity and extends the network's reach.
What our managers look for in infrastructure companies
Our managers have developed a method of identifying what infrastructure companies to invest in by assessing opportunities using three essential criteria:
The asset owned by the infrastructure company must be a physical asset
The asset must provide an essential service
The asset must be regulated in such a way that returns are guaranteed
An asset may be regulated through long term concessional contracts or an industry regulator, but whichever method is used, it must clearly illustrate how the company will provide a stable, predictable cash flow.
The types of infrastructure assets our managers avoid
Our fund managers do not invest in two types of infrastructure assets – competitive assets and community and social assets.
What's the risk of investing in competitive assets?
Competitive assets include energy retail and generation, logistics and telecom services. These assets involve a higher risk than regulated and user-pays assets because they're not physical assets and may be exposed to the forces of supply and demand.
For example, in the electricity sector, our managers would invest in a company that owns hard assets, but they would not invest in a company exposed to wholesale energy prices. This is because an electricity company's revenue is created by generating electricity and selling it back to the network, so they are exposed to supply and demand. As a result, their profits may be unpredictable, which would lead to an unreliable cash flow and higher levels of risk.
What is the risk of investing in community and social assets?
Community and social assets include housing, public health, schools and universities, prisons, and stadiums. The risk of investing in assets of this type is that they are generally unlisted, which means they're a long-term investment with capital locked in for an extended period. In addition, they do not offer the protection of regulated assets as there's no guaranteed cash flow or built-in protection against inflation.
We invest in global listed infrastructure.
At Clearwater, we invest in managers who invest in global listed infrastructure. This means that our managers buy shares in global electricity, water, and airport companies. The benefit of this type of investment is that you'll see returns that can be more stable than share markets and enjoy protection from inflation. What's more, you'll also benefit from all the standard aspects of investing in listed markets, including ease of liquidity, lower fees, and the flexibility to quickly move investments around when the market shifts.
Understanding risk
At Clearwater, we believe that investing isn't just about getting you the best returns but about managing risk in our portfolios. We combine investments that have the ability to generate higher returns, which as a consequence carry more risk. At the same time, investments such as infrastructure aim to deliver lower, but steadier returns. If you need assistance working out what's right for you, have a chat with your financial adviser, they'll be able to help.