When you think of consistent earnings, what comes to mind? For Sarah Shaw, it comes down to a strict definition of the infrastructure universe and the characteristics that underpin earnings.
“One is that earnings are underpinned by regulational contract, and two is that they have an inflation hedge in the business model."
In part 2 of Livewire's
How do you define infrastructure?
Put simply, infrastructure provides the basic services essential for communities to function or economies to prosper and grow.
For us at 4D Infrastructure, this equates to the owners and operators of essential services, being your regulated utilities in the gas power and water space, and user-pays assets such as toll roads, airports, port and rail companies where a user pays for the services.
All of these assets are underpinned by some unique characteristics, which sees them known as a defensive asset class. For us at 4D, we really make sure that the assets that make it into our investible universe have those unique characteristics.
So what are they?
They are monopolistic markets, positions, or ones with high barriers to entry. You've got earnings that are underpinned by contract or regulation. You’ll have a largely upfront capital cost, but then very low maintenance spend and scale advantages, and you'll have inflation hedges in the business.
These characteristics all come together to give you long-term visible and resilient earning streams, which either underpin yield or growth. And it's these characteristics that make it a defensive asset class. So we are really making sure our universe of opportunities offers those characteristics.
What led you to specialise in infrastructure investing and what gets you excited about this space today?
I must admit it was not something whereby I woke up at the age of 16 and decided I was going to be an infrastructure fund manager. To be honest, when I was growing up, I didn't even know my job existed. And I kind of fell into the role and then into the asset class. But I'm really lucky that I did because I've now developed a huge passion for it.
Infrastructure's known as a defensive asset class, but it's so much more for me. It's got those defensive characteristics, but it's also got a huge and exciting growth thematic, as well as the ability to actively position for all points of an economic cycle. This means that you can position infrastructure for the long term as well as the short term, which for us makes it a really exciting investment proposition.
What are the key opportunities and risks that you are seeing in the infrastructure space today?
It's all about defensive characteristics coupled with exciting growth opportunities and the ability to actively position for economic cycles.
A lot of people understand the defensive characteristics of infrastructure, but I don't think the growth opportunity is well understood, and I think that's part of the real excitement of the asset class. So just to touch on that, there's a huge need for infrastructure investment globally as a result of decades of underspend, as well as the changing dynamics of our population.
There's really four key themes that we really try to capitalise on.
To touch on those, we have what we call developed market replacement spend. That's the ageing infrastructure that we have. And if we don't improve it, efficiency's going to go backwards, and so are we.
You have population growth with the east getting younger and the west getting older. Both of those need infrastructure investments.
You had the emergence of the middle class, which is a really, really exciting proposition, and infrastructure is going to drive that evolution.
Then finally, you have the energy transition. We hear a lot about that. We don’t know the speed of that transition, but it's a decades-long opportunity set.
You can see those four thematics are not going anywhere. They're unaffected by short-term cyclical economic events. So to be able to capitalise on that in one asset class makes it a really exciting opportunity set.
Are there any areas that you're particularly focused on or avoiding in the current environment?
Infrastructure should be a position in all portfolios across all points of the cycle, but you know what we can say about 2023, it is very uncertain.
We have inflation ticking up, we have interest rates ticking up, and policy response is really quite unknown. For us, we really come back to revisit the unique characteristics that underpin infrastructure and two in particular in this environment.
One is that earnings are underpinned by regulational contract, and two is that they have an inflation hedge in the business model.
When we are looking to position our portfolio in this environment, we are really trying to capture that inflation and capture that regulatory underpinning. So it really comes down to how quickly you can pass inflation and interest rates into your earnings profile. And that really comes back to two very distinct sub-sectors within infrastructure.
On the one hand, we have our user-pays assets, which are your toll roads, your airports, your port, and your rail. They're 100% correlated to economic activity with GDP driving volumes and an explicit inflation hedge, which is then compounded for future valuations.
These are the assets that we are overweight in the current inflationary environment.
By contrast on the essential services or the regulated utility side, how fast inflation passes through into your earnings profile is dictated by whether your regulatory model is real or nominal.
The real regulatory models get an explicit inflation pass-through, much like a user-pays asset. We like these assets in these environments.
Your nominal rate utilities must weather inflation and interest rate upticks until they can go through a regulatory reset. And sometimes those regulatory resets, particularly when we've got affordability issues, can be quite sensitive. We are actually underweight the nominal rate utility sector within this environment.
At 4D, we always look to have a balance, but we are really trying to capture that inflation at the moment and hedge against the interest rate risk. And that's with user-pays and real rate utilities and underweight the nominal rate utilities, but still capturing those long-term thematics that we love within infrastructure as they're not going anywhere despite the short-term economic events.
