10 years of the Magellan Infrastructure Fund: Q&A with Gerald Stack

Our aim has always been to construct a portfolio of high-quality listed infrastructure investments to enable investors to benefit from the reliable earnings derived from true infrastructure companies.

In the early days, the Fund was more concentrated, holding about 15 to 20 stocks, and had a significant weighting to non-utility infrastructure stocks such as toll roads and airports. Typically, the weighting to non-utilities accounted for more than 80% of the portfolio.

We came to the view that, while investors wanted the reliable returns offered by infrastructure, the relatively concentrated portfolio structure we had adopted was leading to more volatility than desired. Accordingly, we increased the number of holdings in the portfolio to about 30 stocks and boosted the weighting held in regulated utilities, such as water, natural gas and electricity. Utilities now generally make up 30% to 50% of the investment portfolio and, on occasion, the percentage has been as high as 60%.

The underlying philosophy has remained consistent. From the beginning, we believed that an investment in infrastructure should provide investors with an exposure to reliable income streams and that the consistency of these income streams should give investors great confidence that they will grow their wealth over time.

Infrastructure investors generally define infrastructure as essential assets. Essential assets provide services that communities rely upon for their everyday needs - water, energy, transport, communications - and so demand for the service that infrastructure provides is reliable. However, reliable demand does not necessarily mean that the asset will generate dependable earnings or cash flows. A company, for example, may find itself subject to unfair government action - the government might refuse to allow a company to increase its prices or it might confiscate the asset. As a result, investors in the company may be subject to a loss that is at odds with the desire to gain exposure to reliable investment returns. It is Magellan's philosophy that for a company to be included in the investable infrastructure universe it must not only be an essential asset also its cash flows must be reliable and not subject to undue risk. To ensure cash flows are reliable, it has always been our thinking that the earnings an infrastructure company generates should not be sensitive to competition, movements in commodity prices and regulatory risk.

While the application of these principles to the potential universe of investable infrastructure limits the potential universe in which we can invest, it means that we can be confident that we will deliver investors the reliable investment returns that we believe they expect from the asset class.

While there has been much activity in infrastructure investment over the decade, in many ways not much has changed.

Although there have been companies entering and exiting the sector, the total number of companies that we consider to be investable infrastructure companies has been relatively stable. While the global financial crisis had little impact upon the infrastructure and utilities businesses, the panic that prevailed among investors led to share price falls. As a consequence, unlisted infrastructure investors took advantage of the situation to snap up a number of high-quality investments at bargain prices. Offsetting these public-to-private transactions were privatisations and corporate spin-outs of infrastructure businesses. The net result is that the number of companies in the listed infrastructure sector has remained stable at about 350 stocks.

While the number of companies has been steady, the amount of capital in the sector has grown. This is because capital expenditure for the sector has been greater than depreciation and as a result the size of the average company has grown. Capital expenditure has outpaced depreciation for a variety of reasons: communities underinvested in infrastructure in the 1970s, 1980s and 1990s and to maintain the reliability and integrity of energy, water, and transport infrastructure requires capital investment; following the GFC, governments confronted with a recession resorted to encouraging infrastructure investment as a way to boost employment; and concerns about greenhouse gases promoted the development of renewable energy sources that needed to be connected to the electricity grid. Each of these structural forces remains relevant today and we expect the size of the average company in the sector to grow.

Over the decade, infrastructure businesses have performed in a predictable manner. Regulated utilities have generated reliable earnings and the regulatory regimes within which they operate have been stable. Notwithstanding the economic turmoil experienced just after the GFC, regulators have generally been very even handed in their approach and have resisted any external pressure to artificially reduce regulated rates of return. Non-utilities - toll roads, airports and communications infrastructure - have consistently grown their earnings over the medium term.

In the small number of cases where financial distress has been experienced over the past 10 years, it has generally been due to too much leverage. The dangers of excessive debt are not new to investors but that does not mean that investors won't be burnt again in the future. Personally, I learnt a painful lesson that the maturity profile of a company's debt can be almost as problematic as the level of debt.

Investment performance for the sector included a significant downturn experienced around the GFC followed by strong performance over the remainder of the decade. The strong investment performance reflected the reliable earnings generated by infrastructure companies combined with declining discount rates (or rising earnings multiples) as a consequence of falling real interest rates. It is our assessment that the asset class is fairly priced today, even based on a cost of capital higher than prevailing bond yields. We believe that investors have assumed central banks will normalise monetary conditions in coming years and that share prices reflect these views. However, if central banks were to increase interest rates above expected levels then this would be problematic for infrastructure investors.

Finally, the investment claims of infrastructure are more widely accepted and demand for the asset class is more widespread than it was a decade ago. Investors have acknowledged the financial performance of infrastructure stocks and have increasingly sought to gain exposure. Demand for listed infrastructure has grown across a range of jurisdictions over the past five years and indications are this demand will keep growing.

To date, it would appear that companies that meet Magellan's definition of infrastructure have been shielded from most disruptive technologies. The two most notable disruptive technologies that affect infrastructure are renewable energy and autonomous vehicles.

With renewable energy, while we expect many of the traditional energy generation technologies (coal, gas and nuclear) to have a place in the fuel mix in the coming decades, the transition to increased market share for renewable energy is likely to be problematic for them. However, Magellan excludes energy generation from its infrastructure universe and so this is of little concern to our investment in infrastructure.

Magellan does invest in electricity transmission and distribution - the poles and wires (often known as the grid) that transport electricity from generators to homes and businesses. The dramatic price reductions experienced by roof-top solar and batteries in recent years raise the question as to whether or not these technologies will disrupt this reliable earnings profile of the grid. Magellan believes that for the foreseeable future the grid will remain an important piece of infrastructure in the community. Firstly, studies estimate the cost of a disconnected system to be eight times higher than simply drawing power from the grid. While the cost of installing the system may come down in the future, there are still barriers to mass adoption as many homes have insufficient space available for all the requisite equipment to be installed. Even for those households with adequate roof-top space and large solar or battery systems, there is still a benefit in staying connected to the grid as this allows excess electricity to be exported back to the grid. So for now, we expect utilities to remain a reliable investment and we remain confident on the outlook for the sector.

With automated vehicles, we expect driverless cars will generally be positive for the earnings of toll roads, and particularly urban toll roads, over the next 10 to 20 years. While the basic technology for driverless cars already exists, there are myriad social, regulatory and legal issues that need to be addressed before they become ubiquitous and we expect the shift to driverless cars to take some time to occur. But in the meantime, the technology will develop and can be expected to affect toll-road usage. Based on our analysis, we expect the development of driverless cars to boost toll-road traffic and earnings over the next 10 to 20 years. However, beyond that period, the impact on usage of toll roads is difficult to predict and may be negative.

The nature of technology disruption is that no one sees it coming. We remain aware of the disruptive potential of new technologies but believe it is unlikely to materially affect the companies in our defined investment universe and, where it does, the impact will be spread over many years, even decades.

I would tell myself that the structure of a company's debt is as important as the level of that debt. The profile of debt maturities and the covenants and options associated with debt were significant issues for a number of infrastructure businesses during the GFC. A heightened appreciation for these factors would have been helpful ahead of time.

I am always keen to remind myself that ultimately cash flow prevails. The share price for a company can get disconnected from the underlying performance of a business for a period of time but, in the end, the share price reflects underlying cash-flow generation. Businesses that generate predictable, growing cash flows over the long term will perform well for investors over time while businesses whose operating and financial performance is problematic are likely to disappoint. So concentrate on identifying those companies that can generate great returns for long periods of time.