The lines between utilities and infrastructure have been blurred somewhat. The two investment companies that sit in the utilities sector, Ecofin Global Utilities and Infrastructure (EGL) and Premier Global Infrastructure (PGIT), have (as their names suggest) made significant allocations to infrastructure investments. By contrast, 3i Infrastructure (3IN) had 60% of its portfolio invested in utilities companies at the end of September, prior to its sales of Elenia and Anglian Water, but is classified as an infrastructure fund.
In recent years, with low income yields from all the traditional asset classes of equities, bonds and cash, talk is of ‘alternative’ sources of income. Some of these are highly complicated, esoteric and vulnerable to risks that are not present in traditional asset classes. So, why, when complexity is not necessarily desirable, are the relatively straightforward areas of utilities and infrastructure out of favour? These deliver high, relatively predictable, and often inflation-linked and government-backed income.
I suppose that for those of us focused on the UK market the answer is obvious. The electricity price caps which will allow Ofgem to put a cap on energy tariffs from the end of 2018 to 2020 and possibly 2023; the Labour Party’s talk of nationalising utilities and PFI contracts, maybe without compensation; the collapse of Carillion; rising interest rates; and the momentum behind growth stories, particularly technology-focused stocks. No wonder, perhaps, that utilities were amongst the worst performing sectors in 2017.
I would make some observations, however. First, you are by no means restricted to a diet of UK-based utilities and infrastructure investments. EGL had half of its portfolio positioned outside Europe at the end of February and I think only a fraction of its European exposure is invested in the UK and PGIT had just 8.8% of its portfolio in the UK at that date. The other funds have varying degrees of non-UK exposure, the figure for BBGI for instance is less than 50% of the portfolio.
Investors nearly had a further option in the form of Global Diversified Infrastructure. This proposed new investment company from Gravis Capital Partners was to have a maximum exposure to infrastructure projects in the UK of 10% (with no other UK investments) and the rest was to be spread across the US, Europe ex UK, Canada and Australia. It was seeking a minimum capital raise of £75 million, which it just failed to achieve, and the issue has been cancelled with the board saying it did not feel it would be able to achieve the necessary diversification.
It seems a shame to me that investors didn’t embrace the idea given the attractions of the asset class and that we are increasingly late cycle. Valuations, which were previously looking stretched, have also markedly improved, which should have helped. For example, towards the end of November 2017, global utilities (as measured by the MSCI World Utilities index) traded at 16.9 times forecast earnings, close to their five-year high of 17.6 times. Today, the index trades at a multiple of 15.3, below its five-year average of 15.9.
Second, how are the electricity price caps supposed to work in practice? James Smith, the manager of Premier Global Infrastructure, recently pointed out to me a problem: if a key aim of regulation is to ensure that consumers have choice and, almost by definition, the smallest players are the least efficient and hence have the highest break-even prices, any price cap that incentivises small players to enter the market should allow the bigger players to make a reasonable return.
Third, as has been widely discussed in the press, even if Labour wins the next election, how practicable is nationalisation without compensation? How would we ever persuade investors to invest in any sector liable to government meddling again? And, if there were to be compensation, how would we afford it?
The collapse of Carillion hit HICL infrastructure (HICL) more than most after it said that it would make a total provision of £59.4 million on contracts exposed to the company. My expectation though is that this figure will prove to be conservative and we may see some of this written back into the net asset value (NAV) once the dust has settled.
Rising interest rates and the prospect of higher growth should affect most alternative income stocks; not least because these environments should present investors with a more attractive set of alternatives. However, for sectors such as utilities and infrastructure that traditionally support high levels of debt in their capital structures, there is a further worry that rising interest rates will have a greater impact on their profitability. The market does seem to view utilities this way; the rush to sell utilities last year certainly looked like a knee-jerk response to rising US rates.
However, the argument is more nuanced as, over time, most regulators will allow interest rate movements to be passed through to the end user, thereby offsetting the longer-term impact of interest rate rises. This allows utilities to earn a real return, reflective of market conditions, and encourages investment in the sector.
Similarly, in the more inflationary environments that usually accompany rising interest rates, utilities are frequently permitted to increase their tariffs in nominal terms. Both effects will tend to have a positive impact on earnings and exert upward pressure on valuations. It is worth remembering that not all sectors benefit from such adjustment mechanisms.