Infrastructure: a solid foundation for emerging market investment

WHILE the emerging markets story has been well told, gaining access is less clear. With a $2 trillion growth opportunity, one option is infrastructure.

As the investment world faces an unknown future in the near term, one certainty seems to be that the emerging markets will lead infrastructure spending over the next 10 years.

The rise of the emerging markets’ middle class has seen the number of people in cities outweigh those in rural areas for the first time ever.

This preference to live in cities will raise further demands for a better quality of life, which will include improved social and economic infrastructure.

This is beginning to be seen now, with demand for road and rail running much faster than gross domestic product growth. Booz Allen Hamilton estimates that US$7.8 trillion will need to be invested in road and rail infrastructure in the next 25 years and China is planning to lay 25,000 kilometres of track over the next five years.

These factors will generate long-term opportunities for companies that have direct exposure to delivering and maintaining infrastructure assets, such as mobile communications and transportations including roads, rail, ports and airports, as well as industries that supply materials to construct infrastructure such as steel, cement and heavy machinery.

Infrastructure: a good way to dip your toe into emerging markets

With its more predictable and resilient cash flows, infrastructure provides investors with a lower risk exposure than a more blanket investment approach to emerging markets.

The high entry barriers mean many infrastructure assets are the sole providers of an essential product or service and, therefore, monopolistic in nature, bringing predictable returns through long-term contracts.

Once an infrastructure asset is developed, ongoing operational maintenance expenditure may be relatively low and stable. As a result, increases in revenue may not necessarily mean increases in operating expenditure, thereby increasing free cash flow.

Recent events have also made infrastructure assets historically cheap. Both the assets and supporting engineering and construction companies are likely to present very attractive opportunities in this global bear market.

The very low asset prices we see now in equity markets, combined with the long-term structural trends in energy, water, waste and transportation, provide investors with an attractive entry point into emerging market infrastructure.

The relative valuation for emerging markets is also currently compelling, with equity risk premiums (ERP) still higher but the downside economic risks much less than in the 1990s.

The ERP is more attractive than in the 1990s, but the economic risks are lower because emerging market countries are, generally speaking, in better financial shape, with significant foreign exchange reserves and much higher sovereign credit ratings.

Understand the risks and the investment

Risk is reduced through diversification across sectors and geographic regions and the scale of new urbanisation and industrialisation that is happening in the developing world has given long-term strategic confidence to many who participate in this emerging market infrastructure investment. But with good returns, it’s important to respect the risks.

Emerging markets are typically more volatile than developed markets and may be exposed to issues such as heightened political unrest and sovereign intervention.

Investment ideas are primarily generated from understanding the company and country.

This can be achieved through a two-prong approach of understanding thematic trends in infrastructure and identifying companies with strong earnings growth and relatively low business risk.

The current global turmoil is an excellent example of the need to have good macro analysis when investing in emerging markets to highlight investment themes and risks.

To do this, a top-down analysis is needed to assess the overall economic environment and analyse the fundamentals of each country within the broader global and geopolitical environment. This includes an assessment of each country’s economic health, its ability to service its debts, its access to global funding, local sentiment and political conditions.

Complementing this, a detailed bottom-up analysis of individual securities is also required. This will generally include the analysis of key revenue and earnings drivers, growth potential, management quality, competitive analysis and infrastructure characteristics.

In the current market, it’s important to differentiate between what is cyclical and what is more structural. By investing in structural themes like emerging markets infrastructure, investors are able to gain exposure to evolving global trends but with a relatively low risk exposure to the growth of these emerging market economies.

Jonathon Ong (pictured) and Dave Dali are co-portfolio managers, emerging markets infrastructure, Macquarie Funds.