Fledgling giants

Fund Strategy - 15 Aug 2011 | By Rodrigo Amaral

A former mayor of São Paulo once bragged that the Brazilian metropolis’s legendary traffic bottlenecks constituted unmistakable signs of progress. As they spend long hours stuck in their vehicles under a scorching sun, São Paulo drivers are likely to differ. But if the former mayor’s concept of progress was restricted to the economy, he could arguably have a point. In São Paulo, as in other large cities in up-and-coming emerging markets, impressive rates of economic growth have combined with inadequate infrastructures to make the lives of their inhabitants ever more chaotic.

Countries like Brazil, Russia, India and China have lagged the developed world in the quality of their infrastructure owing to decades of underinvestment, as a result of lack of money, poor governance or both. The lag creates discomfort in the daily life of their citizens. It also implies constraints to economic development: experts argue that poor infrastructure costs India two percentage points of GDP growth every year. But as they play catch-up with their rich peers, emerging markets are tackling the problem with unprecedented determination.

”Emerging markets will continue to move to centre stage, and infrastructure investments will be key to generating growth”

“Emerging markets will continue to move to centre stage, and infrastructure investments will be key to generating growth,” says Philip Poole, the global head of macro and investment strategy at HSBC Global Asset Management. The phenomenon is creating plenty of opportunities for international investors. The private sector has been called to play an important role in several of those markets. Indirect opportunities are also being generated in both the equity and fixed income realms for diligent investors.

According to a recent study by the Urban Land Institute, an American think tank, and Ernst & Young, a consultancy, $50 trillion (£30 trillion) will be invested in infrastructure projects around the world in the next 25 years. A large chunk of the money will be spent by emerging markets. (Cover story continues below)

Not surprisingly, the most extraordinary tales come from China. The Asian giant is investing $1 trillion in five years in a series of mammoth projects to cater to its breakneck economic and social changes. If recent train crashes do not derail its plans, China will be soon able to boast a 10,000-strong high-speed rail network that will have no peers in the developed world.

The government also wants to put in place a web of tolled highways to match America’s interstate system, and dozens of top-notch airports and ports. Even nuclear power is on the agenda, with China developing more nuclear plants than anywhere else to quench an insatiable thirst for energy.

But China is not the only game for infrastructure investors. India’s forthcoming five-year economic plan, to be launched next year, is also expected to take infrastructure investments to $1 trillion, doubling the amount it will have spent over the previous five years. The goal is to match China’s investment to GDP ratio, as India vies to keep up with its more dynamic neighbour. The government expects to attract private sector investments to the tune of half the amount required, which should ­create plenty of opportunities for direct involvement in one of the world’s fastest-growing econ­omies. Ports, airports, urban railway systems and energy plants will mushroom around the country if planned spending takes place.

In Latin America, Brazil is making a huge effort to compensate for several decades of underinvestment. For instance, transport links are widely seen as insufficient given the pace of economic activity in the country. Brazil’s ports are often listed as among the least efficient in the world, and its airports are a nightmare for frequent travellers. Many blackouts in the past decade have underlined the need to boost energy production. Recently ­discovered offshore oil reserves require huge investments to turn black gold into hard currency.

Mexico, for its part, is developing public private partnerships for 300 infrastructure projects that aim to modernise ports, airports, railways, energy and water, with more than $140 billion invested since 2007. Other Latin American countries like Peru and Colombia are also making big efforts to upgrade their infrastructure to meet the demands of fast-growing economies. Chile is rebuilding large parts of the country that were devastated by an earthquake last year.

The bravest investors can even look at Africa. Angola, which was devastated by a long civil war that ended in the early 2000s, is making use of its oil wealth to build a much-needed infrastructure network from scratch. African markets are also benefiting from huge Chinese investments, as the world’s second largest economy taps deposits of raw materials and commodities. All in all, Merrill Lynch has estimated that emerging markets will invest $22 trillion in infrastructure projects in the period between 2008 and 2014.

All these countries have plenty of reasons to spend. Although they are the most likely sources of economic growth, many emerging markets have still not gathered all the required ingredients to fulfil their economic potential. Some countries, including India, are having to build new infrastructure. Russia already has plenty of roads and other facilities in place, but most areas need urgent upgrades.

Fast-paced urbanisation is a strong theme across the picture, as the ratio of people living in cities should reach almost 60% of the combined population of least developed countries by 2030, up from less than 18% in 1950. As they leave their rural birthplaces, people expect to find all kinds of services in the cities they settle in. The trend is particularly felt by countries like Indonesia and China, where huge migration movements have generated the need for large investments in transport networks, water and sewerage and other basic facilities.

As a result of all these factors combined, it is suggested that China already invests about 9% of GDP in infrastructure every year, and India 7.5%, which are high ratios by any standards. Other emerging nations still fall far behind such numbers, but they know that to keep up with their giant peers they will have to pump up their spending too. It is unlikely that the process will be cut short, not least because emerging markets enjoy ­better-looking finances than the developed world, and as a result an enhanced ability to draw private funds.

Coping with economic and social changes is not the only reason for emerging market investment in infrastructure, however. Much of the money is being spent on showcase initiatives. China led the way by hosting the 2008 Olympic Games, which cost dozens of billions of dollars. South Africa followed by staging the 2010 Fifa World Cup, and the flow has not stopped there.

”A lot of the large energy companies suffer from state intervention and are not run for the benefit of minority shareholders”

Brazil has updated football stadiums, built sports facilities and enhanced transport links with its sights on the 2014 Football World Cup and the 2016 Olympic Games, which will both be hosted there. Russia will stage the 2014 Winter Olympics and the World Cup four years later. After Russia, the winter games will take place in South Korea, a borderline developed economy, and the football circus will move on to Qatar, a geographical minnow with large coffers of petro­dollars. Sports governance bodies argue that change is well under way and will benefit markets that were once thought to be peripheral to the global economy.

Investors see this trend as a means to match the benefits of a defensive strategy with faster economic growth. The logic is not difficult to grasp. Governments invest in infrastructure with an eye to the long term. To attract private partners to the projects, concessions and other collaborations are signed with long maturities that span for up to several decades. As long as everything goes according to plan, the companies that bag the projects have a sure stream of revenues.

“Infrastructure is a stable and cash-generative business,” says Evan McCordick, the managing director at Cordiant Capital, a Montreal-based fund management firm that specialises in emerging markets. Investors like McCordick argue that, in emerging markets, well-designed projects answer real demand for airports, roads, hospitals and schools, for example. When a company earns the right to upgrade and manage a port in India or Brazil, it is reasonable to expect that the facility will live off a steady stream of work for several years.

Experienced infrastructure inves­tors suggest that it is a play for people with a long-term investment horizon. Stephen Parr, an investment manager at Aberdeen, points out that long-term planning, predictable earnings and cashflow are some of the main characteristics of a good investment related to infrastructure. “We are long-term holders of companies, and this is a perfect strategy for infrastructure stocks,” he points out.

But some could think twice at the prospect of betting on the long-term stability of a project in countries such as Russia, Brazil or India, where unpredictability has been the norm rather than the exception for most of their recent histories. “When you talk to investors who want to get into emerging markets, their major concern is often political risks,” says David Creighton, the chief executive of Cordiant Capital. “They want to know whether there can be an expropriation of assets if a new government comes in, or whether assets will be properly maintained over the course of a contract, which is a concern that we have certainly seen with projects in Latin America and Africa, for instance.”

Delays are not unusual. Brazil’s ability to meet its World Cup timetable has come under the spotlight. Corruption, red tape and tainted competition are also concerns that crop up for seasoned emerging markets hands.

Another concern is the role played by the state as an economic planner in countries such as Brazil, China and Russia. Chinese companies are also often accused of prioritising government happiness over returns delivered to stock or bond holders. This runs counter to the argument that such firms enjoy a stronghold in their markets and, consequentially, have unequalled ability to generate revenues. Some investors say privately that it is a good idea to stay away from companies like Petrobras, Brazil’s state-controlled oil producer, and Gazprom, Russia’s gas giant, even though their access to immense and valuable natural resources should make them attractive investment propositions. “We feel that a lot of the large energy companies suffer from state intervention and are not run for the benefit of minority shareholders,” the investor says.

On the other hand, there are plenty of international investors who argue that governments in emerging markets have learned from their mistakes and are making an effort to assuage the fears of private capital. “Over the years, the movement towards long-term reliability on infrastructure projects has been quite firm,” says McCordick. At HSBC, Poole shares this view. “We have seen an improvement in disclosure and transparency in many emerging markets over the past 10 years,” he adds.

Even so, keeping investors’ minds at ease in the long run is an important task for companies like Cordiant, which raises money to lend to entities that take part in infrastructure projects in emerging and frontier markets around the world. One solution found by the firm has been to focus on investments originated by international financial institutions, like the World Bank or the Inter-American Development Bank. As such, investments managed by the firm can enjoy a level of protection traditionally associated with such bodies. “They provide us a higher degree of certainty that we won’t be abused as investors,” McCordick says.

”Service stations are something that we take for granted in the US or the UK, but they are becoming a growing area in Russia”

At Cordiant, McCordick notes, funds have been able to deliver 5-7% returns a year in dollar terms. McCordick claims that the infrastructure sector enables the funds to achieve performance with low volatility, which is often not the case with investments in emerging markets. “In infrastructure we didn’t have a single negative credit event during the 2008-09 crisis, which says a lot about how stable it is if you pick the right projects,” he says.

Investors have also been keen on debt from emerging market firms that are trying to raise money for infrastructure projects. Brazilian companies, for instance, have issued record levels of debt so far this year. The range of issuers includes producers in areas like raw materials, energy, oil and cement as well as real estate developers and transport firms. Market conditions have also allowed Brazilian companies to offer their first project finance bonds, sophisticated structured products that promise steady returns by providing indirect exposure to the country’s anticipated oil boom.

But fixed income is not the only game in town. Investors with a taste for risk tend to be most drawn to buying infrastructure-related stocks. The rollercoaster ride in global equity markets this year could make this an offering for only the boldest investors, especially given the traditional risks of emerging markets. Despite a turbulent period, however, the JP Morgan Emerging Markets Infrastructure fund has delivered annualised returns of over 19% in the 12 months to the end of June.

Equity investors also have a broad range of companies to choose from. Definitions of what can or cannot be described as infrastructure stocks vary, including sectors like energy, water, transport networks and telecommunications. Each sector has several sub-sectors that can be deemed to be providing the right exposure. ­JPMorgan Asset Management, for instance, classifies companies in the sector in three broad areas: builders, providers and operators. The classification encompasses a large group of companies, from construction players to high-tech firms that can profit from the boom in IT infrastructure.

For Aberdeen, eligible stocks are typically linked to operators of per­manent assets that support the economic development of emerging markets. The definition is broad and allows for some interesting picks. For instance, Parr says that some of Aberdeen’s larger holdings are real estate developers that specialise in the construction and maintenance of shopping malls. “They are efficient, high-end operators, which are market leaders in their field,” he says.

Such firms provide a way to avoid some of the risks of being involved in the retail sectors like housing and mass consumption, while at the same time taking advantage of booming domestic demand.

The strength of domestic consumption is also a strong driver of infrastructure investments in emerging markets, and a theme that has preoccupied international investors for some time. “We try to capitalise on the domestic consumption scene whenever it is possible,” Parr says. “That’s why we prefer telecommunications operators rather than equipment producers, as they are closer to the consumer.”

The consumer side is also an important factor for JPMorgan’s funds. Emily Whiting, a client portfolio manager at JPMorgan Asset Management, points out that in the telecommunications sector, for example, managers look for companies that offer innovations for consumers and providers in local smartphone markets. Unusual plays can also arise at the regional level, she says. One promising development is the construction of service sta­tions on motorways in Russia, which are going through a much needed renovation process. “Service stations are something that we take for granted in the US or the UK, but they are becoming a growing area in Russia,” Whiting says. In Brazil, her fund invests in a company that furnishes scaffolding to building sites. The firm in question has a 40% market share in a country that is rapidly turning into a vast construction site.

For investors who are concerned about the legal and financial risks of emerging market investments, many of these businesses can also be accessed through developed markets, says Poole. “If investors are concerned about corporate governance, transparency and currency risk, they can invest in multinational companies based in the developed world which are benefiting from infrastructure investments in emerging markets,” he says. Multinational firms are not only eager to expand their presence in the emerging world, but are even advertising their exposure to markets that were once seen as potential liabilities. In Spain, the financial media has focused on blue chips’ willingness to dismiss domestic operations and drum up support for Latin American units.

Increasingly, stocks listed in London, New York or Paris are not unusual sights in a portfolio of emerging market infrastructure plays. Funds managed by Aberdeen, for instance, hold at least a quarter of their stocks in firms with a developed world listing. At JPMorgan Asset Management, the definition of an eligible stock is that most of the company’s revenues must come from emerging markets. “Emerging markets infrastructure is a highly diversified play,” Whiting says.

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