Imagine you could dream up the perfect business to own for the rest of your life. What qualities would you want it to have?
If you could ask for anything, you’d probably want a monopoly of some kind. You’d probably want cash flows to be predictable rather than unpredictable. You might look for some protection against inflation. And while you’re at it, you might as well chuck in some supportive long-term trends.
Infrastructure assets often combine all four of those qualities in one. Which makes it little surprise that a certain gentleman from Omaha seems to like them so much.
Warren Buffett’s crown jewels
In Berkshire Hathaway’s 2021 shareholder letter, Warren Buffett highlighted “four jewels” within Berkshire’s collection of businesses.
- One was the company’s stake in Apple, though Berkshire’s reduction of this stake by 50% recently might cast some doubt on that.
- Another was Berkshire’s insurance operations. These provide low-cost funds in the shape of premium payments than can be invested in advance of any claims being paid out. If the insurance firms can eek out an underwriting profit, the cost of these funds is negative.
- The other two gems – the Burlington Northern Santa Fe railroad and Berkshire Hathaway Energy – are infrastructure assets.
While Berkshire’s two infrastructure jewels are unlisted, plenty of high-quality assets remain available for purchase in public markets. In a recent episode of Magellan’s In The Know podcast, members of their infrastructure team shared lessons from 50+ years in the space.
The essence of infrastructure investing
“The essence of what we are investing in are assets with massive capital expenditure upfront, followed by a long series of very reliable, predictable cash flows”, says Magellan’s Head of Infrastructure Gerald Stack. “Our main areas are regulated utilities and transport assets like toll roads and airports.”
The chief attraction of this kind of asset is the predictability of long-term demand and, therefore, their cash flows.
Unless humans stop drinking water, washing themselves or using toilet facilities, there will be a need for water and sewage businesses in the future. Meanwhile, rising populations and prosperity have historically led to more drivers on roads, more flights being taken and growing demand for energy.
My main question, then, would be this: how could investors ever find these assets at an attractive or reasonable price?
According to Magellan’s team, the answer is that short-term panics often lead investors to forget how durable these assets and their demand trends really are. As Ben McVicar put it, “Some interesting opportunities come out if you are able to look through short-term issues and project into the long-term what you've seen happen for the decades in the past.”
An obvious example of a short-term issue comes from Covid, when air travel fell towards zero before returning towards historical trends. But that was just the latest of many episodes, explains Ofer Karliner.
“If you look back at September 11, people were never going to travel again. Sure enough, within a few months, traffic was back on trend. In SARS, people were never going to go to Hong Kong again. In a few months, people were back travelling to Hong Kong like nothing happened.”
Other situations where short-term uncertainty can reveal long-term value include concerns over regulation or a company’s financial position. Investors can also be guilty of throwing the baby out of with the bath water, as happened with British water stocks in 2023.
Thrown out with the bath water
The opportunity arose after several operational and financial missteps by Thames Water, which serves around 25% of Britain’s population and therefore has a big public profile.
“Thames Water has very serious balance sheet issues. They've got very poor operating performance metrics. Their regulated return on equity for the first few years of the current regulatory period is something anaemic like 1.9%. So it's absolutely tiny” says Ben McVicar.
Other British water utilities – like the publicly listed United and Severn Trent – have shown far better returns on equity, cleaner balance sheets and better service stats over time. Yet their stocks suffered as investors projected Thames’ problems to other companies in the sector.
McVicar said the Magellan team felt that investors misunderstood the impact that Thames Water's travails could have on its better-run peers.
“The market said "Okay, you've got this problem with Thames Water, the government must therefore look at the rest of the sector and try to penalise [it]. If anything, it could give them an opportunity to continue to grow their asset bases. For most infrastructure businesses, that’s the main growth engine”.
Recognising these differences in quality and having a different take on the main issue bugging markets – the prospect of more investments in their service – served up what McVicar saw as a compelling opportunity.
“There were times last year where these companies traded at close to one times regulated capital value, which is not that typical for us”.
A different perception of Capex
Stack sees the perception of capital expenditures as a key difference between infrastructure assets and investing in other companies.
As he put it, “you're providing an essential service in something like a monopoly setting. It’s the CapEx that gives you the right to charge for that. Many investors get a bit scared when they hear CapEx. Our eyes tend to light up a bit.”
This can lead to situations, like the UK water utilities case, where concerns regarding future CapEx weigh on a stock price yet actually provide an opportunity for the company to grow their earnings base.
Another example could be the US electric utilities and the huge investments they’ll need to make to support any energy transition.
“These guys are not that heavily levered by global standards or by historical standards” said Ofer Karliner. “Yet people will look at them and say they’ve got to fund massive CapEx. People look at it as a problem, we see it as a massive opportunity”.
The importance of incentives
Magellan’s team also touched on the power of incentives to inform outcomes.
Examples here include pre-GFC utilities being managed by external managers compensated for how much and how quickly they could grow the asset base. Several companies, quite predictably, ended up with far greater asset bases and far too much leverage heading into the GFC.
More recently, huge cash rewards for investment bankers pitching toll-road deals to buyers led to aggressive traffic forecasts that ultimately disappointed. “Incentives drive behaviour" said Karliner. "Getting management wrong and getting their incentives wrong can have a material impact on your outcomes as an investor.”
The most important lesson I took from the discussion, though, was the overarching opportunity to turn short-term worries to your advantage as a long-term investor. As Ben McVicar put it, "you’re investing in high quality, reliable businesses. Short-term issues don’t tend to sink the ship. They are just gate issues you’ve got to get through”.
Joseph Taylor is an Associate Investment Specialist, Morningstar Australia and Firstlinks.
Here's a link to the full podcast from Magellan: https://magellan.podbean.com/e/lessons-learnt-from-investing-in-essential-services/