Infrastructure investing has historically benefited in inflationary environments and is emerging to be an attractive feature given today’s market dynamics. In the latest episode of WP Talk, Dave Wahl, director, senior portfolio specialist at Franklin Templeton, discusses the importance of investing in infrastructure today and the top advantages it provides. He also delves into the current market conditions and makes a case for why you’ll need an active strategy if you’re going to reap the benefits of infrastructure investing.
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James: Hello and welcome to the latest edition of WP Talk. I'm your host, James Burton, managing editor of Wealth Professional Canada. For this episode, I'm delighted to welcome David Wahl senior portfolio specialist at ClearBridge Investments. We turn the lens on infrastructure and discussed why it's a good investment opportunity today, how it performs in differing environments, and why active management is critical. Nice to speak to you Dave. Welcome.
David: Yes, nice to be here. And happy New Year to everyone.
James: Absolutely. Now we will be getting into the Franklin ClearBridge, Sustainable Global Infrastructure Income Fund and its ETF system, if you like. But before we go into that, I just want to set the scene a bit early, Dave, because the world has obviously changed a lot in the past 12 months with significant investment implications. So as we hone in on infrastructure, why do you think investors should be excited about infrastructure as an investment opportunity today?
David: Yeah, I guess that's the million dollar question and one that I hope we can answer here today. I'd just like to thank everybody for allowing the opportunity to speak today and appreciate the time that your audience is going to take later on, I guess, to understand the in first story. But you know what, just before we get started, I wanted to just briefly talk to people about how my day has gone. So my alarm went off way too early this morning. First thing I did was turn on the lights, went to the washroom to splash water on my face. Notice that the gas furnace was running to warm up the house from a cool night. I guess I went downstairs, made breakfast on the gas stove, hurried back upstairs for a shower. As obviously I'm running late, as I usually do. Got in the car, took Highway 407. I'm living outside of Toronto to the go station. I took the train to my first meeting, went directly by the airport. Now that seems normal enough to everybody. And just to level set, I just want to say. But what does my entire morning routine have in common? And what it does is each step of the way involves some form of infrastructure, electricity, gas, water, 407s, a toll road, rail, airport. These are all infrastructure assets that are listed portfolios such as the one that's available at Franklin Templeton could invest in. And just for everybody sake, infrastructure are those assets that provide services for us that are essential to live our everyday lives, they're services we use and interact with every day. You know, I just talked about gas, water, electricity. We do all of those things to carry out our daily activities. We use infra like airports, rail and roads to move people, goods and services, you know, from location to location, whatever. But no matter if markets are in boom or embossed, we generally will interact with these essential services every day as our demands for these services usually are fairly constant. So there's little impact to fundamentals vary via uncertain economic conditions or or even a downturn in market conditions as we're talking about now. So that's one part I just want to make sure everybody level set and why this investment opportunity is good in most market conditions. And I think maybe we can talk about that later on. But additionally, it's the solution for all the issues that are concerning investors right now uncertain economic, environment, inflation, interest rate increases, geopolitical uncertainty. All of this is the perfect storm for infrastructure because sometimes the headwinds for other investments are tailwinds for infrastructure investing, and it can solve for many issues. Income, stable and predictable inflation hedge 90% of the names in our portfolio have some sort of inflation hedge preservation of capital. Over a ten year period, it gets 80% of the upside, while only capturing about 45% of the downside reduced volatility. All of this makes it not a product to invest in, but probably a solution as you're looking at it for these uncertain times. I know that was a long answer to to begin, but I wanted to kind of level set and why I think it's a great opportunity now and in the future.
James: Yeah, absolutely Dave. No, it's a great answer. I just wanted to add an additional question here for me. I was speaking to someone recently who was sort of reflecting on some of the changes that have happened. And you mentioned that, you know, the economy or the markets have gone from sort of a fantasy to a fundamental reality shift. And we're talking maybe I was alluding to my Silicon Valley, you know, maybe social media boom zoom. And now, as you just eloquently talked about, we're talking about infrastructure and taps and energy and furnaces and stuff. Well, I mean, would you would you agree that in that with that shift.
David: Yeah, I think the market has proven it. And you know, going forward it not only for the current market environment, but I think for the long term there's opportunities for for infrastructure not only to invest in infrastructure from a defensive perspective, but to thrive in that atmosphere as well.
James: Yeah. So what are the key attributes that you'd name that would make an infrastructure strategy a right fit for current market conditions?
David: Yeah. So, you know, and I guess I just mentioned it. So if you want to look at a quick overview of why we would invest in infrastructure for the long term and we'll probably talk more about it as we have our discussion today. But there's a few things that I think are important. One, there's significant growth in in infra assets globally, and that's from both emerging and developed markets. It's not a lot of people believe this is an emerging market phenomena with urbanization, with the enhanced and the increase in wealth in the middle class, the burgeoning middle class. But it's also in in the developed markets and with increased capital, increased capacity, with maintenance of infrastructure, it's already there developing new infrastructure. All of those things make this infrastructure significant investment going forward. We have a study that we used to do a long time ago and it's still relevant today. So it's not a recent phenomenon of infrastructure. We have a study from Hale Economics that stated assets were expected to grow from $50 Trillion in 2014 to 110 trillion in 2030. So that study in 2014 was already talking about the opportunity for investment in infrastructure, and it's even a larger investment today. Some of the issues are private sector has got to play a larger role with all the government constraints. Government used to be able to build infra and maybe not maintain it. Now it's getting harder and harder to set aside assets to to even build infrastructure for government, energy and transportation sectors. They're going to drive that growth. And from our perspective, that's in the listed infrastructure sweet spot. And I guess finally, we've all heard of this many times, especially recently. Green stimulus around the globe is going to encourage renewable investment net zero 2050 are going to be is going to be a large driver. I think also that when people are looking for stable and predictable growth that infrastructure provides, that cash flows are underpinned by either regulation, government regulation or long term contracts. And like I mentioned earlier, most revenues are linked to inflation. And and finally, I think the asset class does provide diversification of your equity portfolio. It has a lower correlation to most asset classes. I spoke about the strong upside capture and the low downside caps, and I think that's what people are looking for that path to get to a good return profile, but they want that smoother path. A couple of thoughts I think that we have on the outlook for next year. From our perspective, secular growth drivers for infrastructure are probably going to be on full display on 2023. The dire need for infrastructure spending is going to underpin growth in this sector for the next decade. And really the first steps for meeting long term climate and electrification goals are being taken right now. The second phase of bear markets, which we think we're going to is generally an earnings recession and we expect that to be in full force as well in 2023. But we think that's really going to have a muted impact on infrastructure. And I think finally and thirdly, energy or energy security, I guess I should say, and whether that's on showing or reshoring investments in wireless towers and industry transformative tax credits that the US Inflation Reduction Act driving renewables and utility utilities investments are among the tailwinds for infrastructure in 2023 and even far beyond. I think those are all kind of the attributes that are going to lead to profitable infrastructure investing.
James: Yeah. Now, as you've alluded to, there and talking about the secular drivers and it kind of leads on to the next question nicely about how you think infrastructure will perform in different environments over that decade that you mentioned there. And importantly, how do you manage that opportunity within your fund?
David: Yeah, that's a long I'll try to make this a the shortest long answer I can possibly give you. But it's a great question and it's something that should be important. And number one in people's minds when when they're thinking about infrastructure and more specifically perhaps looking for an infant manager, that I think would be a good option. But let me just start about, I think our philosophy for infra. We really believe that infra assets and that's whether they're listed and that means they're in the public market or unlisted in private companies, they all have the same characteristics and operating cash flows. We think that by us using longer term fundamental valuation approach when we're investing in listed markets and that's throughout the different cycles, there is a lot of opportunities arise as those markets mispriced infrastructure assets, and that's generally lower than they should be in the short term. And through us accessing those markets, we really think. We have the ability to get in and out of a company and and the number of companies to invest in is greater, and that allows us to get an enhanced return. So that's just the very first part. I think that. The funny thing about infrastructure is that it's not apples to apples when it comes to investing. And this all goes to your question on how we manage in these different environments. And it's really not the same as everybody knows what a large cap name is or what a small cap name is. But there's really no universally agreed upon definition of infra. And I think from our perspective and relative to most infrastructure indices and other managers, we really have a more focused view of what we think constitutes infrastructure. We really think that pure infra is assets with monopoly characteristics, long life assets or contracts and relatively stable and predictable cash flows like it spoke about. So again, trying to make this long, long answer shorter, our definition of infra really can be described as core and two buckets. So we really focus on regulated assets and that's your poles, your wires, your pipes, really the transmission and distribution of utilities. And these are defensive with high income and lower GDP exposure, lower leverage to GDP. The second bucket we focus on are user pay assets and that's that's more your traditional infra sectors that I was speaking about in the introduction. That's your roads, your rail, your ports, your airports, really essentially transportation. And these sectors are more growth, your assets, they have a lower income component and they're leveraged to GDP. We exclude unregulated assets names with supply, demand, risk, energy, retail and and unregulated generation construction and service companies. All of those things we exclude to try to reduce commodity price exposure and volatility. We're really looking for low volatility and income stability. So all of that being said, so you get an idea on how we look at infrastructure. How does how did we perform in different market conditions? And one important note is that we are benchmark unaware. We are looking for G seven inflation plus five and one half percent return, really real five and one half percent return over a 3 to 5 year cycle. So an example during a declining growth with inflation that's positive for utilities because your rate base grows and it's a good ROE, but there's a rotation away from the economic sensitive infrastructure or the user pays and towards those regulated utilities. Another example is if we're in a recession with low inflation, that's low negative growth and low inflation. Bond yields are lower, utilities shine with strong earnings growth, the user pay side will disappoint. So we would rotate to more the regulated utilities. Those are just a couple of examples on on how we would change our portfolio so we could get performance in different market conditions or throughout an economic business cycle.
James: Yeah, excellent. Great insight there, Dave. Next question is can you discuss the advantages following the smart money brings?
David: Yeah, and this is more it's a good question. And it's you know, I've talked about this in the past, and I'm sure that you've been given this question to kind of get drawn out of what I'm talking about, because it's not really about the investment side. I'm doing this putting my sales hat on when I talk about this in presentations. And it's really interesting. And I think throughout the conversation we'll probably discuss and we have a little bit the reasons why I think info makes sense as an investment. But following smart money is validation of the investment to real assets and more specifically, infrastructure. I've done a little work on trying to understand the level of infrastructure, investing in some prominent pension plans in Canada from all regions and even nationally. And if you look at the level of investment between now and say ten years ago, the allocation to infra has been increasing and the outlook going forward is to continue to make those greater investments to real assets and more specifically, as we're talking about today, infrastructure. So I refer to these large institutions as the smart money and for all the reasons they are investing. And that can be reflected and kind of translated to the smaller investment or the smaller investor. I guess it for me, it's in a sense it's trying to as an advisor, which many, many moons ago I was, it's like creating a pension like portfolio for advisors to to pass through to their clients. That's really where the smart money comes from. It's not anything more than that. And the smart money, as far as I'm concerned, is if you respect those larger pensions and the I guess the track record they've had, that's where I bring that forward.
James: Yeah. Thanks, Dave. Well, let's let's take some of those insights and thoughts that you've just articulated there and hone in a bit on on your firm. How do you how do you differentiate yourselves and your colleagues as PMS and obviously as an investment firm itself?
David: Yeah, and it's a great question, especially for those that are new to infrastructure. They can take this answer and obviously I'll talk a little bit about how our firm and I think the advantages we have, but it's really it's really good due diligence when you're looking at looking for an infrastructure manager, because I really do think it's important to know how they differentiate from others in the peer group. And there are differentiations. And from our perspective, I'll talk about three that I think we have an advantage in and you might want to consider going forward. So the first one, I think we're the largest global investment team and dedicated to just listed infrastructure. So we are we consider ourselves infrastructure specialists, managing listed equity funds. We have no investment in infrastructure debt or unlisted assets. And secondly, our expertise is garnered from infra and not public equities. And we have a very deep knowledge of regulation. And if you're going to be looking at understanding investments, relying on regulatory stability, that deep knowledge is important. So that's one. Two, risk adjusted returns to equity, that's paramount to everything we invest in. So we're trying to construct a portfolio that exhibits infrastructure, returns over a cycle and not attempting to achieve the highest returning portfolio of infrastructure names without considering risk. And that really goes back to our proprietary definition of infra that I spoke about, the two buckets that we think are risk and how are our infrastructure and how we incorporate risk into getting our definition of infra and our universe. So we're looking for lower volatility and income stability. That's our desired outcome. And thirdly, I mentioned it briefly earlier on, we're benchmark unaware. So G seven inflation plus five and one half is the target over a five year cycle. And really this approach, it ensures that the focus of of our portfolio construction, it really remains on delivering I guess, consistent absolute returns and avoids any risk that focus may stray towards relative performance versus whatever indices you're looking at. And that can really adversely impact stock selection over the long period of time. We don't want to do that. It also gives us the flexibility to manage through changing economic conditions. We can go up and down the market cap spectrum or we can dial up or down the economic sensitivity which we talked about in an earlier question you posed around how do we perform in different environments whether we become have a greater allocation to the to the regulated utilities, as we did very early on in 2020, just before COVID, The COVID came upon us as we thought we were getting late to the business cycle. Or as we recover, we can have much higher allocation to the user pays, which take advantage of the GDP and leveraged to G.
James: Excellent. Thanks, Dave. Now, you've talked about this already, but I think it's worth stressing active management. Why do you need an active strategy for infrastructure investments?
David: Yeah, it's a great question and it pertains a lot to the investment sometimes in institutions, but also around the retail advisor as well who are looking for allocation to a sector and sometimes make that allocation using passive investments. I think from an infrastructure perspective, there are really times in the economic cycle when managing to a benchmark doesn't make intuitive sense. And and I'll use our approach, obviously as an example, as mentioned a couple of times already today, we're benchmark unaware. So G seven inflation plus five and one half percent is the target over a five year cycle. And this approach really ensures that the focus of the portfolio construction remains on and I just mentioned it earlier, delivering consistent absolute returns and avoids any of the risks that we strayed to get that relative performance. And for instance, having to be heavily weighted to North America and or gas even when it isn't prudent, is can be a problem on long term performance. It can be good in the other in the other instance, when it's doing very well, it might help performance, but we get the flexibility to manage through changing economic environments. We can go up and down the market cap spectrum like I just mentioned, or up and down the economic sensitivity. And I mentioned very briefly about March of 2020, we were heavily weighted to the regulated asset bucket, over 80% to that side, and we were really able to outperform during that year because of the focus on absolute returns that it allowed us. So not being beholden to an industry or a benchmark really allows us to pursue those absolute returns and not worry about relativity.
James: Great stuff there Dave. Well, I appreciate that, that insight. Just in summary, do you have any any sort of closing remarks, any words of advice to our advisor audience about infrastructure and your strategy?
David: These are my words of wisdom. Is that what you meant to say? All right. Yeah. Listen, I said a lot of what I wanted to do to say throughout this about all the characteristics infrastructure can provide for foreign investor. I'm not. To say this again, I'll just say that it's a solution for all needs. It's right now it's difficult market to navigate and you can't afford to be wrong as an advisor or an investor. So this is an opportunity to take a portion of your equity portfolio and de-risk it by adding infrastructure. And aside from all the points we talked about, let me just mention a couple more considerations that the people that are listening to us later on might think about investors who are thinking about infrastructure. And I've heard this many times you haven't missed it and there's no limit on when to get in and when to get out on infrastructure. It's a very good I hope we've talked about this and emphasize this point long term investment. And here's why I think you should contemplate the asset class. And it's three things public policy, fiscal policy, secular growth story. And let me elaborate just very quickly on the three. Public policy. You always want to invest alongside public policy as an investor. And policy right now is that we need energy security. And to do that, we're going to have to build a whole lot of infrastructure. The high gas prices and supply constraints brought on by the Ukrainian conflict, they've really highlighted the importance of that energy investment and the energy security that we need. And over the next decade, people are going to continue to realize just how important it is to have energy security. Europe and UK have figured that out. There's liquid liquefaction facilities that need to be built in North America and gas facilities in Europe. That's all starting to happen. That takes a lot of infrastructure buildup and there's also societal pressure for greener policies and the push for net zero. We'll continue to press government and business investment. So that's one. Two is fiscal policy. One of the PM's on our team, one of the senior guys says don't fight fiscal policy, invest where the government money is going. And in the US, for example, and President Biden wants to reduce emissions in the US by I think it's 50% by 2030. Yes it is 50% by 2030, with roughly half of the US power coming from solar plants. That's going to take 40 to 100% more electricity to accomplish that. And the Inflation Reduction Act being signed into 20 2022 is super significant for investment in the direction of investment. So that's fiscal policy. You want to invest where the government is and they're looking at renewable energy and the electrification process that's going to take on becoming less dependent on fossil fuels, etc.. And finally, secular growth. There's a real dire need for infrastructure spending, and that's going to underpin growth for the next decade and beyond. There's going to be, we think, structurally higher rates than inflation. And the good news is 90% of the cash flows in the portfolio are either directly or indirectly linked to inflation. And when these companies go back to regulators, they're allowed returns are reset the prevailing bond yield environment. So we have a pass through of bond yields on a medium term basis. So the US is going to need high, high voltage to be an interconnected grid to make net zero possible, and that's going to take a billions and hundreds of billions of dollars of investment in electricity transmission. Finally, I think the US Inflation Reduction Act allocated almost $350 Billion of spending to zero carbon energy and emissions reduction technology alone. And all of these things combined really are a telltale story and tailwinds for a secular growth story. All in all, an environment that makes infrastructure investments and attractive position going forward takes into consideration. Public policy, fiscal policy and the secular growth story.
James: Fantastic, Dave. That's a great way to end. Really appreciate your time and insight. Thanks so much for joining us on WP talk.
David: Not a problem. Thanks very much and I hope that people can take just a little bit away from this in the future.
James: Thanks so much for joining us for this episode of WP Talk. And thanks to Dave Wahl for sharing his insights. You can go to franklintempleton.ca/infrastructure where you can find out more details on the fund that they've talked about, the Cambridge Sustainable Global Infrastructure Income Fund and the active ETF. The page includes quarterly video updates from the portfolio team. Further insights into why infrastructure might be a good investment for your clients and details of the ClearBridge management team. For more WP talk episodes, go to wealthprofessional.ca, click on the resources tab and select WP Talk. The site also includes all the latest news and views from the industry. And if you haven't already, feel free to sign up to our daily newsletter. I'm James Burton. Until next time.