Infrastructure stocks have been the one of the hardest hit sectors of the equity market over the past five months. It is our view that sentiment and not true fundamentals have caused much of this impact. But such sentiment is reversible given long-term fundamentals for infrastructure, with large investors now seeing multiples here at attractive valuations.
The bond impact
The biggest impact to valuations has come from sharp changes to bond yields. It is our experience that when such changes happen over a short period the market sentiment around utility stocks is much greater.
Marginal buyers of these stocks have been trading on the reduced yield differential with bonds. This has been exacerbated by expectations that bond yields will rise further. We believe this does not reflect that rises in bond yields are neutral to the fundamental long-term value of utilities. This is because the formula that regulated assets typically use to calculate allowed returns take into account changes in bond yields.
Additionally, while we expect four rate rises from the Fed by the end of the year, we think the US 10-year Treasury yield will remain below 3% at the end of the year – lower than market expectations. Any revision of market expectations to a yield lower than 3% should, we believe, lead to a correction in valuations for utilities.
Performance comparison - infrastructure vs global equities
Figures as at 31st March 2018. FactSet Research Systems and RARE calculations. The Infra Index Range is composed of the performance of the following indices - The DJ Brookfield World Infrastructure – TR, MSCI World Core Infrastructure – (net), FTSE Global Core Infrastructure, FTSE Global Core Infrastructure 50/50, FTSE Developed Core Infrastructure 50/50.
The sharp return of volatility has caused markets to re-rate equity valuations. Higher volatility creates more risk for investors, which requires higher equity risk premiums. This brings a reduction in price to earnings (P/E) multiples and a rise in the cost of capital. As infrastructure stocks are generally long duration assets, a rise in the cost of capital will have a magnified impact on their valuations. This is why we are seeing negative market sentiment around companies in the energy, telecom and utilities sectors. Again, we see this impact as exaggerated and likely to normalise.
The CBOE Volatility Index (Vix), the most widely followed barometer of expected near-term stock market volatility, was at historically low levels of 7-8% in 2017, but since February, we have seen forecasts for a normalised Vix environment going forward of 20%. It is our estimation that the Vix will not remain at 20%, but end up around the mid-teens. When this happens the market risk premium will fall and investors will see higher multiples applied against longer duration assets, which should be reflected in better market valuations. We have seen such reactions before, notably in 2013 on the back of the “taper tantrum” after the Federal Reserve said it would taper its monetary stimulus.
The valuation opportunity
It is the view of some of our institutional investor clients that after a period of high-octane equity growth in markets, a slice of money should be taken off the table and placed into more defensive assets. Notably, while global growth still looks strong, the US is getting later into the business cycle and companies are trading at historically high multiples. A conventional response here is to increase bond allocations at the expense of equities, but bond yields globally are still repressed by quantitative easing (despite recent rises). So instead, we have seen institutional clients topping up on defensive equities that offer an attractive yield and are attractively priced.
The relative valuation opportunity in infrastructure stocks can be seen in that their P/E multiples have not risen in line with global equities. Slide 2 shows utilities have traded at 10 to 11 times earnings since 2012, while in the same time frame multiples for the MSCI World have risen from around seven to just over 10 times earnings.
Utilities have maintained this P/E level due to new investment – for example among companies that own electricity distribution assets there has been the modernisation of grids in response to the creation of renewable energy production and battery charging stations for electric vehicles.
MSCI World steadily more expensive
As at 14th February 2018. Fact Set Research Systems and RARE calculations. Infrastructure company universe as determined by RARE, representing approximately 300 companies, representing the arithmetic average, current EV divided forward consensus EBITDA, EV = Market Cap + Net Debt + Minority Interest and Preferred Stock.