Infrastructure and real estate construction in China’s second-, third- and fourth-tier cities will remain robust for the foreseeable future.

— Yiannis Mostrous, Global Investment Strategist

Economic growth in the developed world (e.g., Europe) may be elusive, but emerging markets continue to put up strong GDP numbers as their middle class populations continue to grow and demand more urban infrastructure. I liked the interview my colleague Ben Shepherd recently did with fund manager Aaron Visse of the Forward Funds so much that I am reproducing it in full below. Enjoy! — Jim Fink

Prior to the Great Recession, hot money was channeled into infrastructure investments at a blistering pace. But as the markets crashed and credit became scarce, infrastructure-related stocks sold off sharply and interest in the sector has been slow to return. Aaron Visse, co-manager of Forward Global Infrastructure (KGIAX), believes this is an ideal time to establish positions in the sector. Valuations are still attractive and infrastructure operators are an excellent hedge against inflation.

Ben Shepherd: Why should investors consider the infrastructure sector now?

Aaron Visse: Infrastructure stocks disappointed investors in 2008 by declining with the market. The problem was more related to the perception of these firms, because infrastructure companies lived up to their billing. They had low volatility and reliable cash flows that weathered significant macroeconomic shocks.

The infrastructure business model often uses leverage to bolster the return on equity for investors. But after the collapse of Lehman Brothers in 2008, any business employing leverage was put in the penalty box.

The reality is that infrastructure companies were able to obtain financing throughout the worst of the economic crisis, often on favorable terms. The reason for that was basic. If you shut down infrastructure, you cut off a society’s lifeline and cripple its economy. It’s in a society’s best interest to have operating infrastructure.

There has to be financing available for infrastructure projects, even when other businesses are incapable of obtaining financing. None of the worst-case scenarios that many predicted for the infrastructure sector were realized in the last economic downturn.

But in 2009 growth-oriented and cyclical names went on a run. This isn’t a favorable environment for infrastructure stocks, and the industry underperformed that year.

In 2010 the sovereign debt crisis struck Europe, which hurt many infrastructure stocks in the early part of the year. But infrastructure stocks have grown more competitive with other sectors since mid-2010 as investors focused on valuations. Because infrastructure stocks haven’t had a strong rally, there’s still value to be found in the sector.

Infrastructure companies also serve as a good hedge against inflation, which is an issue many investors are worried about. That’s created a strong environment for infrastructure-related investments.

Ben: How will the austerity programs implemented by governments across the world affect infrastructure development?

Aaron Visse: The case is different in each region, but the world is moving toward greater use of public-private partnerships to finance infrastructure projects. This model started in the UK in the 1970s under the Thatcher administration and has been adopted throughout Europe, Australia, Asia and South America. The US is a laggard in this regard.

We live in a flatter, more competitive world than ever before thanks to the Internet and other information technologies. This results in increased infrastructure spending because the ability for any society to compete effectively will hinge on its ability to move people, goods and services within and beyond its borders as efficiently as possible. Crippled infrastructure will drag on any country’s ability to grow its gross domestic product (GDP) and remain competitive in the global economy.

The world has experienced a major credit crisis and governments have taken on significant debt to sustain their societies’ livelihood. This has hurt the ability to fund spending at all levels. But emerging-market economies are growing at the expense of the developed world. If developed economies want to remain competitive, they’ll have to invest in infrastructure. 

If a government can’t afford to pay for all the infrastructure investments it wants to make, private enterprise will have to fill the gap. Governments will offer private players long-term concessions to run infrastructure assets. The government will receive a sum of cash up front, which can be allocated however the government sees fit. The private side will benefit from the ability to go after existing infrastructure assets or compete for the build out of new assets. That’s been the global trend for decades and its accelerated after the global economic crisis.

There is a wild card in play: a functioning credit market. Companies won’t want to make equity-only purchases; they’ll want to invest with equity and debt. At its heart, infrastructure is about very stable, cash flow intensive assets that are extremely predictable. When you have that type of asset it makes financial sense to apply moderate leverage. But you need a functioning credit market to do that.

Ben: How does an infrastructure investment serve as a hedge against inflation?

Aaron Visse: Infrastructure projects have a high upfront fixed-cost structure and revenues that are usually linked to inflation. When inflation rises, costs don’t grow significantly because it’s a fixed-cost business. But revenue starts to pick up because it’s contractually linked to the producer price index or, in many cases, the consumer price index.

Consider a toll road. It requires a huge upfront cost to build the road. But after the road is built, it’s a long-life asset requiring minimal additional capital expenditures. Features such as electronic toll collecting mean that the road can operate with very few employees. Furthermore, the toll charges rise with inflation but the cost structure doesn’t change. 

Ben: How should investors play infrastructure theme?

Aaron Visse: It’s hard not to be excited by the opportunities in the emerging markets. These economies are expanding rapidly and boast solid balance sheets. In 2009 the ratio of public debt to GDP in the emerging markets was about 33 percent compared to about 78 percent in developed markets. These governments in developing nations can afford to spend on infrastructure. Emerging economies have rapidly urbanizing populations, rising affluence and a growing middle class.

We’re excited about Brazil. The country’s infrastructure spending has declined over the past 40 years, and accounted for about 2.1 percent of GDP over the previous decade, lagging China, India and Russia. Brazil has two big catalysts for a boost in infrastructure spending. The country will host the World Cup in 2014 and the Olympic Games in 2016.

Companhia Energetica de Minas Gerais (NYSE: CIG) is an integrated utility in Brazil. Brazilian utilities are primarily hydroelectric, so there’s not so much event risk and they’re clean generators of electricity. In this case, 77 percent of the company’s installed capacity is hydroelectric. It has a market capitalization of about $12.5 billion and its shares yield around 5.4 percent.

The company’s stock trades at about 10 times trailing earnings and 9 times 2012 estimated earnings. We estimate the company’s earnings per share will grow at a compound annual growth rate in the low double digits for the next three years.

The company’s operations are located in the heart of Brazil’s industrial area, with its primary exposure to Minas Gerais, Brazil’s second-most affluent state. The company has inflation-protected revenue and is able to pass on the previous year’s inflation to consumers. The firm is active in all aspects of the business, from generation and distribution to transmission. But it’s gradually shifting its model in favor for the generation and transmission business, which reduces some regulatory risk.

The other Brazilian company we like is CCR (Brazil: CCR03), a toll road operator with an $11 billion market capitalization and a yield of about 4 percent. CCR is set to grow earnings by 20 percent annually for the next three years.

The stock trades at about 20 times this year’s earnings and 16 times 2012 earnings. The company’s tariffs increase annually with inflation as well.

To understand the scope of the opportunity, investors must recognize that there are more cars in California than in all of Brazil. California has a population of 40 million with 32 million registered vehicles; there are 200 million people in Brazil and 29 million cars. But auto sales in the country are rising as the country becomes more affluent and credit becomes available to the average citizen.

This company has 1,622 kilometers of concessions, primarily in the urban areas of Sao Paulo and Rio de Janeiro.

China represents another significant opportunity. Over the last 15 years, about 10 million Chinese have moved to urban areas each year–equivalent to the population of Chicago. Despite that trend, less than half of the country’s population lives in cities. China had an urbanization rate of about 18 percent at the end of the Cultural Revolution in 1978. That figure has risen to 46 percent and will grow to 60 percent by 2020. That amounts to 180 million people living in urban areas, which will require massive infrastructure investment to support that trend.

One of the companies we like in China is Sichuan Expressway (Hong Kong: 107). This toll road operator has a market cap of $2.2 billion. Its stock yields a little more than 2 percent and earnings have grown by just more than 10 percent annually. It’s the only listed toll road operator in Sichuan province with about 460 kilometers of concessions.

Beijing’s 12th five-year plan includes a major initiative to develop the western part of the country–where Sichuan is located. These government plans can be powerful drivers of growth. The country’s special economic zones often grow at twice the pace of the overall Chinese economy. That was the case in 2009 when Sichuan’s GDP grew by 17 percent–more than double the national average.

Auto sales in Sichuan grew by 40 percent year over year in the first half of 2010, and car ownership has increased by 15 percent annually for the last 10 years.

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