Don’t give up on infrastructure

PFI is funding 122 new intercity trains

Despite having a tough year, the outlook for funds investing in PFI and support services is improving.

The setback to the listed infrastructure sector in the last year has come as a shock to investors who had experienced ten years of increasing dividends and steadily rising share prices. HICL (LSE: HICL), which had the highest exposure to private-finance-initiative (PFI) contracts and defunct support-services group Carillion, now trades at 22% below its 2016 peak.

Reassurance needed

It’s been a valuable, if unwelcome, reminder for investors that PFI remains politically controversial, and that the employment of sub-contractors does not eliminate risk. Fears over rising bond yields have also undermined the yield attraction of infrastructure funds. In response, the sector has sought to reassure investors about asset values, to show that its customers are satisfied, and to diversify abroad.

For example, HICL sold its Highland Schools project at a 21% premium to the valuation of just seven months earlier, while the purchase by asset manager Axa of a 15% stake in InterCity Express Programme (IEP) implied that a similar stake held by John Laing Infrastructure (LSE: JLIF) was undervalued. With share prices trading below asset values, companies have been unable to finance acquisitions with new equity. Still, HICL, with the lowest overseas exposure in the sector, was able to boost its stake in a motorway concession in southwest France to 21%.

JLIF recently highlighted for investors its 26% stake in a contract to manage the Ministry of Defence (MoD) main building in Whitehall. The MoD is “delighted” with the building, it said. On top of this, a £5.7bn programme, in partnership with Hitachi Rail, to bring 122 new intercity trains to the Great Western and East Coast Main Lines, is at last becoming operational. Invitations to tender were issued in 2007, but it has taken Network Rail longer to approve the contract than it took to build, test and install the trains, notes Hitachi.

Overseas contracts can appear risky, and few have attracted as much scepticism as JLIF’s contract to operate 23 service stations in Connecticut. Yet with no competition, steady growth in traffic, guaranteed minimum takings on franchisee sales and provision for deducting maintenance costs from rental payments to the state, the risk has clearly been over-estimated.

While PFI contracts in the UK have proved to be riskier than once thought, the non-PFI and overseas contracts now seem less risky – and, as JLIF’s CEO says, “demand for infrastructure assets is very, very strong”. This makes the shares of both JLIF and HICL, trading on small discounts to net asset value and yielding 5.4% and 6% respectively, attractive. INPP and the more globally focused BBGI are a little more expensive, while 3i Infrastructure (LSE: 3IN), with the best growth record, is deservedly the most expensive.

What now for PFI?

This all presents a good opportunity for investors, but what about the broader implications for the UK? A recent report from the Public Accounts Committee has claimed that PFI is not working for the taxpayer, with the implication that equity returns have been too high. However, this is seen only in the context of successful projects and falling interest rates, says broker JPMorgan Cazenove. If the government wants private-sector involvement, the potential returns need to reflect the risk taken.

The report makes a number of recommendations intended to tighten the terms and financial transparency of PFI contracts further. But as JPM Cazenove points out, the modest changes already made to the PFI contract process in 2012 have resulted in few new contracts. The prospect of the government’s targeted £300bn of infrastructure spending by 2021 being funded by the private sector gets ever slimmer.

Activist watch

The pressure on the chief executive of Premier Foods has increased this week, after activist investor Oasis Investment upped its stake in the company from 9.3% to 17.3%, says James Booth in City AM. The Hong Kong-based activist investor has accused Gavin Darby of “shareholder value destruction”, and called for the company to sell its Batchelors brand of instant foods. Oasis’s share purchase follows the decision last Friday of fellow shareholder Paulson & Co to triple its stake in the company from just under 2% to 6.1%. Premier’s board has confidence in Darby, it said in a statement last week.

Short positions… small-caps dominate

Investors have withdrawn around $580m from Bill Gross’s bond fund in the first half of this year, says John Gittelsohn on Bloomberg. June marked the fourth straight month of withdrawals for the Janus Henderson Global Unconstrained Bond Fund, with outflows pulling assets down to $1.48bn, estimates Bloomberg.

Gross’s fund, which relies largely on derivatives and options-based strategies to generate returns, is down 6.3% over the first six months of the year and ranked last among 44 peers for its performance. The fund lost 3% on 29 May alone, the largest one-day drop among bond funds with more than £1bn. Gross blamed that setback on a bet that the gap between US Treasury and German bond rates would narrow, which did not happen.

Small-cap fund managers “completely dominated” the latest Wall Street Journal ranking of top-performing US funds, says Suzanne McGee. The quarterly contest seeks to identify the actively managed US equity funds that have had the best performance over the previous 12 months. Usually, the top few funds have something in common. For example, they may all have big overweight positions in Apple or be heavily invested in biotechnology.

Typically the list is then relatively diverse after the first few names. But “things were different this quarter” – all but one of the ten best-performing funds for the 12 months to the end of June were managed by small-cap teams. One explanation for this may be that investors are showing an “overwhelming desire” to avoid companies that are exposed to global turmoil, such as tariffs and trade disputes, says McGee. “People are investing as if we’re building a wall around our entire country,” says Jack Ablin of Cresset Wealth Advisors.

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