Profit from the coming infrastructure spending splurge

Last month, traders in London's Oxford Street were furious. The country's busiest shopping district was shut down for a weekend when a burst main sent millions of gallons of water pouring into the road. Unsurprisingly, Thames Water took a lot of flak for the incident. But the problem is also part of a wider trend Britain's infrastructure is getting to the point where it's simply too old to keep doing its job.

Take that Oxford Street water main, for example. It is over 100 years old it was laid by Victorian engineers. And it's not just water. Britain's ageing power, road and rail systems also need huge investment to serve the 21st century. So far, we have been able to sponge off the hard work of past generations. But events like the Oxford Street flood show that we are reaching breaking point.

In America, the situation is even worse and a spate of infrastructure failures has made reconstruction a political issue. The crisis has sparked a rethink among politicians on both sides of the Atlantic and new, ambitious investment plans have been drawn up. More importantly, the managers of some of the largest investment funds in the world have signalled that they are ready to invest in the West's infrastructure. That's good news for those private investors who manage to pick the winners in the West's impending infrastructure splurge.

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Why is the bill arriving now?

In both Britain and America, investment in infrastructure as a share of GDP has fallen in the last 40 years. That was fine while the infrastructure held out, but now large swathes of it need to be repaired or rebuilt, meaning that investment levels need to rise again. Another problem is that a lot of existing stock was built in an era of lower commodity prices. Old power plants or landfills use resources less efficiently and aren't up to new regulatory standards, or have higher operating costs than contemporary models.

Demographics are also putting pressure on infrastructure. Unlike most other Western countries, the US and Britain both have growing populations. By 2050, America's population is expected to grow by 35%, while Britain will have the largest population in Europe. As a result, our infrastructure has to expand to deal with the increasing demand.

In response, chancellor George Osborne has unveiled an ambitious 500-project infrastructure plan that would involve £250bn of investment. In America, the bill is even higher. The American Society of Civil Engineers estimates that the US needs to spend at least $2.2trn on infrastructure repairs or rebuilding.

Britain's most pressing infrastructure challenge is to update its power network, as around 20% of the country's installed capacity will be shut down by 2019. By then, many of our older coal-fired plants will fall foul of tougher EU emission regulations, while the country's older nuclear plants will be reaching the end of their lives.

The coalition's plan to replace them, the White Ppaper for Electricity Market Reform, is pretty radical, says the FT's Lex column. "The UK power industry is on the brink of a transformation that could rival that of the privatisation era, as it tries to make the switch to cleaner energy, invest in nuclear power, and replace a quarter of its generating stations. That will require a huge capital outlay."

The plan calls for £110bn of investment in new power stations, with nuclear and wind power being favoured. Of course, just because a government says something, doesn't mean it's going to happen. Yet private firms are ready to invest. Energy regulator Ofgem has fast-tracked £7.6bn of infrastructure spending by energy companies Scottish Power and SSE. The firms will use the money to upgrade their ageing transmission lines and make improvements that will allow them to link up more renewable energy, especially offshore wind, to the grid.

Meanwhile, National Grid has tabled a £30bn investment plan that is awaiting Ofgem approval. The plan would replace ageing lines, expand capacity, hook up renewables and introduce smart features' that would allow the grid to be run more efficiently. Plans for new nuclear and wind plants have also been submitted.

America's transport nightmare

As for the US, it's going down another route. The most obvious growth area in America's infrastructure, and the one most people are talking about, is energy. More specifically, shale gas.

Unconventional drilling methods have boosted the country's gas reserves and new infrastructure is being built to take advantage. However, while shale gas might have given the US an unexpected boost, it still faces lots of other infrastructure challenges.

Indeed, as The Economist notes: "America, despite its wealth and strength, often seems to be falling apart." One of the biggest challenges is transport. "Total public spending on transport and water infrastructure has fallen steadily since the 1960s and now stands at 2.4% of GDP." That compares to 5% in Europe and 9% in China. As a result, Americans suffer worse road congestion than Europe, a terrible passenger rail system and overcrowded airports.

Both Republicans and Democrats have drawn up expansive multi-billion-dollar infrastructure spending programmes, but political gridlock means that they are unlikely to be approved before this year's election. "Roads, bridges and railways used to be neutral ground on which the parties could come together to support the country's growth. But as politics has become more bitter, public works have been neglected," says The Economist.

Yet even without grand schemes, some private companies have already started investing in profitable infrastructure ventures. That trickle of investment should turn into a flood when America finally faces up to its infrastructure deficit we look at some of the stocks that could benefit below.

Building roads with your pension

Back in Britain, transport is also an issue. A report undertaken as part of the Treasury's National Infrastructure Plan found that roads in Britain are more congested than those in other European countries, while its trains are more expensive and suffer worse delays.

As a result the Treasury has outlined a host of projects that it wants private companies to fund and build. The £17bn high-speed rail link (HS2) between Birmingham and London might be grabbing all the headlines, but the Treasury has also outlined a £1.4bn upgrade and expansion plan for conventional regional lines and London's tube network. The road network will also receive more than £1bn.

Again, this is not the first time politicians have talked about infrastructure. But the difference now is that the government has managed to line up some serious investors. One group it is looking to tap are pension funds. Canadian and Australian funds already invest in British infrastructure, but their British peers are far more reluctant. Indeed, of the £1trn assets held by UK pension managers, only 2.5% is invested in Britain's infrastructure.

Why the apparent lack of interest? The problem is that "infrastructure has not been recognised as an investable asset class for much more than a decade", notes Kate Burgess in the Financial Times. Moreover, many pension funds were put off by the complexities of investing in infrastructure.

However, that looks like it is about to change. The Treasury has signed a memo of understanding with the National Association of Pension Funds (NASPF), which controls £800bn, to develop new platforms to make it easier for pensions to invest in infrastructure. Treasury officials told us that the platform would trigger £20bn of investment and would be ready "within months".

For its part, the pension industry is keen to invest in infrastructure. As you might have realised if you've looked at your pension pot recently, money managers have had a tough time of it of late. Choppy stockmarkets and falling bond yields have made it harder for pension funds to make the 6% returns that were common between 1970 and 2000.

Indeed, Andrew Lapthorne, equity analyst at French bank Socit Gnrale, notes that the average traditional balanced pension portfolio now only yields 3%, down from 6% 20 years earlier.

"Gilt yields are at record low levels and do not offer sufficient returns even to keep up with inflation, let alone to keep up with rising pension liabilities," Dr Ros Altmann, director-general of Saga, told the FT. "Therefore, pension funds urgently need new ways of earning good income."

Infrastructure offers a way for pension funds to boost their performance. The projects tend to be long term, relatively low risk, and pay returns linked to inflation. It's just what they need to make up for the fact that government bonds are offering such low returns.

Moreover, the success of Australian and Canadian pension funds shows that investing in British infrastructure can pay off. Indeed, some pension funds have already started to snap up assets. For example, in January Leicestershire County Council Pension Fund put 3% of its portfolio £70m into infrastructure funds.

Sovereign wealth investors

Another boost is expected to come from sovereign wealth funds. Normally countries that run massive surpluses, such as China or oil-producing Gulf states, reinvest their wealth in government bonds. But the massive volatility caused by the sovereign debt crisis has taken the shine off supposedly risk-free' assets, such as US Treasuries. It has also made a lot of European government debt seem simply too risky.

As a result, many sovereign wealth funds are now looking to diversify their holdings by buying up hard assets', such as infrastructure. And that's where Britain comes in, says Lou Jiwei, head of China's $410bn sovereign wealth fund, the China Investment Corporation.

"The UK is one of the most open economies in the world, a position bolstered by its sound legal system. [Public Private Partnerships are] a regular form of investment in infrastructure development that should be encouraged and replicated in other developed countries."

Those comments, made last November, were backed up this month when the China Investment Corporation bought an 8.68% stake in Thames Water. That followed a 9.9% purchase by Abu Dhabi's sovereign wealth fund in December 2011.

Investors can profit as infrastructure investment rises we look at the companies that could benefit from the influx of money below. And who knows? The injection of cash might even help Thames Water repair its leaky pipes.

The three best homes for your money

One company that looks set to profit from the infrastructure boom is MoneyWeek favourite Balfour Beatty (LSE: BBY). Britain's largest builder, Balfour Beatty builds, operates and maintains all sorts of infrastructure, ranging from bridges to power plants. It's heavily focused on the developed world, with 60% of revenues coming from Britain and 30% from the US.

The stock is up 10% since we tipped it back in December, but it still looks cheap on a forward p/e of 7.8 and a very healthy dividend yield of 5.4%.

JP Morgan Cazenove analyst Michael Morris is bullish on the stock and expects the American business to grow. "While the US states remain under considerable budgetary pressure, at a local municipal level there is still significant support for infrastructure spending and tax to fund it Around 80% of total funding for public transportation comes from state and local sources."

US engineer General Electric (NYSE: GE) will be heavily involved in both the rebuilding of America and Britain, especially in the energy sector. The firm earns around half its revenues in America, with another 21% coming from Europe.

Its energy division makes the gas turbines, wind generators and nuclear plants that are being touted as the future of energy on both sides of the Atlantic. It also helps to build and maintain a lot of the supporting infrastructure. For example, General Electric's oil and gas pipelines unit inspects more than 100,000 miles of pipeline every year.

Over the last decade the industrial conglomerate lost its way and focused heavily on financial services. However, chairman and chief executive Jeffrey Immelt has repositioned the firm and is now focusing on energy and industry. Early signs are that the approach is paying off; infrastructure orders were up 15% in the fourth quarter of 2011.

"After dramatic underperformance for the last decade, General Electric's fourth-quarter represents another milepost in a story that is close to inflection," says JP Morgan analyst Drew Pierson. With a $200bn order backlog the largest in its history 2012 is likely to be a good year for the firm. On a forward p/e of ten, it is the same price as German rival Siemens, but with less exposure to the eurozone crisis. The dividend yield is 3.6%.

A more general way to play infrastructure is through a fund. Closed-end infrastructure funds (which are listed on the stock exchange) buy into mature UK infrastructure projects, such as private-finance initiative (PFI) maintenance contracts, which generate reliable, frequently inflation-linked revenue streams.

As a result, when inflation is rising, they typically deliver growing dividends. Also, Britain's current low interest rates work in their favour. The value of the investments themselves is based on the income they are expected to produce over the course of the project, compared to what you could get if you invested in a risk-free' asset, such as a government bond.

With government bond yields very low at the moment, that makes these projects all the more attractive, boosting the net asset value (NAV) of the funds. A collapse in inflation or rising interest rates could be bad news for the sector but neither of those look likely in the near term.

Our favourite bet in the sector is the HSBC Infrastructure Company (LSE: HICL), which is mainly invested in mature UK assets. It is not cheap on a 7.6% premium to net asset value, but it has traded at a higher premium in the past. The total expense ratio is below 1.3%, the company has a good track record, is conservatively run, and yields an inflation-busting 5.8%.

This article was originally published in MoneyWeek magazine issue number 574 on 2 February 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.