Bertrand Cliquet, portfolio manager of the Lazard Global Listed Infrastructure Equity fund, reveals how to avoid the yield traps in his sector.
In today’s uncertain and low interest rate environment, yield has lured investors seeking bond proxies to some parts of the equity market. Beneficiaries of this yield obsession have included sectors such as consumer staples and real estate investment trusts (REITs), as well as some parts of the listed infrastructure market.
We believe, however, that asset prices for many regulated utilities, pipeline companies and cell towers in North America, in particular, are now materially overvalued and may be vulnerable to rises in real and nominal interest rates.
No guide to value
It is worth pointing out some of the shortcomings of misinterpreting yield as a metric for valuation.
The value of any asset is the net present value of its future cashflows. How those cashflows are paid out to the various claimants on them—typically shareholders (in the form of dividends) and lenders (in the form of interest and principal)— does not affect the value of the firm.
The higher the dividend payout ratio, the greater the reliance on debt or equity financing for sustaining the firm’s operations and vice versa.
A dividend paid out to shareholders comes directly out of shareholders’ funds, leaving the value of the firm and its equity unchanged, all else being equal.
A dividend yield, therefore, is simply an outcome of the net present value of an asset and its dividend payout policy at any given time, rather than a driver of its valuation.
Using dividend yield as a guide to value is particularly risky with infrastructure assets. Many of these assets have finite lives, with concession periods typically ranging from 30 to 50 years.
This makes conventional valuation methods, such as P/E, enterprise value to EBITDA or dividend yield practically useless, given they are based on the assumption of a perpetual life (not to mention other flaws that are beyond the scope of this article).
Some listed infrastructure companies have unusual corporate structures (e.g. stapled securities and master limited partnerships) that enable or require them to pay out a relatively high proportion of income in the form of dividends.
A high dividend yield is not necessarily an indication of ‘value’ here, particularly if those dividends are supported by borrowings or equity raisings rather than sustainable operating cashflow.
Many yield-hungry investors have compared dividend yields on US utilities of 3.5%–4% to US treasury yields of 2%–2.5% and concluded they are attractive.
Notwithstanding the fact comparing a nominal fixed income yield with a real dividend yield is fundamentally flawed, investors may not appreciate the risks in this approach.
Should US treasuries rise to more normal levels of 4%–5% in the next few years, we believe a fair P/E ratio for the group would be approximately 13x, implying a dividend yield of approximately 5%–5.5% and downside of 30% or more in share prices.
In addition, even if interest rates remain low for a long period of time, regulators are likely to reduce allowed returns, resulting in lower valuations, higher dividend yields and potential cuts to dividends.
In contrast to North America, prices for European listed infrastructure assets have languished in recent years, as the eurozone debt crisis drove a net outflow of capital from the region’s stock markets.
In spite of the crises and recessionary conditions that have prevailed over the past few years, preferred infrastructure companies in Europe have, in fact, performed solidly.
During the past four years, median earnings per share have grown, on average, at 8% annualised for the European preferred infrastructure companies in our universe.
Moreover, many European infrastructure stocks have healthy earnings growth outlooks in spite of weak domestic economies, due to capacity expansion programmes in sectors such as airports, toll roads and electricity transmission.
The yield-chasing behavior of investors in North American infrastructure stocks on the one hand, and an aversion to Europe on the other, has created an opportunity in European listed infrastructure, where you can find Ferrari performance at Volkswagen prices.
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