Advertisement
Skip to Content
Market Update

Is It Time to Build a Stake in Infrastructure Stocks?

The Trump administration's delayed infrastructure plan aside, there's plenty to like about this sector today.

In February, President Donald Trump unveiled his $1.5 trillion infrastructure spending plan. It wasn't quite what many had expected, with only $200 billion in direct federal spending going toward toward fixing roads, bridges, and other initiatives, with the rest of the funding expected to come from state and local governments. And with the departure of the administration's top infrastructure advisor earlier this week, the plan will likely remain in limbo until after the midterm elections. 

In any case, at some point, more money will be spent on upgrading America's aging infrastructure. Naturally, that's good news for engineering and construction companies, which will surely enjoy an earnings boost if more money starts coming their way.

That additional spending could also give infrastructure stocks a boost as companies will be contracted to provide engineering and construction services projects that may not have otherwise been given the green light. However, considering how long it can take to get an infrastructure initiative off the ground--and with the plan hitting a snag--it shouldn't be the only reason to buy into this sector.   

David Daglio, lead manager of Dreyfus Opportunistic Midcap Value (DMCVX), which earns a Bronze medalist rating from Morningstar, doesn't think investors should rush in simply because of the plan, especially because many of the details are still unclear, and it's not certain which companies will benefit. While Daglio does think additional spending is a good thing for the sector overall, there are, in fact, better reasons investors should be looking at infrastructure stocks today.

"If the infrastructure spending happens, our infrastructure holdings would benefit even more than we expect them to benefit right now," he says.

Since 2014, capital spending and investments in new infrastructure projects has been in multiyear downturn, says David Silver, an equity analyst with Morningstar. Lower energy prices have caused resource companies to spend less on energy-related building. Infrastructure spending growth has also slowed over the past five years, and that has stifled performance of these stocks. The MSCI World Infrastructure Index is up just 0.31% since January 2014 as of this writing, while the ISE Global Engineering and Construction Index is up just 3.3% over that same time.

While neither index has done much this year--the MSCI index is down by 5% year-to-date, while the ISE index is up by 3.2%, still better than the S&P 500’s  return--Silver thinks the sector's stocks will start climbing again soon.

"We think the downturn will end in 2018," he says.

Major Upgrades Ahead
There are several reasons why the sector may be ready to rebound, but a main one is that the world's infrastructure is crumbling and needs massive upgrades. According to the Global Infrastructure Hub, a G-20 backed initiative, $94 trillion must be spent by 2040 to keep up with demand from an expanding population. The U.S. is expected have the largest infrastructure investment gap, which is the difference between needs and investment, of $3.8 trillion, according to the World Bank. On that point alone, infrastructure companies should be kept busy for the foreseeable future.

However, Trump should help infrastructure companies make more money in the near-term, and not because of increased infrastructure spending. Tax cuts and reduced regulation will help these companies significantly, says Silver. If corporations and people have more money in their pockets, then, in theory, they'll use those additional funds to invest in projects they've been putting off. That could be building homes for individuals or new warehouses or plants for companies.

"On any proposed capital project, all the sudden the after-tax return you're anticipating goes up meaningfully," he says.

Regulatory reform also means less bureaucracy and less paperwork for construction companies. That reduces the risk that businesses take on when working on new projects.

"You can start and complete something more quickly," says Silver. "And then you can start generating income from tolls, road projects, or a new factory faster."

Brock Campbell, an analyst who works with Daglio, points out that more states are taking matters into their own hands and spending money on infrastructure; he thinks that spending will, finally, increase across the board.

"For the first time in decades, cyclical, secular and structural trends are aligning, which we believe will usher in a period of investment not seen since the Eisenhower administration," Campbell wrote in a 2017 report. "We forecast over $1 trillion in projects that could be built over the next 10 years."

Particularly Promising Subsectors
The infrastructure sector is broad, with roads and bridges only being a part of it. Daglio's definition of infrastructure includes water, utilities, energy, and commercial construction. The latter, which includes office buildings and other commercial projects, has been on a 10-year bull run, so it does look overextended, he says. Much of the rest of the sector, though, appears attractive.

Campbell is particularly bullish on water-related infrastructure and water utilities. He thinks more utilities will be privatized in the coming years, and when that happens, companies will need to invest in upgrades. No one wants to see another Flint situation.

"That was an alarm for everyone across the country to get capital into the ground and improve services," he says.

Thyra Zerhusen, CEO at Fairpointe Capital and lead manager of AMG Managers Fairpointe Mid Cap (ABMIX), which earns a Silver analyst rating from Morningstar, is keen on companies that operate in the more traditional infrastructure space. As some of those trillions of dollars start to work their way through the system over the coming years, U.S. engineering and construction firms will certainty benefit.

"Bridges are collapsing and old roads need to be fixed," she says.

Silver adds that spending on transportation has been healthier, and investment in aerospace-related infrastructure, like airports, is strong and should continue.

All also expect to see an increase in energy-sector spending. With West Texas Intermediate crude now at about $64 a barrel, up from $42 last June, companies are likely to invest in pipelines again.

"They will spend more," says Zerhusen. "They went through a tough period, but they're coming out of it."

Silver expects to see more spending on upstream and midstream activities, such as drilling for shale and getting petroleum from one place to another via pipelines.

Buying at a Discount 
Clearly, the long-term potential is there, and so too is the opportunity for shorter-term gains, if Trump's infrastructure plan goes through. There's another good reason to consider the sector today: Many infrastructure companies are undervalued. Daglio has found stocks that are trading at 30% to 45% discount to their historical levels, and while some businesses aren't as cheap as they may have been a year ago, deals can still be found.

Two engineering and construction stocks Morningstar covers are 4-star-rated, which means they're trading below Morningstar's estimates of their fair values. Chicago Bridge & Iron , which is in the process of being purchased by McDermott International , and Fluor (FLR), should both do well going forward, says Silver. Both these businesses are "elephant hunters," he says.

"They're big project companies that have suffered over the past couple of years because of the dearth of capital spending in energy, mining and elsewhere. But they have an end-market profile that shows the most opportunities over the next one to three years."

Silver is also keen on Canada's SNC-Lavalin Group (SNC) and AECOM (ACM), both 3-star companies today that investors should keep on their watch lists.

For those who prefer buying mutual funds and ETFs, only one earns a Morningstar medalist rating: the Silver-rated Lazard Global Listed Infrastructure (GLIFX). While there are other nonrated infrastructure-focused funds to choose from, Tayfun Icten, a Morningstar analyst, says this fund is the best in class. It's managed by an experienced management team, hedges its currency exposure, and invests in traditional infrastructure operations, like utilities, toll roads, and airports. It boasts low turnover, too.

"Low turnover is especially important in this space," he says. "These are long-term assets, so if someone is turning over their portfolio frequently it doesn't bode well."

Investors should be mindful of the U.S. utilities exposure in some of these funds and ETFs, especially because many U.S. utility operations are overvalued, notes Icten. Lazard's fund, which only holds 28 stocks, currently has 48% of its assets in the utilities sector, but much of it is in European equities. Some ETFs, such as  iShares Global Infrastructure ETF (IGF), the largest infrastructure fund by total assets, has about 40% of its portfolio in utilities.

While ETFs will give investors exposure to the the long-term infrastructure investment story, there are three different indices that these ETFs can follow, each with different sector and geographic allocations. Investors must do their due diligence and decide what kind of exposures they want to the sector, Icten adds.

Ultimately, infrastructure is a promising sector, regardless of whether Trump’s infrastructure plans pan out. There's strong long-term potential, and some stocks are attractively priced.

"There are a lot of high-quality companies in this sector," says Silver. "You have world class operations with clean balance sheets and that are poised to benefit from a cyclical upturn in demand."

Bryan Borzykowski is a freelance columnist for Morningstar.com. A Toronto-based business and investments writer, Bryan has contributed to The New York Times, CNBC, BBC Capital, CNNMoney and other publications. The views expressed in this article do not necessarily reflect the views of Morningstar.com. 

Bryan Borzykowski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.