Infrastructure and Long-Term Investing July 2013 Peng Chen, PhD, - - PowerPoint PPT Presentation

Infrastructure and Long-Term Investing

July 2013 Peng Chen, PhD, CFA, Chief Executive Officer & Portfolio Manager, Asia ex Japan, Chairman, Dimensional SmartNest

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Agenda

• 1. Who is Dimensional
• 2. Defining Infrastructure
• 3. Historical Risk and Returns
• 4. Infrastructure and Long Term Portfolio
• 5. Return and Cost of Capital of Regulated

Infrastructure

• 6. Methods and Inputs for Calculating

Cost of capital

• 7. Summary

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Who is Dimensional

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Global Investment Team, One Dynamic Process

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Vancouver Santa Monica Austin London Amsterdam Berlin Singapore Sydney Tokyo

Portfolio Management Client Service Dimensional Fund Advisors LP founded in 1981. Global AUM and number of employees as of March 31, 2013. Locations with offices operated by Dimensional. “Dimensional” refers to the Dimensional entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd., and Dimensional Japan Ltd.

Fully integrated portfolio management

715 employees globally $283B in global AUM Founded in 1981

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Closely Affiliated with Leading Academics

Deep working relationships benefit Dimensional’s solutions and investors

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Academic Members of the Investment Policy Committee US Mutual Fund Board of Directors

Kenneth R. French, Chairman Tuck School of Business Dartmouth College Eugene F. Fama Booth School of Business University of Chicago Robert C. Merton, Nobel Laureate Sloan School of Management Massachusetts Institute of Technology George M. Constantinides Booth School of Business University of Chicago John P. Gould Booth School of Business University of Chicago Roger G. Ibbotson Yale School of Management Yale University Edward P. Lazear Graduate School of Business Stanford University Myron S. Scholes, Nobel Laureate Graduate School of Business Stanford University Abbie J. Smith Booth School of Business University of Chicago

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“Dimensional” refers to the Dimensional entities generally, rather than to one particular entity. These companies are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., DFA Australia Limited, and Dimensional Fund Advisors Canada ULC.

• 1. Global asset allocation assets are for information only; these assets are primarily an aggregate of underlying funds and are not counted in totals.

All assets in US dollars. Numbers may not total 100% due to rounding.

Dimensional Global Investment Solutions

$283 billion in global AUM as of March 31, 2013

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US $83.0 Non-US Developed $70.0 Emerging Markets $56.8

All Cap Core $24.7 All Cap Core $16.8 All Cap Core $15.6 All Cap Value $3.8 All Cap Value $5.6 Value $29.9 Large Cap Value $13.4 Large Cap Value $18.8 Large Cap $7.4 Large Cap $4.8 Large Cap $5.4 Small Cap $3.9 SMID Cap Value $7.9 SMID Cap Value $0.9 Small Cap Value $13.1 Small Cap Value $11.3 Small Cap $10.6 Small Cap $11.3 Micro Cap $4.6

Fixed Income $59.3

US Taxable $31.9 US Tax-Exempt $2.3 Non-US & Global $22.2 Inflation-Protected $2.9

Global Equity $5.9

All Cap $5.9

Other $7.9

Real Estate $7.0 Commodities $0.6 Global Asset Allocation1 $6.2 Non-US Developed Equities 25% US Equities 29% Fixed Income 21% Emerging Markets 20% Other 3% Global Equity 2% (in billions)

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Defining Infrastructure

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Infrastructure

Essential physical assets, facilities, and systems that enable society to function. It includes

• Transportation (roads, bridges, tunnels, airports, railroads, ports, etc.),
• Energy and utilities (power generation, fuels, water systems, etc.),
• Communication (line-based networks, air-based networks),
• Social (schools, hospitals, prisons, other public buildings) assets of society.

These are long-lived, real assets that are costly and time-consuming to replace, often without immediate substitutes, that typically generate relatively stable cash flows that increase with inflation.

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Is Infrastructure an Asset Class?

Criterion for An Asset Class

• Logical grouping of assets that share similar characteristics
• Collectively have an inherent, non-skill-based return (Beta, not Alpha)
• Unique risk and return characteristics and non-overlapping with other asset classes
• Investable

Infrastructure

• Stable cash flows: usage does not materially decline with price increases or during

periods of economic weakness

• Long-term returns: governments allow private owners to earn fair returns in order to

incentivize them to keep facilities in good working order

• Inflation protection: the ability to increase rates linked to inflation over time

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Source: EIA, J.P. Morgan

Is Infrastructure an Asset Class

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Source: EIA, J.P. Morgan

Is Infrastructure an Asset Class

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Ways of Investing in Infrastructure

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• Direct ownership – control, but concentrated risks
• Private Equity Funds/Partnerships – more diversified
• Listed Infrastructure Vehicles

– Traded on an exchange, – Liquid, and have extensive financial reporting requirements regulated by the various stock exchanges

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Historical Risk and Return

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Source: Dow Jones, FTSE, MSCI, S&P, UBS *Estimate

Various Index that Tracks Infrastructure

Industry Breakdowns

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Source: Ibbotson Associates.

Various Index that Tracks Infrastructure

Geographical Exposures

15 Source: Dow Jones, FTSE, S&P, UBS

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Source: Ibbotson Associates.

Historical Performance

Benchmark Historical Risk and Return Characteristics (June 30, 2013)

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S&P Global Infrastructure - Total Return Index MSCI AC World Infrastructure Sector Capped - Total Return Index UBS Global Infrastructure & Utilities 50-50 - Total Return Index UBS World Infrastructure & Utilities - Total Return Index S&P 500

Inception Nov-01 Jan-99 Jan-95 Jan-06 Jan-26 Return (%) 1 Year 11.69 12.91 14.67 8.64 20.60 3 Year 10.39 12.64 12.28 9.10 18.45 5 Year 1.84 4.09 1.20

• 0.77

7.01 7 Year 4.12 5.96 4.87 4.56 5.66 10 Year 9.67 9.17 10.79 NA 7.30 Inception 8.72 5.18 7.56 5.20 9.95 Risk (STD %) 1 Year 8.24 8.97 12.12 11.38 6.74 3 Year 10.07 9.28 13.94 12.98 13.56 5 Year 14.86 12.45 18.58 16.54 18.42 7 Year 14.45 12.61 17.67 16.19 16.71 10 Year 13.57 11.45 16.56 NA 14.58 Inception 13.51 11.62 14.89 15.91 19.02

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Source: Ibbotson Associates.

Infrastructure and Other Asset Classes

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Returns-Based Style Analysis of Infrastructure

Source: Morningstar EnCorr

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Risk Return Trade Off

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Source: Author’s own estimate and Ibbotson Associates.

CAPM Expected Returns

Asset Class Risk-Free Risk Free Rate Beta Relative to US Stocks US Stocks Risk Premium CAPM Return Estimate Risk Estimate (Standard Deviation) Cash 3.38% +

• 0.01

x 5.95% = 3.30% 0.89% U.S. Bonds 3.38% + 0.03 x 5.95% = 3.54% 4.36% Non-U.S. Bonds 3.38% + 0.24 x 5.95% = 4.81% 10.47% Global High Yield 3.38% + 0.46 x 5.95% = 6.11% 12.77% U.S. Stocks 3.38% + 1 x 5.95% = 9.33% 20.18% Non-U.S. Developed Stocks 3.38% + 1.26 x 5.95% = 10.88% 22.05% Emerging Stocks 3.38% + 1.46 x 5.95% = 12.06% 35.93% Global Real Estate 3.38% + 1.16 x 5.95% = 10.27% 23.04% Commodity Futures 3.38% +

• 0.03

x 5.95% = 3.18% 18.48% Global Private Equity 3.38% + 1.5 x 5.95% = 12.31% 39.89% Infrastructure 3.38% + 0.84 x 5.95% = 8.35% 18.70%

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Efficient Frontier Asset Allocation

Source: Ibbotson Associates.

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Return and Cost of Capital of Regulated Infrastructure

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Return and Cost of Capital

• Regulated Utility’s return is closely tied to the target cost capital set by regulators
• Long-term forecasts

5 Methods of Estimating Cost of Capital 1) The build-up method 2) Discounted Cash Flow Model (single stage and multi stage model) 3) Capital Asset Pricing Model (CAPM) 4) Modified CAPM model 5) Fama French 3 Factor Model

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Build-up Method

Treasury Bills LT Treasury Bonds LT Corporate Bonds Default Premium Large Cap Stocks Small Cap Stocks

Small Cap Premium U.S. Equity Risk Premium Horizon Premium Real Risk-Free Rate Expected Inflation Real Risk-Free Rate Expected Inflation Real Risk-Free Rate Expected Inflation U.S. Equity Risk Premium Horizon Premium Real Risk-Free Rate Expected Inflation Horizon Premium Real Risk-Free Rate Expected Inflation Horizon Premium

Risk-Free Rate + Market Risk Premium +Firm Size Premium + Industry Premium +potentially other factors Cost of Equity =

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Estimating Cost of Capital

• Discounted Cash Flow Model (single stage)
• CAPM
• Fama and French

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Pastor and Stambaugh (1997), Costs of Equity from Factor Based Models. NBER Working paper.

Cost of Capital Estimation Models

• Incomplete, Not Incorrect
• Two sources of estimation errors

– Error introduced by the specific model used: e.g., CAPM vs. DCF – Error Introduced by the specific inputs used: e.g., the equity risk premium

• Drawing on multiple sources of information may help reduce such errors.
• Pastor and Stambaugh (1997) found that uncertainty about inputs are as big source
• f overall cost capital estimation uncertainty as model misspecification.

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ERP Estimation Methods

• Historical RPs measure over various markets and time periods (Ibbotson & Sinquefield)
• Consensus forecasts:

– Individual investors (USA today) – Economists / Professors: e.g., Welch (2001), (2004); – CFOs, e.g., Graham and Harvey (2013)

• Demand: degree of investor risk aversion, e.g., Mehra & Prescott (1985), Mehra (2003),

Constantinides (2003)

• Real economy (supply): stock market is constrained to be part of the economy, e.g.,

Diermeier, Ibbotson & Siegel (1984), Shiller (2000), Fama & French (2002), Ibbotson and Chen (2003)

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Source: Ibbotson Associates (2013)

Summary Statistics (1926–2012)

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DISTRIBUTION OF ANNUAL RETURNS

Large Company Stocks Compound annual return Arithmetic annual return Risk (standard deviation)

9.8% 11.8% 20.2%

Government bonds Compound annual return Arithmetic annual return Risk (standard deviation)

5.7% 6.1% 9.7%

Inflation Compound annual return Arithmetic annual return Risk (standard deviation)

3.0% 3.1% 4.1%

Treasury Bills Compound annual return Arithmetic annual return Risk (standard deviation)

3.5% 3.6% 3.1%

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Historical RP approach

• ERP is stock returns minus average bond income return (5.1%)
• Historical (1926–2012) ERP equals 4.47% geometrically
• But, extrapolating stock market ERP would outrun earnings and GDP growth

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Possible Biases in the Historical ERP

Survivorship Bias:

• In 1900, an informed investor may have chosen the U.S., Germany, Russia, the U.K., Japan, or Argentina
• 100 years later, only U.S. and U.K. investments still have value
• The return on U.S. stocks was much higher than investors expected

Changes in Investors’ Attitudes and Market Conditions

• Investors are more comfortable with equity investing
• Stock volatility has fallen since 1946
• Bond volatility has risen since the 1970s
• These changes suggest that the ERP is lower today than it was over much of the historical period

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Source: Ibbotson Associates SBBI Yearbook (2013)

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Growth of Stocks, GDP per Capita, Earnings, and Dividends (1926–2012)

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The Supply Of Stock Market Returns

• Stock market participates with earnings and real economy growth
• Supply factors include inflation, earnings, PE ratios, dividends and payout ratios,

and GDP per capita

• Retained corporate cash can be used for dividend payouts, share repurchases,

acquisitions, etc

• Assumes Miller & Modigliani, constant ERP, inflation pass-thru, and current fair-

priced PE ratio

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Decomposing Stock Market Returns

Results add geometrically, not arithmetically

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0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11%

1—Building blocks 2—Income and capital gain

Inflation 3.00% Real risk free 2.08% ERP 4.47% Real capital gain 2.52% Income 4.10% Inflation 3.00%

Source: Author own estimate based on data from Ibbotson Associates SBBI Yearbook (2013)

Total 9.8%

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Source: Author own estimate based on data from Ibbotson Associates SBBI Yearbook (2013)

More Decompositions Of Historical Equity Returns

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0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11%

2—Income and capital gain

Real capital gain 2.52% Income 4.10% Inflation 3.00%

3—Earnings

Earnings growth 1.97% Income 4.10% Inflation 3.00%

4—GDP/POP

Growth GDP per capita 1.86% Income 4.10% Inflation 3.00%

Growth of factor share 0.65%

PE growth 0.54%

Total 9.8%

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Source: Ibbotson Associates SBBI Yearbook (2013)

PE Ratio

The PE ratio has gone from 10x to 30x in 2000, to 16X currently

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10.92 16.37

As of Dec 31, 2012

0.00 5.00 10.00 15.00 20.00 25.00 30.00 35.00 40.00 45.00 1926 1931 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006

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Source: Author own estimate based on data from Ibbotson Associates SBBI Yearbook (2013)

Forecasting Stocks From Earnings Growth

PE Growth of 0.50% per year is not forecast to continue

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0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11%

3-Historical

Inflation 3.00% Earnings growth 1.97% PE growth 0.54% Income 4.10%

3F ERP

Real risk free 2.08% ERP 3.91% Inflation 3.00%

3-Historical ERP

Inflation 3.00% Real risk free 2.08% ERP 4.47%

3F-Earnings Forecast

Inflation 3.00% Income 4.10% Earnings growth 1.97%

Total 9.8% Total 9.21%

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*Arnott & Asness (2003) disagree, claiming that corporations waste retained earnings.

The Dividend Yield Approach

• Add the current dividend yield (2.14%) to future dividend growth
• But Miller & Modigliani show that lower payouts do not affect total returns*
• Future EPS and dividend growth will be higher than past growth because of low dividend

payouts and the high current PE ratio

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Bloomberg and Wall Street Journal (July 10, 2013): http://online.wsj.com/mdc/public/page/2_3021-peyield.html

Historical Vs. Current Dividend Yield Forecasts Based On Earnings And Dividend Models

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0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 3F- historical earnings forecast 3F(ERP)-historical earnings forecast 4F- current dividend forecast 4F'- current dividend forecast ERP

Past dividend

growth

Real risk free 1.07%

ERP 3.91% 1.50% Current income 2.14% Inflation 2.20% Inflation 2.20% ERP 2.50% Inflation 2.20% Total 7.29% Total 5.87% Total 5.87% Total 9.21%

Real risk free 2.08% ERP 3.91% Inflation 3.00%

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Source: Graham and Harvey (2013)

CFO Survey Forecast— Graham & Harvey (2013)

10-year forecasted S&P 500 (mean) annual returns over and above the 10-year Treasury bond yield

• As of end of 2012, 10

year expected S&P Total Return: 5.46%

• As of end of 2012, 10

year expected equity risk premium 3.83%

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Source: Author own estimate based on data from Ibbotson Associates SBBI Yearbook (2013)

Arithmetic and Geometric Estimate

ERPA = ERPG + 0.5σ2 = 3.91% + 0.5 × 20.182 = 5.95%

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Summary

• Infrastructure should be treated as an separate asset class
• Infrastructure investments has lower risk and returns than traditional equities. Return is tied to

long-term cost of equity targets

• Long-term strategic portfolios should allocate to infrastructure, particularly for investors on the

lower to modest risk levels.

• The dedicated allocation to Infrastructure tends to be around 3-5% (in addition to existing weights

in the broad equity portfolios)

Cost of Capital

• Many potential methods. No method is incorrect; only incomplete methods
• Estimation error in inputs needs to be considered, in particularly equity risk premium

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Ang, Andrew and Geert Bekaert. 2001. “Stock Return Predictability: Is It There?” Columbia University and NBER Working Paper. Campbell, John Y. and Robert J. Shiller. 2001. “Valuation Ratios and the Long Run Stock Market Outlook: An Update”, NBER Working Paper, No.8221. Diermeier, Jeffrey J., Roger G. Ibbotson, and Laurance B. Siegel. 1984. “The Supply for Capital Market Returns,” Financial Analyst Journal,

• vol. 40, no. 2 (March/April): 2-8.

Fama, Eugene F. and Kenneth R. French. 2002. “The Equity Risk Premium,” Journal of Finance, vol. 57, no. 2 (April): 637-659. Graham, John R. and Campbell R. Harvey. 2013. “Expectations of Equity Risk Premia, Volatility and Asymmetry from a Corporate Finance Perspective,” Working Paper, Fuqua School of Business, Duke University. Ibbotson Associates. 2013. Stocks, Bonds, Bills, and Inflation 2001 Yearbook, Ibbotson Associates, 2013. Ibbotson, Roger G., and Rex A. Sinquefield. 1976a. “Stocks, Bonds, Bills, and Inflation: Year-By Year Historical Returns (1926-1974),” The Journal of Business, vol.49, no. 1 (January), 11-47. Ibbotson, Roger G., and Rex A. Sinquefield. 1976b. “Stocks, Bonds, Bills, and Inflation: Simulations of Future (1976-2000),” The Journal of Business, vol. 49, no. 3 (July): 313-338. Mehra, Rajnish, and Edward Prescott. 1985. “The Equity Premium: A Puzzle,” Journal of Monetary Economics, vol. 15, no. 2, 145-161. Miller, Merton, and Franco Modigliani. 1961. “ Dividend policy, Growth and the Valuation of Shares,” Journal of Business, vol. 34, no. 4 (October): 411-433. Shiller, Robert J. 2000. Irrational Exuberance, Princeton University Press, Princeton, NJ. Welch, Ivo. 2000. "Views of Financial Economists on the Equity Premium and Other Issues." The Journal of Business, vol. 73, no. 4 (October): 501-537.

References

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Disclaimer

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This presentation is strictly for information purposes only and shall not be used for any other purposes. All information in this presentation is given in good faith and without any warranty and is not intended to provide professional, investment or any other type of advice or recommendation and does not take into account the particular investment objectives, financial situation or needs of individual recipients. Before acting on any information in this presentation, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice. Dimensional does not accept any responsibility and cannot be held liable for any person’s use of or reliance on the information and opinions contained herein.