ETF IFRA: infrastructure stocks slightly undervalued
The iShares US Infrastructure ETF (BAT:IFRA) is an exchange-traded fund that invests in companies that could benefit from increased domestic infrastructure activity. The fund had 157 holdings as of May 26, 2022, with assets under management of $1.807 billion. The the fee rate is 0.30%.
The fund’s benchmark is the NYSE FactSet US Infrastructure Index, although the benchmark does not come with regular fact sheets. Nonetheless, we can use an external data provider Morningstar that tells us that the forward-looking price-to-earnings ratio was around 13.52x as of May 27, 2022, with a price-to-book ratio of 1.83x. This implies a projected return on equity of approximately 13.5%. Future average earnings growth over three to five years is estimated at 15.44%. The rolling dividend yield at 2.28% likely implies a rolling base (earnings) payout ratio of around 40%.
It is possible that Morningstar’s forward price/earnings implicitly overestimates the earnings (denominator) in the equation. However, at first, one can imagine IFRA’s return on equity collapsing to around 10%, until earnings growth drops to around 2% per year (which would happen quickly). in this gradually declining return on equity scenario). With an earnings growth floor of 2% (probably close to the rate of inflation, i.e. a conservative approach), and assuming that we value IFRA at the same forward price-earnings ratio of approximately 13.52 x the fifth year, our assessment implies a forward IRR of approximately 9.50% through the fifth year.
If we suggest a fair risk premium on equities of around 4.20-4.50% and a risk-free rate of around 3% (allowing for a slight upward movement in the US 10-year yield, which is a reasonable approximation for US equity investors and which is currently below 3%), an upside of around 26-32% is possible (on a total return basis). This is a conservative case in which we assume nominal earnings growth close to the likely level of inflation (ie insignificant or even negative “real” earnings growth).
The US economy may well avoid recession in the short term. Fidelity looks at a variety of factors, including economic growth, credit growth, earnings growth, government policy, and inventory and sales growth. The assessment for Q2 2022 is that the United States is in the middle of its current economic cycle.
IFRA’s portfolio is likely to continue regardless. Its historical beta is around 1.06x at the time of writing. But our ERP range of around 4.20-4.50% is fair enough. Even if we took a high ERP of 5% and increased it by 1.06x, then added a risk-free rate of 3%, our implied cost of equity of 8.3% would still be below our IRR implied 9.50%.
That said, there isn’t much headroom here, and the implied TRI is pretty poor compared to the other opportunities out there. If there was a “surprise recession” in the short term, a significant decline in earnings coupled with risk aversion could easily see IFRA take a hit. And the dividend yield is not high, so there wouldn’t necessarily be a very strong floor price.
All in all, while the IFRA is probably slightly undervalued, and to be fair, these are most likely conservative earnings growth projections, I think it’s best to maintain a neutral stance on the funds.
To take a more “optimistic” view, let’s imagine that ROE is held constant at around 13.5% for five years, and then we exit on a forward price/earnings multiple of, again, 13.52x (the multiple current), our IRR would increase to 15.45%. And on a cost of capital of just 8.5%, that would imply an increase of more than 80%. But the distance here is probably too great; the market is more likely to discount lower long-term equity returns and greater uncertainty than the fund’s historical beta suggests.
There is enough headroom to imagine a forward return of up to 10% per year over the five years on a total return basis. However, I suspect that there are short-term risks that could affect risk sentiment in this particular type of stock. The “whiplash effect” discussed recently in the FT describes a phenomenon in which overstocked inventory leads to oversupply, lower prices at retailers, etc. ). All of this could indirectly affect the infrastructure companies that IFRA invests in (which iShares describes in two groups, as “[firstly] owners and operators, such as railways and utilities, and [secondly] catalysts, such as materials and construction companies”).
So, in summary, IFRA is probably undervalued and offers a decent IRR in the medium to long term. However, on the other hand, the IRR does not include a large safety margin that would protect an investor from deflationary forces and/or a recession, let alone investor risk aversion on the back of the one or both. I would maintain a neutral stance on IFRA at current prices, but I wouldn’t be surprised if the fund continues to do modestly well in the short to medium term.