Investors discover the benefits of real assets

Rapid population growth in emerging markets together with increasing affluence represent sound reasons to consider investment in real assets.

There are some very powerful drivers of demand in emerging markets that support the case for a structural allocation to real assets.

The most notable are rapid population growth, rising disposable incomes and changing tastes and fashion.

Rapid population growth has led to real assets being consumed in vast quantities.

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In China for example, huge infrastructure projects have been undertaken to support its large population.

China is a vast economy, and one of the challenges has been to create a transportation system that links up the entire country.

Current long-term projects include building a high-speed rail network, roads and airport infrastructure, which requires real assets such as iron, steel and concrete.

China’s growing urban population also requires vast amounts of resources to provide for basic needs, such as adequate housing.

The negative spillover effects from urbanisation, such as environmental damage, should also be considered.

China has adopted strict European-style auto emission standards, while other emerging markets, like India and Brazil, are implementing similar measures.

This has led to increasing demand for catalytic converters which use other metals, such as platinum.

Rising disposable incomes in urban centres are also nurturing a nascent consumer culture. Many of these consumers can now better afford lifestyles normally associated with the developed world.

For example, mobile phones are rapidly becoming commonplace, there is a growing market for designer clothing and demand is also rising for gold and diamonds for use in jewellery.

Owning a car is no longer seen as the preserve of the rich. Increasing car ownership is another emerging market trend worth considering as it is reshaping the global automobile industry. For example, China is now the world’s largest car market.

This has implications for raw materials such as steel, aluminium, copper, rubber and glass.

On a per capita basis, however, China’s car market still has huge capacity to expand, which gives automobile and related industries great growth potential.

Diets are switching from cereal-based diets to high grain-intensive foods, such as meat. This has led to a rising trend in grain prices globally.

Livestock feed also requires vast amounts of land to harvest grain so the price of farmland real estate may also rise in some parts of the world.

Grain also requires significant amounts of water, which could strain supply in some regions.

Dynamic demand for real assets

Despite these structural drivers of demand, investors should be aware that demand for real assets is ever-changing, according to the vagaries of the economic cycle.

As such, investors should take an active approach to real asset investing.

For example, the pace of infrastructure development in China appears to be slowing – its economy is gradually moving away from infrastructure led growth, towards domestic consumption (although investment is still a huge part of its gross domestic product compared to other markets).

As a result, its demand for construction materials has dropped back somewhat from very high levels – yet it is still strong.

On the other hand, demand is rising for consumption-based materials such as energy, food and precious metals.

The demand characteristics for real assets are not limited to emerging markets. Infrastructure is growing old in developed economies and needs replacing.

In the US, for example, more than a quarter of all bridges need structural repairs and upgrades.

Leaky pipelines are losing billions of gallons of clean drinking water every day. And there are aging sewage systems in the US that are in desperate need of repairs and upgrades.

It is estimated that US$2.2 trillion (A$2.2trn) will be needed to make these improvements.

Disruptive technologies is another theme affecting the developed world because it requires new infrastructure.

For example, the demand for fast internet broadband has led telecom companies to invest heavily in fibre-optic networks.

Smartphones and tablets have spurred demand for fast mobile internet and 4G technology. This requires network operators to install additional radio transmitters.

This generates more revenue for telecom tower operators – for instance, as telecom companies have to pay extra to install additional antennas.

New technological advances in shale oil and gas extraction are increasing the supply of energy in some developed economies, such as the US and Canada.

In fact, the US could become energy independent within the next decade or so, which has huge implications for the global supply of energy.

Companies directly exposed to shale oil and gas production will benefit as they will gain an increasing share of the energy market from foreign suppliers.

Falling energy costs will also benefit companies where energy is a major input to their production process. This is a theme that is likely to have huge implications across the oil and gas supply chain.

Real assets help investors hedge against inflation

Real assets are also a popular investment for hedging against inflation. Major central banks around the world have printed vast amounts of money since the global financial crisis in 2007 – US$8 trillion in total (A$8trn).

This could, over time, lead to higher inflation – it has yet to emerge because many economies are still going through a painful deleveraging process.

Nonetheless, it has created huge amounts of potential inflationary pressure.

Unlike financial assets, real assets are not easy to replicate. Central banks might be able to print money at will, but the same isn’t true with real assets.

Real assets are not produced, or diluted, by the printing press. What this means is that there is now a larger supply of money chasing the same finite supply of real assets.

As a result, real assets will rise in value along with inflation.

From an investor’s perspective, companies exposed to real assets that have managed to retain their pricing power, kept dividends intact and have maintained growth will perform well in an inflationary environment.

Certain real assets lend themselves to this type of inflationary risk. For example, gold is a favoured commodity during times of currency debasement.

However, single assets carry idiosyncratic risks. A diversified portfolio investing in real assets offers the prospect of a real risk-adjusted return at a time when growth is hard to come by and inflation is eating away at conventional fixed income investments.

The importance of diversification

While real assets are intuitively easy to understand, investing in physical assets can prove challenging due to their lack of liquidity, the expertise required to trade in them and the need for storage.

In view of the inherent volatility associated with such relatively illiquid assets, diversification is advisable. A more practical way to gain exposure to real assets is to invest through related equities.

Arguably, this is a much better strategy than taking a simplistic macro call on a particular real asset.

Well-managed businesses that are directly affected by the finite supply of real assets can adapt to the changing demand and supply conditions that they face and thrive.

It is also important to invest across different themes that affect real assets.

Thematic diversification can help avoid political turbulence and policy risks that can affect the supply of certain real assets, namely sanctions, anti-competitive tariffs and the like.

Diversification also softens the negative effects of natural and climatic developments – a famine could wipe out a crop harvest, an oil spill may shutdown a drilling platform.

Another strategy is to vary exposure to different parts of the asset supply chain, depending on the phase of the cycle.

The supply chain for any real asset can be broken down into upstream, midstream and downstream components.

Visually, if you imagine a river, the upstream represents the source (a spring), while the downstream is where the river distributes its contents into the sea.

For example, in the oil sector the upstream consists of drilling platforms and oil wells.

The midstream consists of oil refineries and petrol stations. And the downstream is where oil is finally consumed by vehicles such as cars and airplanes.

If the price of Brent crude appears to have reached an unsustainable high against fundamentals, there is a good chance it will fall in the short to medium-term.

Therefore, it makes sense to invest in companies that benefit from falling oil prices.

These are likely to be found downstream where the consumption of oil is a major input for production – an airline, like Qantas, is a good example, but you could also include refineries and petrochemical companies.

However, if the reverse was true and oil prices were likely to rise, then companies located upstream would benefit.

These would include oil exploration and production groups, like Cairn Energy, offshore drilling contractors like Transocean, as well as oil equipment contractors like Saipem and Larsen & Toubro.

Understanding pricing power at different points of the cycle

The key factor in assessing the value chain is pricing power. Having an understanding of a company’s pricing power is critical, especially in periods of inflation or macro uncertainty.

Companies with pricing power are able to pass on prices along the supply chain with little change in demand for what they produce.

This may be because there is already a limited supply for what they make. It can also be linked to the superior quality of products or services they offer – for example, a well that produces the highest grade of oil.

Those firms that have a greater pricing power than their competitors in their respective part of the supply chain should outperform across market cycles.

They also have a greater ability to pass on rising input costs to their customers.

It is important to remember, therefore, that as well as taking tactical positions along the supply chain during inflection points in real asset prices, stock selection based on in-depth fundamental research is critical.

In fact, it should form the backbone of any actively managed portfolio.

"Picking companies with a strong asset base and good cashflow is important."
 

Picking companies with a strong asset base and good cashflow is important.

Developing an understanding of the full supply chain in which companies and industries operate is key to successfully investing in real assets securities.

If we look at the auto industry, for example, you might think cars leave the factory floor, enter car showrooms, and are sold.

Yet the full supply chain is much more complex, and having an understanding of how the links interact and what raw materials and other assets they require needs thorough fundamental analysis.

One of the difficulties is that the end product can often look very different from the commodities used to manufacture it.

For example, iron ore, mined by companies like BHP, is an important input for steel production. BHP has the ability to maintain its pricing power through a large diversified portfolio of long-life mines. Another example is platinum.

This is used as a catalyst to clean auto emissions and is provided by companies like Johnson Matthey in a range of end-use products, including catalytic convertors.

Further upstream, there are other developments that could change the competitive landscape. China and other emerging economies have become the manufacturing centres of the world due to their abundance of cheap labour.

However, double-digit annual increases in salaries, rising staff turnover and variable quality are threatening this supremacy.

Increasing automation could be a solution and would bring labour costs down and improve quality.

Having said that, the use of robots, combined with muted wage demands in job-scare Organisation for Economic Co-operation and Development (OECD) economies, simplified logistics and the renewed access to cheap energy in geographies like North America, could also prompt the repatriation of some manufacturing operations in developed economies.

Either way, firms that specialise in robot technology are likely to benefit, as more sophisticated robotics can bring costs down and help improve quality and consistency with minimum wastage.

Conclusion

Investing in real assets as an alternative investment approach that offers many long-term benefits, from ongoing exposure to emerging market growth as well as powerful trends in the developed world.

It can also offer a valuable hedge against inflation at a time when unprecedented injections are being made into the financial system.