The infrastructure sector, Standard & Poor’s warned last week, is experiencing a bubble.
To those of us who have been saying the same for some time now, this was no shock. But it does give rise to a depressing reflection. Contrary to what one might think, investors are generally quite well aware of bubbles. But they seem to be incapable of taking avoiding action.
For fast money such as hedge funds, this may make sense. The aim is to be nimble enough to exploit the turning point.
But for real money investors – private equity and infrastructure funds, and the pension funds which invest in them – there is indeed real money at stake.
The one thing we can say with confidence about bubbles is that there is no telling what will burst them or when.
Immediately after the Wall Street crash of 1987, the Yale academic Robert Shiller polled investors on what they thought had triggered the fall.
Their only consistent response was that the market had been too high – which was no answer at all.
But why do so many investors seem determined to hang on until the bitter end? Part of the answer is structural.
Professional investors are under powerful pressure to put cash into the markets. That was why it was handed to them in the first place.
From that perspective, it is not irrational for a mutual fund manager to invest in stocks even when he or she thinks the market is overvalued. Investors in the fund have implicitly taken the opposite view. It is not the fund manager’s job to disabuse them, but to make the best of it.
Similarly, private equity funds are given only five to eight years to make a return.
At present, they have about $300bn collectively to invest, or maybe $1,000bn when leveraged up. Trying to force all that into the market at once might look crazy. But having only five years to play with, they cannot afford to hang around.
Infrastructure funds, one might think, are under no such pressure, since they ostensibly work on a 30-year horizon. The reality is, though, that the infrastructure game has been heavily infiltrated by private equity, so the same rules apply.
In any case, investor behaviour in bubbles is also driven in part by psychology.
As one example, take what Prof Shiller calls the information cascade.
Suppose two very similar restaurants open next to each other at the same time.
The first customer has no basis for choice, so goes into one at random. The next customer will tend to prefer the one with people in it.
By the end of the evening one may be full and the other empty, even if the empty one has better food.
In other words, says Prof Shiller, the notion that the market price is the outcome of an informed vote may simply be wrong. In our context, people are paying up for infrastructure assets because everyone else is.
To be fair, there are no bargains elsewhere in today’s markets. This is in stark contrast with the dotcom boom in 1999-2000, when some conventional companies were startlingly cheap.
At the peak of the market in the UK, for instance, companies such as the cigarette maker Imperial Tobacco, the housebuilder Wimpey and the pub company Wolverhampton & Dudley were all on earnings multiples lower than their dividend yield. Since then the first two have quintupled in price, while the third is up by a factor of four.
This is an essential point in considering the private equity boom. By and large, these have been the kind of safe, high cashflow companies private equity has preferred.
In a deadly little exercise recently, strategists at Citigroup compiled a notional portfolio of such stocks, going back 10 years. They then funded the portfolio with one-quarter cash, three-quarters debt – a typical private equity ratio.
The return on the cash portion worked out at 38 per cent a year over the past decade, compared with an average return for buy-out funds of 14 per cent.
That, of course, is what happens when you gear up in a rising market. But imagine the mayhem if the buy-out funds had used the same gearing to buy dotcom stocks at the peak.
To a much less dramatic extent, this might be happening now with infrastructure funds. It is not a pretty sight.
But if history is a guide, precious little can be done to stop it.
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