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SAN FRANCISCO (MarketWatch) -- President Barack Obama this week proposed spending $50 billion to improve the nation's roads, railways, airports and other infrastructure needs. But to really play this promising theme, investors should look to emerging markets.
Developing countries are expected over the next three years to spend more than 100 times what the U.S. might spend over six. Almost $4 trillion of this estimated $6.3 trillion outlay is linked to China, but major commitments also are coming from governments and private sources in Brazil, India, Russia, Mexico, South Africa and the Middle East.
Their incentive is straightforward -- and unavoidable. Each week, more than one million people are born into or move to urban areas in emerging markets. By 2025, the United Nations reports, 21 of the 25 largest cities in the world will be in developing nations.
To be competitive in the global marketplace, stoke economic growth, and keep exploding populations from becoming explosive, emerging markets have no choice but to spend and build, on everything from ports to power plants.
"They need to build out infrastructure to create stable growth," said Kate Moore, global equity strategist at Bank of America Merrill Lynch, who recently published a research report on investing in emerging-market infrastructure. "Cities with the best infrastructure will attract domestic and international business as well as human capital," the report noted.
Economic stability is not the only purpose for infrastructure spending; there's a strong political motive as well. Domestic infrastructure projects create skilled jobs and improve people's quality of life. People everywhere want clean water, working sanitation, and reliable power and transportation.
A government that provides electric power stands a better chance of retaining electoral power. "Social stability is important for all of the existing political regimes in emerging markets," Moore said. "The best way is to provide a sound economy."
Despite the positive trends, infrastructure investing has been under a cloud as investors fret about anemic global growth. Buyers have been concerned that funding for these long-term projects would dry up as governments focused on pensions and social security.
Those fears are largely overdone. Infrastructure spending across the emerging markets is still robust, though private enterprise is expected to cover more costs and liabilities going forward, particularly in Brazil and India.
Brazil, notably, is hosting soccer's World Cup in 2014 and the Olympics in 2016 -- two events that require a functional infrastructure. China, meanwhile, has embarked on a monumental, multiyear effort to connect the underdeveloped western interior with its wealthy, modernized eastern coastal cities.
Emerging markets nowadays also have access to capital to make these investments happen, unlike a decade or so ago when they were considered low-quality, high-risk backwaters. These countries are in sound financial shape, and not as leveraged as mature North America, Europe and Japan.
"The trend is the same: superior growth potential," said Alec Young, international equity strategist at Standard & Poor's Inc. "There's less doubt about growth, and less debt at the consumer, corporate and government level. Demographics are better too -- more young people."
Moreover, shares of infrastructure-related emerging-market companies aren't as richly valued as their developed-market counterparts. Valuations on emerging-markets stocks average about 12 times earnings, while the broad-based MSCI Europe, Australasia, Far East (EAFE) Index is priced at about 12.5 times earnings and the U.S. benchmark Standard & Poor's 500-stock index trades above 13 times earnings, Young said.
"It's a better story at a lower price," he said of the developing countries. "If the global growth story improves, emerging markets keep outperforming. If it's murky, they still continue to outperform because their story is less murky."
Still, there are substantial hazards with infrastructure investing in these markets.
Political risk tops the list. Government bureaucracy and regulation can slow development and limit profits. In addition, state funding could be cut or priorities altered; China, for example, is emphasizing water projects and shifting somewhat from railways.
"Infrastructure is always tied to political risk," said Richard Kang, chief investment officer at Emerging Global Advisors, a provider of exchange-traded funds. "You don't build a highway unless the government says it's OK.
"I call it 'law and order,'" he said. "India is the rule of law; China is order. In India, the rule of law is there but because of bureaucracy it is very inefficient. In China, when a one-party system says we're going to build a dam, it happens."
A second risk is that these high-profile developments are capital intensive and won't generate revenue for many years. Some of these stocks do offer attractive dividends, but if you put money into this area, be prepared for a long wait.
The best way for investors to succeed is to focus on three of the hottest infrastructure sectors in emerging markets: energy and power; transportation and logistics, and water and the environment. This is where the big money will be spent by 2013 -- accounting for about 80% of that $6.3 trillion estimate.
Of course, emerging-market infrastructure is not a new investment theme. A sizable number of mutual funds and exchange-traded funds are dedicated to infrastructure-related stocks and bonds, offering diversification and relatively low expenses, two advantages when investing in these volatile regions.
"Rapid growth doesn't always translate into strong portfolio returns," said Paul Justice, director of North American ETF research at investment researcher Morningstar Inc.
Also, not all infrastructure funds are created equally. Many are heavily invested in utilities, which tend to sport attractive dividends but are heavily regulated and unlikely to produce much in the way of earnings growth.
Consider two comparable ETFs, PowerShares Emerging Markets Infrastructure Portfolio and iShares S&P Emerging Markets Infrastructure Index Fund . The PowerShares portfolio recently had about three times as many stocks as the iShares fund, with less than 5% of assets in utilities and energy stocks and about 60% in industrial goods; its iShares rival had about 60% of assets in utilities and energy, with about 6% in industrial goods, according to Morningstar.
The two funds' investments also couldn't be more different: The PowerShares portfolio has substantial stakes in China's Dongfang Electric Corp. and Shanghai Electric Group, which it classifies as industrial companies. Other top holdings: Brazil's Vale S.A. ; U.S.-based Caterpillar Inc., and Sweden's ABB Ltd.
In contrast, the iShares offering counts China Merchants Holdings International, Brazilian electric provider Cemig, Czech Republic-based power producer CEZ Group and China Oilfield Services among its biggest positions.
Funds' country allocations vary as well. The PowerShares ETF has about 20% of assets in China, around 10% each in Brazil and South Africa, and a bit less in Taiwan and, surprisingly, the U.S. Meanwhile, the iShares fund had 60% of assets split between China and Brazil.
The PowerShares ETF is geared to investors who are more aggressive and growth-oriented, said Ken Leon, an ETF analyst at S&P, which has an "overweight" recommendation for the fund. But Tom Lydon, editor of ETFTrends, said that while the PowerShares offering is solid, he's uncomfortable with its stake in what he called a challenging South African economy.
For a laser-like focus, consider single-country ETFs from Emerging Global Advisors: EGShares' China Infrastructure, India Infrastructure and Brazil Infrastructure.
"If you feel that Brazil is going to outperform China and India, you've got a choice," Lydon said. "It depends on how thinly you want to slice your pick."
On the other end of the infrastructure-investment spectrum are mutual funds and ETFs that hold some emerging-markets stocks but are mostly tied to companies in developed markets.
For example, S&P Global Infrastructure Index Fund keeps about 90% of its assets in developed markets. The ETF's top holding recently was Canadian pipeline giant TransCanada Corp.
Among actively run funds, T. Rowe Price Global Infrastructure Fund has about two-thirds of its assets in developed markets, said Nick Beecroft, a London-based specialist on the portfolio. One favorite in the developed world is Vinci, the French toll-road and parking giant. The managers also like operators of toll roads, airports, seaports and power facilities in China, along with Indian conglomerate Adani Enterprises Ltd., which has interests in coal mining, power generation, and oil and gas exploration and distribution.
Looking at two other wide-ranging funds: First American Global Infrastructure Fund recently kept about 80% of assets in developed markets, and Forward Global Infrastructure Fund had around 75% of assets in developed nations. Aaron Visse, a portfolio manager on the Forward fund, said he favors toll-road operators in China, such as Sichuan Expressway and Brazilian utilities Cemig and CPFL Energia.
Meanwhile, both Virtus Global Infrastructure Fund and Cohen & Steers Global Infrastructure Fund earmark essentially all of their assets to companies based in developed nations.
Infrastructure companies in developed markets may in fact do a brisk business in the emerging world -- brand-name operators with technical know-how and long experience. They're beneficiaries not only when emerging markets spend on infrastructure, but will be first in line when developed countries reexamine their own fundamental needs, such as that $50 billion plan for the U.S.
Looking out over the next decade, the infrastructure sector likely will be hard-pressed to keep up with demand, said Moore, the BofA Merrill Lynch analyst: "There could be a period where the entire world is building out, rebuilding, or replacing infrastructure," she said. "You only realize your infrastructure is inadequate when it is too late."