First Quarter 2015 GEOS Review – Ginormous Catalysts

We created the Essex Global Environmental Opportunities Strategy (GEOS) because we view the intersection of economic development and natural resource depletion as an enormous global opportunity for investors. GEOS invests opportunistically in technologies that can abate associated environmental degradation stemming from, in the words of my 16 year-old son, “ginormous” global changes or catalysts. These changes are all inter-related, from economic forces, to associated demographic shifts, and trends that exacerbate these catalysts such as global climate change. All this, while many asset owners are increasingly expressing moral outrage at the status quo of powering global economic growth using fossil fuels. By investing in clean technology in diversified fashion, GEOS enables doing more with less. As the baton of economic growth is handed from China to Africa, Southeast Asia and the Middle East – the Rest of World, demonstrated in the chart belowEnergy demand by region, clean technologies will enable as smooth a transition as is possible.

Source: International Energy Agency World Energy Outlook 2014.

Mtoe: million tons of oil equivalent

 

This transition and these catalysts are happening more often and with greater force now. Over the past few months, we have observed more global environmental action than in all of the past several years – some examples:

  • China will double its share of zero-carbon energy to 20% by 2030.
  • In 2014, renewable energy accounted for nearly 50% of global net power additions (source: Bloomberg New Energy Finance).
  • 73 national and 11 regional governments responsible for 54% of global greenhouse gas emissions, and more than 1,000 companies and investors have expressed support for carbon pricing.
  • The EU and Norway have pledged to lower emissions by 40% in 2030 using 1990 levels.
  • First Solar (GEOS holding at 3/31/15) announced Apple has committed $850 million to purchase solar energy under a 25 year power purchase agreement.
  • Boeing’s Renton, Washington production facility is now fully powered by renewable energy.

The latest and most dire environmental headlines reflect the global water crisis. While drought conditions proliferated in our Mid-West agricultural belt in 2012, changing weather patterns and macro-economic forces are causing dire water stresses in many countries currently. India is becoming very water hungry, and clean water access is hindering Prime Minister Modi’s development goals. While just now exiting the rainy season, Brazil’s reservoirs are only at 19% capacity – this, on the heels of an already two year drought. Unlike Los Angeles, residents of Sao Paulo are facing intermittent disruptions of water supply, and could see strict rationing in coming years. In another reference to the chart above, depicting anticipated global energy demand: please note that according to the International Energy Agency (IEA), 15% of global water withdrawals are for energy production. Given the slope of energy demand for the rest of the world, by 2035, it is expected energy-related water withdrawals could increase by 20%, as energy consumption rises 85%. As we have expressed in our whitepaper entitled Energy Equation, GDP = BTU – without British thermal units of energy, economic growth is not possible. Water is also a necessary catalyst for economic growth. The nexus of energy and water also bridges to agriculture, and the whole Middle East and southern Africa are beginning to face water stress. We have witnessed increased concerns regarding climate change and other environmental degradation with localized “flagging.” When severe weather effects occur in one’s back yard, concerns and potential actions are more often initiated. California has begun mandatory water reductions, with consumption reduction goals of 25%, as California enters its fourth year of drought, with almost 70% of the State in extreme drought conditions. This is the first ever water rationing for California, as the Sierra snowpack is at its lowest level in recorded history.

We believe that when faced with dire and over-powering news, many are paralyzed by fear or overwhelmed by the situation. We created GEOS as a conduit for action, by solving the world’s most complex social and economic issues. By investing in clean technology, and investing across inter-related environmental themes, we can do something. These frightening trends spell investment opportunity.

First Quarter 2015

As we stressed in our 4th quarter 2014 GEOS Review, we believed the strong correlation between solar stock prices and oil was unwarranted given divergent fundamental growth drivers. As the first quarter progressed, solar stock performance improved, with solar issues beginning to appropriately reflect their global growth trajectories. This was reflected in GEOS performance, as First Solar, SunEdison, SunPower and Vivint Solar were among the strongest contributors to the GEOS 5.11% gross return (4.85% net of fees) for the quarter. GEOS performance did outpace the MSCI World Index Total Return, which posted 2.50%, yet GEOS lagged our clean tech bogey, the Wilderhill Clean Energy Index, which returned 5.83%.

While solar is one of our higher conviction positions in GEOS, we do not let a single theme, industry or group of stocks dilute overall portfolio diversification. As we wanted to keep the GEOS solar weight under 18%, Canadian Solar was sold as the source of funds for a new position Vivint Solar. Canadian Solar has high revenue exposure to Japan, which has very high solar energy penetration, and a market for which we see a dampening of demand over the next year. Vivint Solar has much higher revenue growth given a U.S residential distributed solar focus.  Vivint is a vertically integrated, residential solar leasing company, using a neighborhood clustering marketing strategy, enabling one of the lowest cost structures in the industry. We anticipate a further slowing for the utility-scale solar market in the U.S., but believe the residential solar market will easily fill the potential demand-gap as the residential solar market is the most under-penetrated solar market in the U.S. Vivant was attractively priced given the 50% decline in the stock price following its October, 2014 initial public offering.

GEOS Water

“We never know the worth of water, ‘til the well is dry.”

Thomas Fuller, 1732

Beyond solar, we are observing much improved fundamentals for water. With better municipal financial footing and multi-year pent-up demand for water infrastructure, water companies are communicating much improved order growth. Water is a complex resource as it is localized, and a required catalyst for economic growth. In California alone there are over 2,900 independent water systems, and over 6,700 water sources. There are over 700,000 miles of water pipeline in the U.S., demonstrating how water is inextricably linked to local commerce. Water is also variable, with annual precipitation rates a direct determinant of global agricultural output. Our GEOS water theme runs from water conservation to efficiency and recycling/re-use. Within conservation, we are invested in water metering and industrial process enhancements. An example of a GEOS water holding is Badger Meter, which manufacturers gas and liquid flow control products to water utilities, municipalities and industrial consumers. We believe Badger Meter to be very well-positioned for water as in increasingly fungible natural resource. As water scarcity concerns rise, both utilities and corporations alike will need to invest in infrastructure enabling water usage to be measured, monitored, and increasingly in many markets, priced. As public and private water utilities turn to water conservation practices, the Badger Meter product set is increasingly reflected in their investment for integrated metering systems that include automation at point-of-use. Badger’s Beacon system utilizes cellular fixed-network technology that includes a data analytics platform to facilitate implementation and enforcement of mandatory water conservation programs like those just-announced in California. We anticipate Badger can grow revenue in the 10% range for the next 36 months, while continuing to generate very high returns on capital.

A new water position added late in the first quarter was Advanced Drainage Systems, a manufacturer of water drainage systems, such as storm water management, channels and leaching chambers. Advanced Drainage is well-positioned for climate change adaptation, increased spending on water infrastructure and water quality regulation. Our primary holdings rationale is simple: Advanced Drainage is the leader in the U.S. corrugated high-density polyethylene (HDPE) pipe market, which continues to take share over competing materials as it is safer and cheaper to install given a lighter weight and lower cost. HDPE piping also exhibits more corrosion resistance over traditional materials and better design flexibility allowing for unique applications that meet increasingly stringent environmental regulations. Advanced Drainage systems can assist new build construction with much sought-after LEED credits for water quality. Much tougher environmental regulations are governing storm water release, drainage guidelines and other watershed management issues. The positive outlook for U.S. construction creates another demand driver. The thermoplastic corrugated pipe business is extremely fragmented, and WMS is the only national player, having 48 manufacturing facilities and 20 distribution centers across the U.S. – a valuable competitive advantage as the economical shipping radius for HDPE piping is approximately 200 miles. We deem Advanced Drainage Systems to be well-positioned as our nation re-builds yesterday’s high cost and antiquated water infrastructure with advanced materials engineering.

Water stresses are not decreasing in the near or long terms.  Given population growth, and density combined with associated secular changes to emerging market economies, water technologies and infrastructure development needs significant scale and investment.  Our water theme is particularly attractive, as its growth is driven by new investment in the emerging markets, and a strong replacement cycle in developed economies.