GEOS Q2 2014 Quarterly Review- 5 Points at 5 Years

June 30, 2014 marks the five-year track record for the Essex Global Environmental Opportunities Strategy (GEOS). Our first five years reflect the consistent execution of the GEOS investment philosophy and process, represented by a concentrated portfolio of about 35 stocks held with high conviction across the nine GEOS themes.

As with any maturing industry, the past five years have exhibited instances of severe volatility in the clean technology and energy arena (clean tech). This technological evolution is natural and expected, as we have opined frequently over the past few years, with the current clean tech environment a reflection of ‘Clean Tech 2.0.’  The surviving companies and technologies are stronger now than five years ago and the outlook for continued growth is more sustainable. While many of the clean tech indicies such as the Wilderhill Clean Energy Index are still reflecting negative returns for the past five years (even after very strong returns in 2013), GEOS has been able to achieve an annualized return of nearly 15% over this time period due to our unwavering focus on executing the ‘nexus of environment and finance.’  We have ensured GEOS holdings reflect companies offering compelling and economically viable clean technologies along with sound financial metrics.

At this five year mark, we find it appropriate to make ‘5 points at 5 years’, in response to common questions and frequent misperceptions regarding clean technology equity investing:

1. Clean tech is not solely dependent on government funding and support:

Over the past twelve months, there has been a sea change in the availability of renewable project financing with the emergence of funding vehicles such as renewable power synthetic master limited partnerships (MLPs), real estate investment trust (REITs), and ‘YieldCos’. All of these entities provide debt and equity financing in some form for solar, wind and energy efficiency infrastructure projects.  A number of other solar companies and traditional utilities are currently either planning or actively considering public offerings of YieldCos.  The largest rooftop solar installer in the US has even been able to complete the industry’s first securitization of rooftop solar assets, with demand so great that the yield was pushed below 5%.  The massive increase in the depth and liquidity of the capital pool dedicated to renewable energy projects has dramatically lowered the financing costs of these projects. This lower cost of capital coupled with the continued decline in installed costs from technological advances has increased the amount of energy produced per panel (or wind turbine) while decreasing the manufacturing costs for each panel (or turbine). This dynamic has led to a surge in renewable energy project development in North America. For example, over the past 18 months, more solar was installed in the U.S. than in the past 30 years (Solar Energy Industries Association, GTM Research – 2014).  A key element of the GEOS investment process is the identification of the tipping point when a clean technology makes economic sense and is on the cusp of mass adoption. The landscape for renewable energy projects, solar in particular, has shifted; capitalism is now dictating the growth of the renewable energy segment.  It is how it should be and is a fantastic and game changing development.

2. Clean tech volatility is demonstrative of natural industry progression:

The clean tech cycle since 2002 is not unlike other technology cycles, whether the dot-com boom or the telecommunications revolution.  In the early days of clean tech growth from the low in 2002 to the high in 2007, the Wilderhill Clean Energy Index rose nearly +277%, driven by rapid non-OECD economic growth and related commodity price pressures which stoked fears of prohibitively expensive global energy. Concerned governments, led by the EU, adopted generous incentive schemes to encourage development of alternative energy sources which led to a surge of capital investments in wind, solar energy, and smart grid technologies.  As with every boom, irrational exuberance led to unrealistic assumptions of clean tech adoption rates and related profitability.  Capital was cheap and poorly allocated, leading to huge excess capacity in the aftermath. Over the past five years, clean tech stimulus has been reined-in, as government austerity plans have led to clean tech subsidy cutbacks, punishing companies that have uneconomic business models or clean technologies having little commercial viability.  As the clean tech correction advanced, we have witnessed industry consolidation, and a landscape littered with companies that were rushed to the public IPO markets pre-maturely.

There are many parallels between the performance of clean tech shares these past few years, with that of the internet companies of the mid-1990s. Post the dot-com bust, the internet industry has thrived, with the consideration of risk and prudent capital deployment leading to more sustainable and profitable industry growth. As Amazon and eBay emerged from dot-com 1.0, those investors with the vision to commit capital following the dot-com crash have experienced Google, Facebook and continued strength in stalwarts such as Amazon. The unique and highly profitable business models and fruitful innovations have led to well-financed companies and returns for investors. Clean tech is at this transition point currently, and we believe clean tech 2.0 is unfolding. In many instances, we have reached the tipping point where the economics have caught up with previously lofty expectations.

3. Companies are aggressively adopting clean technologies:

Companies are adopting clean technologies because they make economic sense.  When GEOS was launched five years ago, solar module prices were around $3.50 per watt while today modules are below $0.60 per watt.  In many locations and in many applications, solar energy makes economic sense and adds to business flexibility given its distributed nature – the energy is owned, and the costs are fixed with very few input costs for at least 20 years. Solar power allows energy migration from base load to distributed form, where it becomes a flexible asset, lessening exposure to oil prices and the vagaries of utility power pricing. As energy is a significant variable cost for manufacturing and services industries, owning distributed energy sources such as solar power provides competitive advantage. Many multi-national companies are aggressively scaling solar power, led by retailers such as Kohl’s, Whole Foods, Wal-Mart and Staples, with their retail locations and distribution centers providing ample roof-top real estate for solar panel installation and use (source: EPA National Top 100, April 2014).

A major GEOS clean tech and efficiency industry focus is LED lighting, which offers 75% energy cost savings versus traditional incandescent bulbs along with much longer bulb life (and therefore lower labor costs given the need for fewer bulb changes).  LED light bulbs and systems are being widely adopted in general lighting applications following technology advances and cost decreases that enable more competitive pricing versus current lighting installations. LED lighting technologies are being rapidly adopted in high-end retail and services, given the precision and high quality of LED technology. Additionally, the solid-state nature of LED technology allows lighting automation and usage flexibility, an attractive attribute for commercial and industrial applications such as manufacturing and warehousing. LED lighting is of high and more consistent quality than incumbent lighting, allowing enhanced worker safety, productivity and energy efficiency.

Elsewhere, water usage is becoming an increasingly complex issue for companies given global climate change and associated drought conditions. Companies are increasingly turning to water re-use and efficiency technologies to lower water use and associated energy costs. This is increasingly the case for electric utilities, industrial processing and manufacturing industries, which are turning to water harvesting and re-use technologies such as metering and energy recovery.

Given the current economic backdrop where revenue growth is limited by tepid global GDP growth, CEOs are focused on generating operating leverage to continue to grow earnings.  Energy efficiency initiatives and adoption of related clean technologies provide a major source of cost savings for corporations and allow a faster rate of earnings growth in a slower growth environment.

4. We are still in the early stages of the clean tech multi-year mega-trend:

Our world is experiencing significant forces that are greater than those of the Industrial Revolution and this is happening over a much shorter time period and at a much greater scale than previously seen. This secular shift is being completely driven by the emerging economies whose rapid development is being spurred by demographics, and an associated economic shift to consumption-led, consumer-based economies from export-based economic systems. As the world closes in on nine billion people, we anticipate at least 30% will be middle-class consumers over the next 15 years. Never before has the world economies and capital markets experienced such massive change. As evidenced by the choking air quality in China, the increased severity and frequency of storms, and the diminished supplies of clean water, these economic challenges are compounded by related environmental degradation. Our interactions with companies highlight their ever increasing focus on the need to mitigate significant business risks through the adoption of clean technologies:  trucking companies seek to increase fuel efficiency and hedge exposure to oil by adopting fleets of alternative fuel vehicles, energy companies need to ensure adequate access to supplies of water for incredibly water intensive fracking operations, and technology companies are using solar energy and fuel cells to more affordably and consistently supply the huge energy requirements of server farms.  Further, policy makers, in an effort to safeguard and optimize resources as well as lessen deadly air pollution, increase potable water and clean toxic soil are adopting increasingly stringent environmental sustainability goals. These related secular trends will play-out over the next 20 years, creating enormous opportunity for investors. GEOS is designed to capitalize on these opportunities, leveraging the technologies that will enable the transition to the clean energy economy, while steering clear of industries that will be hindered as these trends un-fold.

5. Investor interest is rapidly increasing:

We are experiencing a significant increase in GEOS inquiries, as financial advisors respond to investor questions regarding fossil fuel divestment (FFD) solutions, and methods of values-based investing. Media news flow is on the rise regarding environmental sustainability, climate change action and clean tech solutions. We are also noting very strong current interest in thematic investing, as investment advisors seek solutions for “next generation” clients, or equity solutions for existing beta exposure. We believe GEOS is highly differentiated, and positioned for these positive demand trends. Over the past quarter, we have fielded inquiries from faith-based investors, foundations and endowments as well as large private banks. We believe GEOS to be a global equity solution for any asset owner seeking to leverage very long-term, sustainable secular trends.