Essex Global Environmental Opportunities Strategy (GEOS) January 2024 Update
For the quarter and the year, GEOS significantly outperformed the secondary benchmark, the Wilderhill Clean Energy Index, as has been consistent with our track record during times of volatility amidst the clean tech sector. GEOS underperformed the primary MSCI World Index for the year, given significant headwinds including:
Rising interest rates: Rising interest rates have impacted the Strategy in two ways. The first impact is from a pure valuation standpoint. The value of a company is equal to its future earnings stream discounted back to today. The present value of those future earnings is worth less in a higher interest rate environment and faster growing companies that will generate a greater proportion of earnings further in the future will lose value to a greater degree than slower growing companies. The second impact of higher interest rates is on infrastructure spend which needs to be financed at higher rates, thereby warranting some projects to be cancelled or delayed as uneconomic. GEOS is impacted by both of these forces since we tend to invest in faster growing companies and a number of our portfolio companies sell goods and services to infrastructure projects (renewable energy projects, grid infrastructure upgrades, new factory construction, etc.).
Inflationary pressures: Inflation rates around the world have increased for three main reasons: COVID-induced supply chain issues which continued, conflict in Ukraine impacting food and energy prices, and the traditional economic impact of loose monetary conditions and heavy fiscal stimulus causing above trend demand pressures. These inflationary pressures caused an upward “kink” in the normal downward-sloping cost curve of emerging technologies. For example, higher lithium and related material prices meaningfully increased the cost of lithium ion batteries therefore diminishing the value proposition of energy storage projects or electric vehicles that have business models predicated on predictable annual technology cost declines.
Political friction: Trade tariff disputes, changes in the regulatory structure of residential solar systems in California (the largest US market), delays in permitting of electrical grid interconnections and confusion/debate around government subsidy programs such as the Inflation Reduction Act have caused confusion in the marketplace and delays in the development of some clean tech projects.
Additionally, following the sharp selloff in clean tech indices and smaller cap growth stocks in general, we see a lot of compelling investment opportunities and brightened prospects for the coming years. We remain focused on companies with differentiated technologies and services led by competent management teams that can effectively allocate capital efficiently. Importantly, we seek to invest in companies that have strong balance sheets that can internally fund their growth and that are profitable or have a clear path to profitability in the near future.
For fourth quarter 2023 transactions, our focus was taking advantage of continued market volatility to purchase several new holdings with differentiated and attractive businesses exhibiting valuations that met purchase criteria. We also added to existing positions if the stock prices had corrected amidst intact fundamentals. A significant percentage of GEOS total portfolio turnover consists of trading around existing portfolio positions, and this was particularly the case in this period of share price volatility.
The differentiation of GEOS rests we believe in the portfolio of environmental solutions, representing technologies and services which are solving global environmental problems. We believe the impacts of these solutions address important global challenges, as defined by entities such as the United Nations with the Sustainable Development Goals (SDGs). The UN has defined 17 SDGs, all addressing social and environmental challenges. The following are several examples of current GEOS holdings, and the impact they are having on global environmental challenges.
Clean water and Sanitation (SDG 6): GEOS water holding Zurn Elkay has a division bringing clean drinking water to institutions, with a focus on school systems. Several states are introducing legislation addressing lead contamination and other pollutants in water supplies, and are initially targeting school systems, given the deleterious effects of lead on children. The Zurn Elkay systems provide clean, hygienic drinking water while eliminating highly polluting, single use plastic bottles. Through the third quarter of 2023, Zurn drinking water systems reduced over 9.4 billion single use plastic water bottles. Zurn water management technologies used by water utilities and commercial customers saved over 16 billion gallons of water for 2023 through the third quarter.
Affordable and Clean Energy (SDG 7): GEOS power merchants & generation holding NextEra Energy owns an electric utility, Florida Power and Light (FPL), and is one of the world’s largest developers of utility scale wind and solar projects. NextEra has developed one of the largest community solar programs in the US, avoiding more than 175 million tons of CO2 emissions over the past 20+ years. NextEra has proven renewable energy can be affordable and clean, as FPL’s residential customer bills are lower than the national average, and among the lowest in Florida. NextEra’s current solar fleet equates to nearly 15 million solar panels with capacity of 4 gigawatts of electricity generation.
Sustainable Cities and Communities (SDG 11): New holding, Swiss semiconductor firm u-blox enhances the Internet of Things (IoT) to enable innovations to make the world more sustainable. u-blox technologies are applied to asset tracking and management, to optimize freight routes which reduce energy consumption. The company enables connected sensors which can protect and monitor the quality of water, air and soil. According to u-blox, 84% of their IoT deployments are currently addressing, or have the potential to address the SDGs. u-blox solutions are used for navigation, the connected factory, connected tools, asset tracking, livestock tracking, home healthcare and the automated car. The firm’s location technology is at the heart of IoT, to integrate and connect in reliable fashion. u-blox has been conducting SDG mapping since 2021, and recently set an ESG strategy for their own operations, from continued solutions tracking, to operational based, including employees and community, and supply chain and environmental responsibility.
Climate Action (SDG 13): Cadeler is in the GEOS renewable energy theme, and is a signatory of the UN Global Compact, and is focused on SDG 13, and 6 other SDG goals which it holds as integral to its business operations. Cadeler is a leading global vessel company providing offshore wind farm construction and maintenance, based in Oslo, Norway. Cadeler owns the industry’s largest fleet of jack-up offshore wind installation vessels and has the capacity to handle the largest and most complex next-generation offshore wind projects. For its operations, Cadeler has pledged to net-zero operations by 2035, with a reduction of Scope 1 and 2 emissions intensity by 50% by 2030. Cadeler will report its Scope 3 emissions later this year. To date, Cadeler has installed 853 wind foundations, equating to almost 12 gigawatts of wind power, providing offshore wind electricity of 12 million EU households.
There were times last year when we heard experienced investors claim that clean tech stocks were dead, because the technologies do not work, and renewables will never scale. We strongly believe these misinformed market participants were reacting purely to stock price movement, sentiment and headlines, not underlying fundamentals. These claims could not be further from the truth. While we do agree some clean tech companies went to the public markets too early, it is a miscalculation to state the broad swath of the arena is not investible. We think this is a symptom of the recent public equity market environment, where trades were made on headlines, or broad speculation, without a significant degree of fundamental analysis. We also observed investor behavior that lacked creativity, or semblance of long-term investment rationale, given the narrowness of trading activity toward long positions.
The vast majority of GEOS holdings have strong balance sheets and profitability. With central banks around the world continuing to tighten, capital is expensive and far more scarce than in recent years. This lends emphasis to companies that can fund growth from existing cash flow and balance sheets, placing a premium on our long-held focus on return on investment, an indication of proper capital allocation. Shoals Technologies Group is an example of a company we believe is well positioned in the solar industry, and more broadly for distributed energy, providing electrical balance of system technology for solar energy, as well as the new fast charging EV market. While Shoals declined last year in line with the broad solar market, the company is growing revenue over 30% per annum, with profitable margins and improved and now consistent free cash flow. With a forward P/E which is in line with the broad market, and strong returns on capital of over 12%, we believe Shoals to be differentiated and left for dead – an opportunity is at hand, speaking to the broad-brush environment we are still amidst. Another current example is Irish efficient building materials company Kingspan Group, which we have owned in GEOS for a decade. Kingspan makes highly efficient insulated panels for data centers and cold storage, as well as energy efficient materials to retrofit commercial building envelopes. Kingspan is a strong steward of capital in our opinion, with returns on invested capital of over 10% for the past decade, consistent net income margins, and strong free cash flow. Kingspan has transacted M&A consistently using their cash flow to acquire for strategic growth, in the form of distribution in North America, and tuck in acquisitions to supplement and enhance current offerings.
As we enter 2024, we continue to execute our GEOS investment philosophy, analyzing, evaluating and potentially holding the companies we believe can solve global environmental problems. At this point in the cycle, there are attractive opportunities, with valuation/growth rates we have not seen in our careers – we think it is an opportunistic period, and look forward to discussing with you this year.
Disclosures:
This commentary is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. The opinions and analyses expressed in this commentary are based on Essex Investment Management LLC’s (“Essex”) research and professional experience and are expressed as of the date of its release. Certain information expressed represents an assessment at a specific point in time and is not intended to be a forecast or guarantee of future results, nor is intended to speak to any future periods. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties.
This does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product, nor does it constitute a recommendation to invest in any particular security. An investment in securities is speculative and involves a high degree of risk and could result in the loss of all or a substantial portion of the amount invested. There can be no assurance that the strategy described herein will meet its objectives generally or avoid losses. Essex makes no warranty or representation, expressed or implied; nor does Essex accept any liability, with respect to the information and data set forth herein, and Essex specifically disclaims any duty to update any of the information and data contained in the commentary. This information and data does not constitute legal, tax, account, investment or other professional advice. Essex being registered by the SEC does not imply a certain level of skill or training.
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