Executive Summary
Despite substantial growth and huge advancements in public policy support, clean energy has had an abysmal stretch in the stock market the last two and a half years. In this paper, we will discuss some of the factors that have led to this discrepancy, how we approach investing in this tricky sector, and why we are so optimistic about the outlook for clean energy going forward.
The drop
Clean energy over the last few years looks suspiciously like one of Jeremy Grantham (Trades, Portfolio)’s bubbles (see Exhibit 1). After outperforming the MSCI All Country World Index (ACWI) by more than 200% over 2020 and the beginning of 2021, the Wilderhill Clean Energy Index lost all that alpha and then some through the end of last month, as it dropped over 70% in absolute terms from its February 2021 peak.
A few factors have played into the poor performance. February 2021 marked the end of a tremendous stretch for clean energy, and valuations in the sector priced in optimal conditions. Optimal conditions, unfortunately, rarely persist, and the combination of inflation and rising interest rates helped to drive the downturn. After more than a decade of declines, solar and wind costs rose due to materials inflation and supply chain issues (see Exhibit 2). The government then raised interest rates to combat inflation, and rising/high interest rates make clean energy projects more expensive to finance and less attractive as future cash flows are discounted at a higher rate. Rising rates also helped drive a revaluation of growth stocks, and clean energy companies got caught up in the broader growth unwind.
Over the past year, the Inflation Reduction Act (IRA) has also impacted clean energy performance but perhaps not in the way one might expect. The IRA is a landmark legislative package of clean energy incentives that will spur investment over the long term. However, over the short term, the IRA has led to project delays as people await finalization of the package’s details by the government. Public policy changes often pull demand forward, but in this case, demand has been pushed into the future.
Softened up by two and a half years of poor performance, clean energy stocks tumbled further in July and August driven by a series of quarterly results that were perceived to be disappointing. Canadian Solar, the world’s largest solar developer, beat Q2 earnings estimates by around 60% after beating Q1 earnings estimates by almost 150%. Q2 net income grew by almost 130% year over year. Revenues grew nearly 40% from Q1 but came in at the low end of guidance. The lower-than-hoped-for revenue numbers were enough to send the stock down over 30% from its early July levels. As of the end of August, Canadian Solar sat at less than five times forward earnings, territory not typically reserved for companies growing 25-30% per year.
Similarly, SolarEdge, a major solar inverter manufacturer, reported Q2 revenue growth of around 40% and earnings-per-share growth of almost 700% year over year... along with an inventory buildup that will take a couple quarters to run through. They maintained their longer-term growth guidance of 20-30%, but two quarters of inventory drag were too much for the market to take. SolarEdge dropped over 40% from its July high and sat at around 16 times forward earnings as of the end of August, a significant discount relative to ACWI at 20x and the S&P 500 at 22x. Not bad for a company growing 20-30% per year...
These types of swings are nothing new. Clean energy has always been a sentiment-driven sector, and the swings tend to be dramatic. This dynamic makes clean energy an uncomfortable place to invest for many, particularly when sentiment turns sour. However, this is not the Tech Bubble or Tech Bubble 2.0. Clean energy companies are growing profits rapidly, and the sector is maturing. At some point, one would expect the sector to withstand a bit of bad news. In the meantime, these situations create opportunities for long-term investors.
Our approach
While it’s been a difficult stretch, our investments in the sector have performed much better than the sector more broadly. In our Climate Change Strategy where we have the most exposure, for example, our clean energy outperformed the Wilderhill Clean Energy Index by around 40% net of fees from the February 2021 peak through the end of last month. Our emphasis on quality and value helped spur this relatively strong performance. We’re not just looking for companies focused on clean energy. We’re looking for companies that have competitive advantages that we expect to drive long-term success and that are attractively priced given reasonable growth expectations. As the sector struggled, higher quality, attractively priced companies held up much better than more speculative, unprofitable names.
Furthermore, we invest in clean energy as part of broader strategies. 1 These broader opportunity sets enable us to move away from clean energy when it’s less attractively priced and toward more attractively valued assets. To us, value is critically important in clean energy as it’s an area where hype and excitement dominate every so often while fear and uncertainty take hold at times. In the last couple months of 2020, solar stocks, which had already risen by more than 100% the first part of the year, rocketed up another 50% (see Exhibit 3). In our Climate Change Strategy, we reacted by selling more than half of our solar exposure. When solar came back down to Earth a bit, we rebalanced back in. This allowed us to avoid the worst of the reversal in solar performance.
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