A Fund Cleans Up by Betting on Clean Energy – Barron’s
For the four years of the Trump presidency, the White House was hostile to the concept of global warming, although independent efforts to reduce emissions continued to be made by an array of U.S. players, from states and municipalities to universities and corporations. The government’s attitude toward the issue has changed with the arrival of a new administration.
Through most of it, the GMO Climate Change fund has focused on companies that benefit from mitigating climate warming or adapting to it. Last year, the fund jumped 42.7%, versus 17.9% for the average world small/mid-cap stock fund, and 27.1% for the MSCI ACWI SMID index. The fund (ticker: GCCLX) emerged from GMO co-founder Jeremy Grantham’s thinking about resource scarcity and the realization that climate change was one risk that investors couldn’t diversify away from or wait out. Lucas White, the fund’s co-manager, also helps oversee GMO Resources (GEACX), giving him a front-row view of how the fossil-fuel industry is adapting as the climate issue heats up. Barron’s recently interviewed him. Here are edited excerpts:
Barron’s: World leaders just met on global warming. What does this mean for the sectors you cover?
Lucas White: Political outcomes are notoriously difficult to predict, yet governments are moving toward greater public-policy support for climate-change-related efforts. As you know, Donald Trump was a climate-change denier, was very supportive of coal, killed the Clean Power Plan, pulled out of the Paris agreement. But administrations change. And in the absence of leadership from the Trump administration, cities, states, businesses, and universities around the country banded together and increased commitments to fighting climate change. Now, the Biden administration is very progressive on climate. China is targeting decarbonization by 2060. Europe continues to lead the charge. It’s the first time the three big players in the global economy are acting in concert on climate.
What does the push to decarbonize mean for Corporate America?
It’s hard to argue that going full-bore clean will be money-saving now for the average company. But companies will find more and more attractively priced options as time goes on. Clean-energy solutions are getting cheaper and cheaper every year, in wind and solar, in electric-vehicle batteries.
On the other hand, you focus on companies that will benefit from efforts to address climate change.
Addressing climate change means both attempting to mitigate it and helping the world adapt to it. So, we focus on clean-energy companies in solar, wind, geothermal, biofuels, batteries for electric vehicles, utility-scale energy storage. We look at grid companies, because incorporating a higher percentage of renewables into your mix needs a more sophisticated, interconnected, modern grid.
You might think everybody’s going to buy electric vehicles in the next five to 10 years. The pure-play EV manufacturers are all tremendously expensive, and it has been a relatively easy ballgame so far, but it’s about to get incredibly competitive. Tesla [TSLA] is one of the only games in town, but that will change in the next year or so; every major vehicle maker will come out with their own EV line.
So, we look for other ways to get exposure to EV growth: to lithium-ion battery manufacturers; to semiconductor companies, because semiconductors are used up to six times as much in EVs as in internal-combustion vehicles; to auto suppliers working on EV drivetrains and other components; and to raw materials that go into batteries or the vehicles themselves.
Copper is used three to four times as much in an EV versus an internal-combustion vehicle. Every electric bus uses something like 800 pounds of copper. And then we all know that lithium, nickel, cobalt, manganese are major inputs into lithium-ion batteries. The obvious ways of playing EV growth have been bid up tremendously, but among the less obvious ways, you can find very attractively valued companies.
You still own fossil-fuel company shares. How do you pick them?
Fossil-fuel companies are trading at the cheapest levels we’ve ever seen, going back to the 1920s. Royal Dutch Shell [RDS.A] would have to go up 60% to get back to where it entered 2020. Oil prices are up 20% or 30% since the beginning of 2020. The expected fundamentals for Royal Dutch should have improved by 20% to 30%, yet the valuation has dropped dramatically.
There’s this disconnect due to the fear of displacement of oil by clean energy. Because of that, we’ve actually increased our fossil-fuel exposure a little bit. It took 150 years to build our fossil-fuel-based energy infrastructure. We’re not going to replace it in 10 years. We invest in companies at the low end of the cost curve, where you have less stranded asset risk, because those will be survivors—like some Russian energy companies, such as Lukoil [LUKOY] in the resources fund. [Dallas-based] Kosmos Energy [KOS] has a lot of upside, too. The U.S. majors have been more expensive than their global counterparts for years. We don’t own Exxon Mobil [XOM], Chevron [CVX], or ConocoPhillips [COP].
What are your big gainers?
Our solar positions like SolarEdge Technologies [SEDG] and Enphase Energy [ENPH] entered 2020 dramatically undervalued, and [rose more] with Biden getting elected, the Democrats getting control of Congress, China announcing decarbonization targeting. Add in the fact that these companies grew earnings and cash flows dramatically, and they were up 200% to 250%. Wind positions like Vestas Wind Systems [VWDRY], batteries and storage, did very well, too.
In materials, our copper positions were up about 65%; lithium, about 100%. We trimmed wind throughout 2020 and cut our solar exposure in December. After solar stocks fell in February and March, we increased our exposure again. In the first quarter, we had very strong performance in agriculture, water, building efficiency, such as Owens Corning [OC], and in copper, such as Freeport-McMoRan [FCX].
Biofuels are a big theme for your fund. Don’t they involve lots of emissions-heavy processing?
If you look at the full life-cycle emissions for a lot of biofuels, broadly you find something like an 80% reduction in the carbon footprint, relative to the fossil fuel you’re displacing. There’s biodiesel, which is a blend, and then renewable diesel, which is a molecular substitute. Some of the things just getting started are sustainable jet fuel, which would mean an 80% to 90% reduction in carbon emissions. These industries need to grow, mature.
Finally, we focus on renewable natural gas—the methane leaking out of a landfill, wastewater-treatment facility, or dairy farm. It’s much more harmful for the climate than carbon dioxide. Renewable natural-gas producers capture that methane, process it, and produce a biofuel that leads to massive emissions reduction. The [pollution] credits they get are huge. Ameresco [AMRC] is one of the larger ones, with a $2.5 billion market cap. It’s very reasonably valued, given its growth prospects. It isn’t just a play on renewable natural gas; it also works in solar, energy efficiency. Another is Clean Energy Fuels [CLNE], approximately $2 billion market value, which is more on the distribution side of renewable natural gas, rather than production.
Do you still like the solars?
SolarEdge is a key position in the fund. We began buying it at $13 a share or so; it’s now $275. If you said early in its run, “Oh, it’s up 200%; it’s no longer attractive,” you would have missed hundreds of percent more upside. Canadian Solar [CSIQ], Sunrun [RUN], and SolarEdge had overrun fair value in January, but with the pullback over the past few months, they have significant upside.
SolarEdge makes inverters that convert the DC current produced by solar panels into the AC current used in buildings and grids. The old inverters on 90% of solar installations today are like Christmas tree lights; if one goes out, the entire strand goes out. So, if one panel is broken, then the entire array is compromised. SolarEdge has technology to optimize the electricity produced by solar arrays. They’re also working on EV drivetrains—not competing with the Teslas of the world but looking at small vehicles, such as gas- and diesel-powered golf carts and forklifts.
Canadian Solar is vertically integrated. It produces solar panels and also has a portfolio of solar projects producing clean electricity. Sunrun is a U.S.-focused residential solar installer. Based on a reasonable expectation for growth in installations and Sunrun’s market share, it’s undervalued and has significant upside.
What else do you like?
GrafTech International [EAF] produces ultrahigh-power electrodes for electric-arc-furnace steel makers. Steel-making is incredibly emissions intensive. You’re using coking coal and lots of energy. It’s nasty. GrafTech produces electrodes that reduce carbon emissions by 90%, compared with traditional blast-furnace steel-making. It’s trading at a price/earnings ratio of 7.5. Almost all the growth in the steel industry is expected to be from electric arc furnaces. GrafTech has very strong fundamentals. It’s a deep value play with solid growth prospects. Another pick is Renewable Energy Group [REGI], a biodiesel and renewable diesel company. It can access different feedstocks because of its long-term supply relationships. There’s a lot of upside.
What would you avoid?
The EV manufacturers like Tesla. The aggregate market cap of the automobile manufacturing industry has doubled over the past couple of years, due to EV manufacturers coming out of nowhere. Think about what a weird statement that is. Is there any reason to think that the EV manufacturing industry is twice as attractive now as it was two years ago? We also would steer clear of hydrogen companies, which remind me of solar many years ago.
Write to Leslie p. Norton at firstname.lastname@example.org