Energy transition – Opportunity knocks

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Investors might wonder when to enter investment strategies related to energy transition given the stellar performance of the segment. We believe the outlook for this segment is incredibly constructive over the medium to longer term, but there will be bumps and sell-offs on the way.

Currently, the segment is going through just such a patch, as does any theme. This will create new entry opportunities.

A healthy correction

Finally, we are seeing a healthy shakeout of generalist investors who broadly missed the ‘green rally’ of 2020. This is illustrated by the 28% plunge by a leading clean energy ETF from the highs in January (see exhibit 1), compared to a 38% peak-to-trough sell-off in last March’s market panic/capitulation.

All this has happened in a context rife with global announcements of green deals and plans. They include the EU Green Deal, China’s net zero emissions target, and Japan and South Korea launching green programmes. Meanwhile, the new US administration is re-joining the Paris Agreement and coming out with hugely supportive policies for environmental solutions.

New enabling technologies are getting scale such as hydrogen and battery storage, pricing in carbon markets has almost doubled from EUR 20 a tonne to EUR 40, electric vehicles are hitting parity with internal combustion engines and demand for environmental solutions equipment and services has never been stronger.

That said, we also believe that we will see greater differentiation between structural winners in the environmental solutions market where fundamental research, technical due diligence on the technologies and a solid understanding of total addressable markets will be key inputs to selecting ‘tomorrow’s winners today’.

Avoiding the interest-rate sensitive infrastructure segment can play well. The same goes for commoditised environmental solutions companies operating in industries with low barriers to entry. We believe such selectivity will be key to any environmentally themed portfolio.

Also, diversification have never been more important. An all-cap approach should provide a cushion. Large companies in this universe have become crowded trades with high valuations.

So why has the sell-off happened?

A leading clean energy ETF has announced a technical reweighting effective 2 ^April that has created substantial re-weighting flow in a handful of stocks across Europe and US. We believe a lot of pre-positioning ahead of the actual change has already been happening, resulting in downward pressure on single stocks. This has sparked a broader sell-off from passive and retail investors.

At the same time, we have seen a rapid rise in nominal interest rates alongside an increase in inflation expectations as a result of price rises for oil and other commodities. We think this move could have further to go.

The US oil benchmark West Texas Intermediate should rise to USD 100/barrel in the next 18-24 months after seven years of underinvestment in the oil & gas sector, a more coordinated OPEC approach to supplies and carbon prices having forced the sanctioning of new projects so as to have high breakevens.

What do we go from here?

We think an economic recovery is well under way with successful global vaccination programmes that should see activity kick-start again. The US Fed and other global central banks have done everything in their power to support the economy with unprecedented monetary stimulus. Together with fiscal initiatives, we firmly believe they will not risk seeing the recovery being derailed by nominal rates rising too much further.

The latest earnings reports by companies in the energy transition investment universe have beaten analyst expectations apart from infrastructure and development companies that we have been avoiding because of their interest-rate sensitivity.

We have been tilting more towards ‘value’ and ‘cyclicals’ since June 2020. As a result, our approach did well relative to the market and peers so far in 2021.

An opportunity knocking

For the medium to long-term investor, the next couple of weeks should be a great time to take advantage of what we believe to be transitory market moves and of the outsized underperformance in the energy solutions investment universe relative to the market.

We have long argued that while the market might look calm on the surface in 2021, we expect there to be violent rotation because of the macroeconomic factors mentioned above and the effects of economies reopening. That will ultimately see risk assets do well in 2021, driven less by the multiple expansion seen in 2020 and more so by strong earnings growth.

What about valuations? The broad universe of companies involved in the energy transition has a price/earnings ratio adjusted for growth (PEG) of just 0.81x with an earnings compound annual growth rate of more than 43% over the next three years. This compares favourably to the broad NASDAQ index, for example, which trades at a PEG of 1.5x.

What is the risk?

We see the main risk to our view and timing as additional downwards pressure from passive flows coming from the reweighting of the clean energy ETF. While this could be the case, we also know that many position adjustments have already happened in anticipation of the re-weighting.

We could see a sharp reversal higher ahead the re-weighting event on 2 April given the extent of the recent underperformance relative to the market.

In addition, if interest rates do march higher towards 2% this could not only hurt and put pressure on equity markets more broadly, but also on the environmental solutions universe. We believe this is relatively unlikely given central banks’ commitment to lower rates for longer.

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