Green Alpha Advisors’ Market Commentary – Q2 2018

It has been a year since the Trump administration withdrew the United States from the Trans-Pacific Partnership (TPP), a free trade agreement for nations around the ring of fire. This has had its effects on corporate America, such as Harley-Davidson CEO Matt Levatich said “We were very optimistic about what the TPP would enable for Harley-Davidson. It took seven years for it to come to fruition. We could see the writing [of the US withdrawal] on the wall, and we got busy with Plan B.” Plan B was to build a plant in Thailand and close its plant in Missouri. Markets largely shrugged all that off in 2017, but in Q2 2018, things got a lot worse for global trade, and markets noticed.

In Q2, the administration threated to impose tariffs on up to $450 billion of Chinese imports and began imposing some of them, including large tariffs on steel and aluminum that affect America’s closest allies in Europe and Canada.

Of course, these threats and actual trade taxes did not go unanswered. In June, Europe imposed higher taxes on consumer goods made in the U.S., including products from jeans to motorcycles, in response to White House tariffs on European products. Worse yet, the US’s new trade policies seemed to galvanize the world into a stance of unified retaliation. “European and Chinese officials have formed an unlikely team at the World Trade Organization,” is how Business Insider put it, and many nations and companies are now suing the U.S. in courts and at the WTO. Reuters reports that “Trump’s trade policy, labeled ‘medieval’ by former WTO head Pascal Lamy, has inflamed international opinion this year.”

As the Tax Foundation, an independent tax policy nonprofit, recently wrote, “Trade barriers such as tariffs raise prices and reduce available quantities of goods and services for U.S. businesses and consumers, which results in lower income, reduced employment, and lower economic output.” That’s exactly what markets fear.

What have the market effects been so far? Mostly, increased volatility. Days with news of increased trade tensions see markets consolidate; days with more hopeful news, or at least no trade news, have been pretty good.

Another effect has been a flight to US small and mid caps on the theory that smaller firms are not as exposed to global trade, and therefore not as vulnerable in a trade war. US small cap indexes have roughly doubled the returns of large caps during the quarter as a result. Green Alpha views this trading thesis as spurious, as markets will quickly realize that small and midcap firms depend on global commerce and global supply chains as much as large and mega cap firms.

Today, the news is full of stories about smaller firms suffering under newly-imposed tariffs, such as layoffs at a nail-finishing company in Missouri that imports steel from Mexico, but now must pay the 25% tax for their basic material. Harley-Davidson, a solid mid-cap at ~$7.1 billion, is moving some production overseas to avoid retaliatory tariffs from the EU, costing American jobs. Smaller firms may in fact be more vulnerable as they have less capacity to weather periods of higher input costs, likely less access to capital, and higher costs of capital to bridge the gap during periods of lower revenues.

As risky as these developments are, they are small blips in the context of Green Alpha’s investment thesis. Our thesis—that innovations driving productivity gains and tackling economic risks are the best sources of wealth generation—is perennial. As we’ve said before, trade sparring may influence which nation takes the lead and benefits most from technological progress, but it will not shift the trajectory of innovation itself. As a result, we hew closely to our thesis under all market conditions.

Some key developments within the Next Economy:

Infrastructure inflection point:
Traditional infrastructure—like bridges, roads, water mains, and water treatment—desperately need upgrades. Companies that supply and utilize waste-to-value materials, like recycled steel, are meeting critical infrastructure and sustainability needs. Infrastructure construction saw an uptick in Q2 and is forecast to be up overall in 2018 versus 2017.

In less-traditional infrastructure, Q2 saw the increasing development of infrastructure as a service (IaaS) from major tech firms. Data ownership and management are key to today’s global economy. As such, the tech-driven economy also requires infrastructure to support the twenty first century’s most precious commodity: data. Global fiber networks, wireless networks (including 5G), cloud services, and satellite communications (including internet) will continue to be key areas to watch.

Is genomics investment-worthy?
Genomics technology continues to achieve significant medical and scientific breakthroughs. For investors, new opportunities and risks are unfolding in diagnostics, treatment and direct IP resulting from the development of gene-editing techniques. Although potentially transformative for medicine and human as well as biosphere well-being, the industry faces some political headwinds and both questions and backing from sustainable and impact investors. Q2 saw some major advancements that lead Green Alpha to believe in the long-term ability of a selected basket of related stocks to drive long-term performance with periods of significant volatility along the way.

U.S. China solar flare-up:
China’s recently announced changes to national solar policies have rocked the global PV market. With the resulting oversupply of panels, prices may fall 35% or further—more than nixing the impact of U.S. trade tariffs. Stock prices of panel manufacturers are following suit, offering some fantastic buying opportunities for investors.

Adding to the momentum, the US Internal Revenue Service handed down new guidance in Q2 allowing solar developers to claim a 30% investment tax credit on any project they begin by the end of 2019 and complete by 2023. Since the US administration’s section 201 tariff on panels sunsets in February 2022, this means developers can both enjoy their ITC tax credit and avoid nearly all tariffs on imported panels.

Such positive developments for solar have thus far gone under-appreciated in the markets, making them perfect examples of how information asymmetry provides juicy opportunities for the vigilant investor. Long-term, solar’s prospects shine bright.

Battery tech fully charged:
With their ability to power electric vehicles and offer dependable electricity storage, batteries are exponentially growing. Storage can provide a critical service during sudden electricity demand peaks and offers stability in the presence of intermittent renewable energy. Due to improvements in technology and increases in scale of battery production at an increasing number of companies around the world, the price of lithium-ion battery storage has fallen from US$1,000 per kilowatt hour of storage (kWh) in 2010 to US$209 per kWh in 2017, according to Bloomberg New Energy Finance. That price is projected to fall to less than US$100 per kWh by 2025, making both grid storage and EVs much less expensive, potentially catalyzing explosive demand.

In Q2, China made announcements about their commitment to growth in energy storage technologies, which may overtop the rest of the world’s combined production capacity (this may or may not be possible as plans for large-scale battery production continue to grow worldwide).

Gender and diversity investing elevated:
Gender and diversity investing is one of the fast-growing categories of sustainable and impact investing, with public equity assets in these strategies growing from $100 million in 2014 to more than $900 million in 2017.

Investors have been encouraged by diversity-focused research, which demonstrates that diverse management teams outperform homogeneous groups in material ways, from creative problem solving to executing on short- and long-term goals.

While increases in the percentage of women in top management positions and on corporate boards has stalled, female inclusion and influence continues to materially increase across Green Alpha’s Next Economy universe.

While some investment vehicles overtly focus on gender, all portfolio managers should be evaluating the quality of a company’s leadership, including their diversity and social inclusion efforts. Just as analyzing a company’s material sustainability efforts shouldn’t be relegated to a ‘niche market,’ examining the quality of a company’s leadership should be taken seriously. Leadership impacts every company and the likelihood of an investment’s success – no matter the sector, market-cap or domicile.

Next Economy Index

Click here for Q2 Portfolio Review

• Up 2.23% for Q2 2018, our oldest and most comprehensive portfolio’s performance was driven primarily by gains in the Consumer Non-cyclical sector, which contributed 1.41% to portfolio return during the quarter.
• Biotechs were responsible for half of Consumer Non-cyclical’s contribution to the Index at 0.71%. Genetics-based diagnostics and therapies to treat cancer and other diseases were particularly strong in the quarter.
• Consumer Cyclical added 0.58% to portfolio return during the quarter.
• Contributed entirely by electric vehicle manufacturers, as the global growth in EV sales—led by China—continued to outpace growth in sales of traditional internal combustion vehicles.
• The largest negative contribution during the quarter came from Industrials, detracting 0.73% from portfolio performance during the quarter.
• The entire 0.73% negative contribution came from firms providing IP and manufacturing for displays in flat-panel TVs, smart phones, notebook computers, and monitors, among other applications.
• Trade concerns (justified) and speculation (misguided, in our opinion) about the plans of the world’s largest smartphone OEM by market cap combined to bring down flat-panel-related firms’ share prices.
• Negative contributions secondarily came from the Energy sector, detracting 0.24% from portfolio performance, but here, results from individual holdings were particularly mixed.
• Solar installers benefitted from expectations of lower input costs and favorable policy to perform strongly in the quarter, adding 0.33%.
• Advanced materials makers that provide material inputs to wind turbine blade manufacturers also contributed to the quarter’s return at positive 0.17%.
• Some (not all) solar panel manufacturers suffered from tariff concerns and expectations of decreased abilities to maintain average selling prices, the net contribution of their mosaic performance was to detract 0.69%.

Next Economy Social Index

Click here for Q2 Portfolio Review

• The Social Index was our best-performing strategy for Q2, returning 3.97% for the quarter. Gains in the Consumer Non-cyclical sector can be credited with the lion’s share of these returns, adding 2.47% to total return.
• Biotechs and pharmaceuticals were responsible for 1.79% of the 2.47% Consumer Non-cyclicals contributed to portfolio return. Genetics-based diagnostics and therapies to treat cancer and other diseases were particularly strong in the quarter.
• Commercial services added 0.59% to the sector’s returns as our holdings in firms that are disintermediating traditional financial services continued to gain traction.
  Consumer, Cyclical sector added 0.92% to portfolio performance during the quarter.
• Electric vehicle manufacturers were entirely responsible for this contribution, as the growth in EV sales globally—led by China—continued to outpace sales growth of traditional internal combustion vehicles.
• Of the nine sectors held within the Social Index, two exhibited negative performance in Q2. The first was industrials, detracting 0.79% from portfolio return.
• Industrials’ performance was led downward by firms providing IP and manufacturing for displays for flat-panel TVs, smart phones, notebook computers, and monitors, among other applications.
• Trade concerns (justified) and speculation (misguided, in our opinion) about the plans of the world’s largest smartphone OEM by market cap combined to bring down flat-panel related firms’ share prices. Display-related stocks detracted 0.47%.
• The remainder of Industrial’s negative contribution was the result of underperformance in smart meter manufacturing at -0.32%, despite strong growth and the positive outlook for improving infrastructure.
• Technology, which was pushed downward by upstream capital equipment for semiconductor manufacturing (-0.94% at portfolio level), overall took just 0.02% away from the portfolio’s quarterly returns, as losses were offset by gains in software, computers and digital security.

Green Alpha Next Economy Select

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• Green Alpha Next Economy Select was our performance laggard for Q2, returning -1.93%, the only negative returning portfolio among those we manage. The strategy was led lower by Energy and Technology, detracting 1.18% and 1.17%, respectively.
• In energy, renewable energy OEMs (wind and solar makers) deducted 3.57%. This was the main story in the quarter’s performance, as our relatively high weighting on these stocks was damaging in a quarter that was challenging for the industry. Global trade fears and U.S. tariffs on solar panels and modules were the main drivers of the declines, but these events also set the stage for good entry points into these stocks as the long-term macro picture continues to favor growth in renewables.
• Technology stocks’ declines in the portfolio were driven by losses in upstream capital equipment for semiconductor manufacturing. Here again, fears of disruptions in global trade have dimmed expectations for these firms, as they sell to semiconductor fabricators globally, but predominantly in Asia. Semiconductor capital equipment makers’ stocks deducted 0.94% from overall portfolio return.
• The leading sector within the portfolio was Consumer Cyclical, which added 0.70% to the portfolio’s return.
• Electric vehicle (EV) manufacturers provided the majority of the returns in Consumer Cyclicals, with EVs continuing to gain worldwide market share from conventional, gas-burning cars.
• Sustainably-produced, higher-end furniture also contributed to sector performance.
• The second bright spot for the portfolio was Consumer Non-cyclical, which contributed 0.48% to the portfolio’s return.
• Biotechs were responsible for most of Consumer Non-cyclical’s contribution to the portfolio. Genetics-based diagnostics and therapies to treat cancer and other diseases were particularly strong in the quarter, adding 0.43% to portfolio return.
• The stocks of natural and organic food related companies provided the remainder of Consumer Non-cyclical’s contribution, as quarterly earnings results for the companies demonstrated a continuing trend of gaining market share from more traditional foods.

Growth & Income Portfolio

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• The Green Alpha Growth and Income Portfolio was up 2.14% in Q2 2018. These gains largely came from Financials, which added 1.27%.
• Contributions from the financial sector came from data center and connectivity-related REITs, which in aggregate added 1.41%, as growing and anticipated future demand for cloud services, fiber connectivity and wireless data transmission capabilities continued to drive performance.
• Energy was the second highest contributor, adding 0.73% to portfolio return.
• The energy sector added 0.73% to the portfolio’s Q2 return, with renewable energy-based utilities, or YieldCos, responsible for 0.94% of portfolio returns for the quarter. YieldCos sport attractive dividends, with very credit worthy customers buying their electricity. After a negative quarter for the shares in Q1, positive sentiment returned for this business model.
• Sectors detracting from the portfolio’s Q2 return were fortunately few and their negative returns relatively minimal.
• The water utilities industry of the Utilities sector detracted 0.41% as water consumption during Q1 decreased in some regions due to fears of drought.
• Consumer Non-cyclicals reduced returns for GAGIP by 0.07% as the portfolio’s sole biotech was down.

Sierra Club Green Alpha

Click here for Q2 Portfolio Review

• The Sierra Club Green Alpha portfolio returned 0.41% in Q2 2018, aided primarily by the Consumer Cyclical sector, which contributed 0.72% to portfolio return.
• Electric vehicle (EV) manufacturers provided most of the returns in Consumer Cyclicals at 0.59%, with EVs continuing to gain worldwide market share from conventional, gas-burning cars.
• Sustainably-produced, higher-end furniture also contributed 0.13% to sector performance.
• Technology was the second highest contributing sector, adding 0.29% to the portfolio’s return for Q2.
• The digital security and computer maker industries were the main contributors, adding 0.26% and 0.11%, respectively.
• Internet of Things hardware-makers and power control chip-makers were down, together detracting 0.08%, preventing the sector from contributing more to overall performance.
• Negative contributions primarily came from the Energy sector, detracting 0.50% from the portfolio’s return, but here, results from individual holdings were mixed.
  • Solar installers benefitted from expectations of lower input costs and favorable policy to perform strongly in the quarter, contributing 1.45% to portfolio return.
  • Advanced materials makers that provide material inputs to wind turbine blade manufacturers also contributed meaningfully to the quarter’s return, adding 1.08% to the portfolio.
  • These bright spots were not enough to lift the sector into positive territory as the portfolio’s exposure to solar panel manufacturers hurt performance by detracting 2.68%. These companies suffered from tariff concerns and expectations of decreased abilities to maintain average selling prices. Wind turbine manufacturing also detracted from performance by 0.68%, as global trade fears hurt supply lines.
• The sector detracting the second most from the Sierra Club Green Alpha portfolio in Q2 was Industrials, taking 0.45% away from the quarter’s total return.
• The sector’s negative return can be attributed to underperformance in smart meter manufacturing at -0.47%, despite strong growth and the positive outlook for improving infrastructure.
• Smart meters were partially offset by the Building Materials industry, which added 0.46%.