Dear Green Alpha Clients & Stakeholders,
Welcome to our review of the Next Economy in 2017, and thoughts about 2018 and beyond.
In 2017, markets held up in spite of uncertainties, and Green Alpha strategies performed particularly well (see portfolios’ individual Quarterly Reviews for details), outpacing major benchmarks, and our assets under management grew substantially to $112 million. So, what was relevant about our Next Economy investment thesis in 2017?
For those of us who don’t live and breathe Next Economics, a refresher may be useful. Next Economics rests on the idea that the global economy is becoming ever more efficient and productive as it 1) increasingly incorporates tech-leveraged innovation and 2) moves to minimize the global risks that threaten the economy’s ecological and social underpinnings and, as a result, economic growth. In its ultimate realization, the economy will be efficient enough that it can provide good standards of living for everyone without overtopping any of these tolerances, thereby preventing probable systemic collapse. By generating long-term wealth via risk-mitigating products and services – rather than short-term wealth via risk-exacerbating industries like fossil fuels – it is possible to achieve an economically, environmentally, and socially “sustainable” economy.
In terms of portfolio construction methodology, we take a private equity-like view of public equity investing in that we seek the best growth opportunities representing the most innovative, dynamic, risk-solving, and fast-growing companies, often tech-leveraged, that we can identify. Therefore, our strategies are all cap, cross sector, cross industry, and global. As such, our portfolios don’t lend themselves to comparison with any individual benchmark. Indeed, as a matter of thesis, we believe that most traditional benchmarks reflect the inefficient legacy economy as much as, and probably more than, they do the highly productive Next Economy. Not only do our strategies not correlate especially closely with most traditional benchmarks (apart from definitional equity correlation), we don’t especially want them to; correlating with the legacy economy is not within our mission.
Since our thesis holds that Next Economy innovations will increasingly gain market share from their legacy economy predecessors and counterparts in any given industry, we believe that our strategies should, within the additional context of stock selection, realize this lack of correlation as an ability to earn alpha over the long term versus traditional index benchmarks. Over time, we anticipate broad market index turnover to reflect the growing scale and number of representatives of Next Economics in the global economy, and therefore the differences between the output of our thesis and major market indices will become less. This will be a decades-long process.
Common threads of 2017 among Green Alpha portfolios
What, then, are the primary portfolio drivers of ever-increasing, sustainable productivity? In 2017, tech-leveraged innovation and cheap renewable energies led the charge. The global economy is increasingly characterized by automation, machine learning and AI, robotics, connectivity for all smart objects, and waste-to-value based resource management – all powered by true renewables like wind and solar. Unsurprisingly, the leading companies behind these inventions have been growing. More detail about specific sectors and industries can be found below within each strategy’s review, but let’s begin by looking more closely at renewable energy, the cornerstone of an indefinitely sustainable economic system.
We’re keen to own leaders in renewable energies since overall, renewable generation remained one of the fastest growing global industries in 2017. Solar is poised to install 108 GW of new capacity in 2018 – up from 9 GW in 2007. Don’t expect these trends to slow down. According to Bloomberg, “Electricity demand worldwide grows 58% to 2040 and this is met by a doubling of installed capacity to 13,919GW in 2040 from 6,719GW today, with wind up 349% and solar expanding a whopping 14-fold.” In this light, we have to agree with the energy journal TerraJoule, which recently observed (December 18, 2017 edition) that “while surprising, it’s not complicated: two technologies for capturing energy (wind + solar) were comically uneconomic for 30 years and, now, are dangerously competitive. Moving the world economy steadily towards the power grid is, by definition, a process whereby the next unit of GDP is far likelier to be created on the platform of electricity, rather than oil.”
In the case of renewables in particular, one additional factor supported share prices in 2017: increasing demand for the stocks themselves. This could have been the result of expanding acceptance of renewables as the soon-to-be primary energy source for the global economy, pro-sustainability galvanization in the face of destructive U.S. policy, or, most likely, some combination of the two. Although the world emitted historic levels of CO2 in 2017, renewable power and electric transportation had meaningful impacts, and are now transforming the global system, with both industries consistently and significantly outstripping expectations and forecasts. Wind and solar are now making power so inexpensively and growing deployments so fast, Wired magazine has gone so far as to say, “clean energy… is, in effect, the new Silicon Valley—filled with giddy, breathtaking ingenuity and flat-out good news.” On the tech progress front, a recent headline from Vox proclaims “Solar panels have gotten thinner than a human hair. Soon they’ll be everywhere.” We agree, and we believe that, as a result, there is no clear long-term path for demand growth in fossil fuels. For a detailed round up of the remarkable business advances in renewable energies and electric vehicles, see Michael Liebreich’s “Long-Term Clean Energy Optimism, Short-Term Caution.”
So, after a long time in the doghouse, many of our energy positions finally saw sentiment turn positive in 2017.
Renewable energies weren’t the only sector where Green Alpha portfolios returns were propelled by greater–than-average market demand for Next Economy stocks; we also saw this phenomenon in technology, industrials and some consumer non-cyclicals. This was the result of one key factor: better than expected business results, leading to frequent upside revenue and earnings surprises from companies across our strategies. As the best positioned and most productive denizens of the Next Economy continue to gain market share from their legacy economy predecessors, we expect this trend to generally continue over the long term. As with renewables, we may have also seen a shorter-term increase in portfolio constituents’ share demand resulting from backlash against political efforts to undermine progress towards general and economic sustainability, but this is harder to quantify.
Within each sector, we of course select only representatives of the future economy. In utilities, that means renewables-generated electricity providers and responsible water custodians. For financials, that means firms that provide financing for renewable energy and efficiency projects. In industrials, makers of stainless steel and connected water infrastructure, providers of efficient displays for phones and other devices, and makers of highest quality decking material made from recycled plastics, all of which made meaningful 2017 return contributions. Yes, we do invest in traditional sectors. No, we don’t always or even frequently select the traditional candidates.
Clearly, some things don’t change from year to year; innovative companies and their problem-solving ideas remain integral to our Next Economy thesis. However, the Next Economy’s results can emerge differently across portfolios due to distinct portfolio construction goals, so let’s take a brief look at performance by sectors for each portfolio. While you may invest in one portfolio but not another, you may find comments regarding other strategies provide a broader view of the Next Economy and how this variety plays out in the portfolio construction process.
When reading the portfolio-specific comments below, we recommend opening our Quarterly Portfolio Review documents. You can find links to them at the beginning of each brief portfolio commentary section below. On page three of each portfolio’s document, you’ll find full since inception performance details. In addition, you’ll find a sector attribution chart on page six for all portfolios (except the Next Economy Index, which can be found on page seven) that can provide visuals to aid the descriptions below.
What you won’t find below is an explanation of why a particular sector had a negative contribution to a given portfolio’s return for 2017 as none of the 10 sectors, as defined by the Bloomberg Investment Classification Scheme, had a detracting effect on any of the portfolios.
Next Economy Index
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The Next Economy Index provides the broadest view of the Green Alpha Next Economy universe, because it serves to benchmark the sustainable economy’s evolution, and therefore represents the largest and most diversified spread of Next Economy companies across approximately 95 stocks.
The five sectors that contributed the most to the Next Economy Index’s returns for the year, from greatest to least are: technology, industrials, consumer non-cyclical, communications and renewable energy.
Within the technology sector, the semiconductor industry contributed the most to performance. Leading semiconductor firms all contribute critical pieces of the Next Economy, including powerful processors that enable machine learning and automation, IoT connectivity, and upstream machinery needed to fabricate these and other kinds of integrated circuits. Processing power in particular made great strides in 2017. The CEO of one of our best performing firms noted that his company’s advances in processing power are far outstripping the gains predicted by Moore’s Law, and that the advances in machine learning and processes for automation are therefore poised to realize equally impressive advances. A real world example of the magnitude of these gains in 2017 came from the world of AI vs. humans in the ancient game of Go. DeepMind program AlphaGo had famously defeated world Go champion Lee Sedol four games to one in March of 2016 running on a system requiring 48 AI optimizing processors. By May of 2017, DeepMind was running a vastly superior version of AlphaGo on a system using only four processors. This may seem like it’s just about a game, but it gives us real insight into the rate of change occurring in both machine learning efficiency and in semiconductor advancements. Customers, accordingly, are lining up to take advantage of the power of these systems, and revenues are growing fast for the market leading companies.
Elsewhere in tech, the software subsector drove returns with products like simulation software that enables major efficiency gains in areas like engineering and architecture. In computers, we saw the largest company in the world by market cap demonstrate leadership by transitioning to 100% renewable energy and striving to make all its products using 100% waste-to-value sourced feedstock.
Industrials delivered with products like digitally-connected industrial equipment, efficient lighting systems, and infrastructure. One of the world’s leading power grid and engineering firms – that is working to integrate renewables and to enable demand response via automation – was particularly strong, and two water infrastructure builders showed impressive growth. Consumer non-cyclicals (including non-invasive cancer diagnostics, small business payment services) and communications (including efficient online commerce, world-leading search engine, information-democratization platforms) followed industrials.
Despite real political headwinds (e.g. “In 2017, climate change vanished from a ridiculous number of government websites”) and perceived ones, renewable energies did well overall, and represented the fifth largest sector (out of 10 sectors) contribution to the Next Economy Index’s overall return for the year. In solar, the global leader of thin-film solar PV manufacturing grew its business and gained market share, booking at least 6.7 GW of solar panel sales in 2017 and announcing a production capacity expansion that will bring up to 5.7 GW of additional capacity by the end of 2020. The firm continued to exhibit innovation and industry leadership as well, unveiling new utility-scale solar panels that are three times larger and more efficient at converting photons to electricity than previous generations of panels.
Across technology, renewable energies, and utilities, one theme was consistent: the innovators in the economy continued to gain market share. The world’s leading turbine company, for example, logged record order flow and service contract intake, further cementing the company’s global leadership in onshore wind. This record-breaking sales activity signaled the company’s growth in absolute, organic terms and also gained market share from legacy economy fossil fuels-based electricity generation capacity makers.
Lest we sound like unrepentant techno-optimists, let us make one note: we don’t believe that technology itself is deterministic. We must, as a global economy, and in full awareness of our limitations, strive to put new technologies to their most productive and highest uses. The Next Economy universe is doing just that.
Sierra Club Green Alpha
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The Sierra Club Green Alpha portfolio is unique to all portfolios available in the marketplace, because it applies the Sierra Club’s proprietary investment criteria to our Next Economy universe. Our exclusive right to use these environmental, social and corporate governance criteria provides an interesting lens through which to view what we believe is already a very forward-looking, sustainability-focused universe of investable companies. The practical effect of these criteria is to exclude most large- and mega-cap stocks in the Green Alpha universe and to limit the number of older, more established firms. The portfolio is also more concentrated than the Next Economy Index or Next Economy Select portfolio, holding between 30 and 40 stocks. Taken together, these factors represent the real possibility of more portfolio volatility over a given time period than the Index or select portfolios. In a strong performance year, that means Sierra Club Green Alpha has a good probability of being Green Alpha’s best performing strategy, and this was indeed the case in 2017.
Renewable energy is the heaviest weighted sector in Sierra Club Green Alpha at an average 28% of the model portfolio over the year. Even though the industrials sector (~17% weight) outperformed energy in absolute terms in Sierra Club Green Alpha, energy was the portfolio’s top contributing sector, followed by industrials (including LED-producing machinery, high quality recycled decking material). Technology and the consumer cyclical (including electric vehicles, sustainably sourced and constructed furniture) sectors also provided meaningful contributions.
Growth & Income
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The Growth & Income Portfolio is designed to provide a combination of long-term capital growth and high dividend income payouts via firms from the Next Economy universe that meet the same criteria as our other portfolios. Not all stocks in the Growth & Income portfolio pay a dividend, bust most do, and additional weight may be given to equities with the most meaningful dividend yields, all else being equal.
As equities broadly rose this past year, the Growth & Income holdings with the most growth-leaning characteristics performed the best, and the technology sector (primarily semiconductor equipment) led the portfolio in both absolute return and portfolio contribution terms. Financials (including sustainable infrastructure, energy efficiency, and renewable financing; climate-centered reinsurance; green real estate) were a close second, just under half a percentage point of contribution behind tech. Financials also yielded the second most in terms of dividend yield (with the Energy sector providing the highest dividend yields in the portfolio). The Utilities sector – meaning those selling only renewably-generated electricity and some water utilities – provided the third largest contribution to portfolio returns for 2017. Industrials and energy round out Growth & Income’s top five sectors contributing performance in 2017.
It might be interesting to note, for clients not already invested in the Growth & Income portfolio, that while it’s also a more concentrated portfolio holding 25 to 35 companies, it’s our most stable in terms of performance over time. Its portfolio construction methodology of favoring high dividend-paying stocks means that it holds a larger number of older, more established companies that are less volatile by their very size and nature.
Next Economy Select
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This strategy is available both as a mutual fund and as a managed account to help provide democratized, low-minimum account size access to high quality investing. Because of this, the portfolio’s primary objective is capital appreciation via high-conviction, market-leading Next Economy companies, with moderately less volatility than some our other strategies. The target number of securities for the Next Economy Select portfolio is 45 to 65, with the typical number hovering around 55. In our opinion, that’s a sufficient quantity to meaningfully mitigate risk unique to a given firm (again, this is a point of relative volatility mitigation), but not broadly diversified enough to reduce probabilities of outperformance relative to markets. The Next Economy Select portfolio is managed without respect to market cap, sector, industry or country of domicile, since its primary aim is to invest in the best Next Economy innovators wherever they may reside.
In 2017, energy was the sector with the highest weighting and also was the best performing sector in the portfolio; therefore, it contributed the most to the overall performance. As always, energy in any Green Alpha strategy refers to indefinitely renewable generation sources like sunlight and wind, and battery technologies designed to capture both of these saw large demand growth last year. Industrials (including machines required to manufacture semiconductors, LEDs, and solar panels) and technology (including integrated circuit makers, AI and automation software) were the portfolio’s second and third largest drivers of performance for 2017.
Our 2018 Outlook
What this adds up to is that the Next Economy already exists in a meaningful way. This highly efficient, technology-leveraged, sustainability-first economy is growing across the globe and in every sector. Yet the inefficient legacy economy still has claws and is winning some dramatic victories in its campaign to remain relevant and profitable for as long as possible. As the tension between what was and what’s next plays out, 2018 and 2019 will expose several bright areas of fast technological growth, with unsupportable bubbles (e.g. things with fiat value only like cryptocurrencies) on one side and malaise (legacy commodities, like oil and biofuels, entering their decline phase) on the other. But short term gyrations in specific sectors are impossible to predict, so let’s zoom out to the bigger picture.
From a macroeconomic view, things look good – for now. “The global upswing in economic activity is strengthening,” as the IMF has it, and U.S. wages are expected to increase by 3 percent nearly across the board in 2018. This will be driven by continued high workforce participation, with the U.S. unemployment rate hitting 4.1 percent in November 2017, the lowest since December 2000. The picture appears so rosy, CNBC reports that “Goldman says the economy is doing so well the Fed will need to stop it from overheating next year.”
This time of growth may not have been the best time for Congress to introduce a $1.5 trillion “stimulus” via tax reform, but leaving that aside, the prospect of an overheated economy is actually far from the most damaging outcome of the bill. In fact, much of the tax cut isn’t likely to actually find its way into the economy, which is precisely the problem. If passed, the bill will sow the seeds for long-term economic sabotage in the form of deepening inequality, as money that could have been invested in social safety, healthcare, education and infrastructure is instead sequestered in stocks and offshore bank accounts. Brokerages, asset managers, investment banks and private banks in Switzerland and the Cayman Islands might be the places that see the most stimulus from U.S. tax reform. Could tax reform result, as sold, in a surge of companies hiring, giving raises and spending on real capex? History says no, experts say no, and executives say no.
What else is on the horizon? A Bloomberg headline predicts that “The Global Economy Looks Good for 2018 (Unless Somebody Does Something Dumb).” This rings true; we all know there are a lot of things in this world that could mushroom into civilization-threatening level events: nuclear war, pandemic(s), a tipping-point climate event, and regional issues like the Saudi consolidation of power could metastasize. Yet the economy-threatening phenomenon we appear to be heading inexorably toward in the near term is, again, ever-widening inequality. As society becomes sharply unequal, social cohesion is undermined with all but predictable political upheaval and even violence ensuing.
With such dire potential outcomes, why do we remain oblivious to this insidious trend? It appears that the U.S. is in the midst of cultural decline. We are told down is up, and more than a third of us somehow believe it. The Trump administration’s most awesome accomplishment may be in further convincing his followers that reality doesn’t matter. We see this with climate change, where the official U.S. position has slipped outside of the global mainstream, as the administration tries to keep the twentieth century economy rolling unchanged. This is like trying to keep the tide off the beach, but they are trying hard.
Innovation increases global productivity, while reducing planetary impact
While the U.S.’s cultural erosion and policy avenues proceed to endanger its economic and social stability, the sustainability-driven economy will continue to pick up pace globally.
By looking to the Next Economy, we can find areas that will continue to grow in 2018 and well beyond. Ultimately, the global economy must become efficient enough that each individual’s ecological footprint will keep us well within our planetary tolerances and carrying capacities, while still providing a good standard of living for everyone. Therefore, the Next Economy must be characterized by efficiency gains: more economic outputs from fewer inputs.
The only way there is via the fastest-growing tech and innovation in the markets, powered by renewable energy and supplied by reusable materials. High tech delivers efficiency gains by way of big data – including, at least in some capacity, blockchain tech – and distributed sensor networks; machine learning and AI; robotics; and automation and interconnectivity to coordinate it all.
For some emerging technologies, like blockchain tech, we must proceed with some caution. We can foresee its disruptive potential, but we don’t know what direction it will take, what rivals will surface, or what unforeseen emergent phenomena may occur. For now, the best investments may be far upstream from applications and directly into the leaders developing the backbone of the technology itself.
Overall, this means the indefinitely sustainable Next Economy will stand on the three pillars of renewable energy, tech-driven productivity gains and waste-to-value feedstock working as a nexus. These will be the best places to look for growth in 2018 and beyond. We would go as far as to argue that these are the only avenues for pursuing long-term growth as the risky, destructive, inefficient practices of the twentieth century fall out of favor.
For example, one of the stories to watch in 2018 will be the continuing rise of electric vehicles, which stand to fundamentally transform the global economy via expansion in China, the U.S., India, and numerous European states. It’s remarkable to observe EIA’s reported year-over-year (12/1/16 to 12/1/17) changes in car sales in the U.S.; internal combustion engine, light duty vehicles were -1.7%, while sales electric vehicles were +30%. If these trends continue for long, simple compounding shows America’s vehicle mix is about to radically change, and gasoline and oil demand will slow proportionally. Watch electric vehicles for indications of the fossil fuel-use trend continuing or slowing. Many nations are far ahead of the U.S. on this front, including the world’s largest car market, as they schedule outright bans of internal combustion vehicles. It’s becoming hard to see where long-term demand growth for oil might be.
Technological change is happening fast, and nowhere is that easier to see than in the renewable energy sector. As economist Gregor Macdonald has put it, this rapid change is “not just disruptive to powergrids. [It’s] disruptive to expertise.” How disruptive? Just look at Auke Hoekstra’s analysis of how completely wrong the International Energy Agency continues to be in attempting to predict the growth of renewable energies. Hoekstra has to conclude that there is a possibility “that the IEA has a habit of dramatically underestimating photovoltaic growth,” because “the difference between predictions and reality is too staggering for my taste.”
What about renewable electricity generation and possible changes to U.S. policies? For the careful and long-term stock investor, any resulting decline in renewable energy stocks will provide a fantastic long-term entry point. As the energy mix tips in favor of renewables, the economic and scale dominance of these newer, tech-based energies will be so undeniable that holding shares in the leading firms will be status quo and no longer considered “impact investing.” It will be important to have been in before that time comes. If politics creates headwinds in the markets, we can simultaneously curse negative short-term performance and be thrilled with the long-term opportunity. And here again, let us remember that the U.S. is diverging from the global mainstream in this area, and global opportunities abound; the rest of the world is moving ahead with or without the United States.
The truth is we will never realize a perfectly de-risked economy, but we can and surely should strive to set a positive course. Technologically, we’re making progress; culturally, we’re sliding backward into the darkness of disdain for science and education.
As innovation is valued and encouraged, this coming year will be exciting for sustainability-driven technologies. The constellation of extreme productivity gains, renewable energies, and waste-to-value is where we believe the global economy may realize optimal growth that can endure. Gaining portfolio exposure to these areas of tech- and innovation-led growth means thinking more like a private equity investor and less like an indexer. Since the economy ten years hence will look very different from the economy of ten years ago, it’s time to move beyond legacy investing styles. As for the state of inequality, we’ll have to stay watchful and get creative. Perhaps these same technologies can be a force for mitigating that risk as well.
This past year was a good one for Green Alpha, in both the portfolio returns our clients experienced and in growth of our assets under management, and we couldn’t have done it without you. Thank you to every client, partner and stakeholder for believing in us and allowing us to do what we love every day.
The Green Alpha Team
Important Information and Disclosures
This letter is for informational purposes only and should not be construed as legal, tax, investment or other advice. This letter does not constitute an offer to sell or the solicitation of any offer to buy any security. Any discussion of an individual security is for illustrative purposes only and should not be considered a recommendation to buy or sell any security. The presentation does not purport to contain all of the information that may be required to evaluate Green Alpha Advisors and its investment strategies.
Sector performance information discussed represents past performance. Past performance does not guarantee future results and current performance may be lower or higher than the data quoted. Investment returns and principal will fluctuate with market and economic conditions and investors may have a gain or loss when shares are sold. For specific performance data for each Green Alpha portfolio, please refer to the performance and investment risk disclosures contained in the Quarterly Portfolio Reviews.
Green Alpha Advisors, LLC is a registered investment advisor. Registration as an investment advisor does not imply any certain level of skill or training. Green Alpha is a registered trademark of Green Alpha Advisors, LLC. SIERRA CLUB, the Sierra Club logos and “Explore, enjoy and protect the planet.” are registered trademarks of the Sierra Club. Please refer to www.greenalphaadvisors.com for more information.