End-of-year 2018 was one of the worst that U.S. stock markets have experienced, and traders have no trouble finding reasons for pessimism. Like, maybe the end of democracy, or at a minimum a slowing of its economic benefits, is nigh. Beginning in December, the U.S. government was closed ‘indefinitely,’ or at least the shutdown can was kicked down the road to the next Congress. An economy-shrinking trade war is in effect. The IPCC told us we have 12 years to get our act together on climate disruption, and a U.S. federal climate change report described the dangerous consequences for American farmers if changes aren’t made soon.
It’s enough that you might ask, ‘what’s the point of being worried?’
Stewart Brand wrote, “science is the only news…Human nature doesn’t change much; science does, and the change accrues, altering the world irreversibly.” In that light, this period is likely to be remembered by history less for Trump and more as the time when humanity took control of its own evolution, artificial intelligence (AI) began to usher in a “New World Order,” and as the time when we either lost or regained control of our system-level risks. It is in these last three pieces of our “only news” (as Brand would have it) that we see our present paradox: risks and innovation are peaking together, today, and it’s not clear to which side of the knife’s edge humanity will fall: toward an unimaginably better future of abundance or to an unimaginably worse one of ruin and dystopia.
This double precipice is why we have to invest to manage the risks that matter, why Green Alpha is here, and why many investors trust Green Alpha to invest in the innovations driving progress toward the Next EconomyTM. When market sentiment is at its most negative is when investors can set themselves up for potential future gains.
Welcome to our 2018 review of the Next Economy and thoughts about 2019 and beyond.
In 2018, and particularly in Q4, markets began exhibiting the volatility we predicted would occur within the context of unpredictable political leadership. At the same time, business results, if not share prices, have been improving steadily in many Next Economy areas.
Green Alpha strategies had negative performance returns for the year, but they performed reasonably well relative to major benchmarks, albeit with more inter-strategy dispersion than we have seen in previous years (see below for portfolio-level analysis and the portfolios’ individual Quarterly Reviews for performance details).
So, what did we observe about the ongoing transition to the Next Economy in 2018? (For those who may need a refresher on our thesis of Next EconomicsTM, a quick audio overview can be found here and a more thorough white paper treatment is here.)
RE 100: growing corporate commitments to 100% renewables-based operations.
In 2018, we saw de-politicization of renewable energy as an idea. Corporations and governments around the world have been making formal commitments to deriving 100% of their electricity production from renewable sources, usually meaning wind and solar supported by battery storage. A Yale survey reported that 81% of Americans, including 64% of Republicans, now support renewable energy. We’ve always believed that renewables represent great economic development and wealth creation opportunities, all while countering climate disruption and reducing pollution. Therefore, wind and solar should not be pawns in culture wars, and innovation shouldn’t and ultimately can’t be contained by ideology.
As of this writing, RE 100 (an informal group of global companies committed to running their operations on 100% renewable energies) had 158 of the world’s largest companies as signatories. Many companies are eager to adopt renewable energies for the same reasons we invest in them; they de-risk the global economy relative to fossil fuels, and they are cheap, meaning they increase the productivity of every dollar invested in a company. It’s not surprising that 2018 was a record year for corporate purchasing of renewable energies. As Deloitte said of energy in 2018, “Solar and wind move from mainstream to preferred.”
EVs are booming.
According to the U.S. Department of Energy, “1 million plug-in vehicles have been sold in the United States” as of October 2018, up from zero in 2010. Electric vehicles (EVs) reached a per-month sales crescendo (until the next one) of 45,000 vehicles per month. This is occurring even though overall vehicle sales are down, meaning EVs are increasing their market share. This has significant implications not only for climate change and pollution mitigation but also for industries all along the value chain of EVs—advanced materials, battery storage, microgrids, AI (including autonomy), charging infrastructure, and electricity demand versus liquid BTU demand. All of these areas are likely to see more rapid growth. Audi, Mercedes-Benz, BMW and BMW Mini, Nissan, Porsche, Kia, and Volvo all have announced new all-electric vehicles for 2019, and many more will follow in 2020, including VW. We predict EVs will continue to be responsible for any new growth in the personal vehicle space.
California is leading.
The world’s fifth largest economy is showing us how to accelerate the transition to sustainability. The 2018 highlight was SB 100, a law that set a target of 100% clean energy by 2045, making California the largest political jurisdiction to make such a commitment. The law confirmed new standards that require panels to be installed on any new home or low rise residential building of three stories or less—about 80,000 new homes a year. That could quadruple the amount of solar in California.
The state’s 100% zero-emission bus rule states that all state transit authorities must convert to 100% electric transit vehicles by 2040. By 2029, all government transit bus services have to be zero-emissions vehicles, and California is providing incentives for cities to get there.
In electricity, transit, and electrification of homes (including heating), the importance of California’s efforts shouldn’t be understated. Over and over, we’ve seen that centers of innovation lead to global changes, even in the face of significant resistance. The economic scale of the state alone means businesses around the world hoping to sell into or work in the state must adapt to their policies.
However, the political economy of technology is now visibly ascendant. The days of policy preceding change are ending, and policy is increasingly reacting to tech- and innovation-based change. Thus, for us, investing on the basis of proactive policy will be of limited utility. California’s leadership is outstanding, but it works because the underlying green tech is productive and economically efficient. All that said, intelligent policy will pay for research that is likely to improve green tech over the long-term, but does not have immediate return on investment. Here too, California is “going solo,” and in the lead.
AI is rising.
Green Alpha invests along the value chain that is enabling AI to emerge as a source of innovation (e.g., Google’s quantum computing) and, perhaps more importantly, a way to address problems insoluble by human minds, perhaps ultimately enabling humanity to have good standards of living around the world without further crossing planetary boundaries. Taking the long view, Steven Strogatz put it down clearly: “we will recall with pride the golden era of human insight, this glorious interlude, a few thousand years long, between our uncomprehending past and our incomprehensible future.”
Common threads among Green Alpha portfolios: thesis and management consistency
To have a shot at earning alpha and outperforming markets and peers, an investment manager has to look at the world from a different angle. Most managers conform to benchmark tracking—settling for beta or market-comparable returns—because the consequences of a period of underperformance could be significant. At Green Alpha, your portfolio managers are founders and plurality owners of the firm. We invest every day, we strive to remain fully invested every day, and we strictly adhere to our thesis, even during periods of volatility, with conviction that long-term results will remain competitive.
This frees us to strive for outperformance without the handcuffs of benchmark correlation. Consequently, we define our own portfolio construction methodologies and address the world as it is, rather than faithfully employing Modern Portfolio Theory. The problem with the ubiquity of the present application of Modern Portfolio Theory is that if any given manager sees the world the same way as every other manager, they will likely miss market inefficiencies and have low probabilities of achieving standout performance as a result. Free of Modern Portfolio Theory, we can fully commit to our Next Economy thesis, and the world we see unfolding, without feeling the need to mimic benchmarks that represent the carbon-intensive economy of the past. Seeing things differently has the risk of short-term periods of underperformance, yet it is a necessary precondition of long-term outperformance.
Next Economy investing, like private equity investing, requires patience, and it does mean that Green Alpha will experience periods of both underperformance and outperformance over shorter time periods. In 2018, we saw both, and with more dispersion among our strategies than we have observed in previous years.
Next Economy Index
Green Alpha’s Next Economy Index returned -9.15%, gross of management fees, during 2018.
- Primary detractors during 2018 were the Industrial and Technology Sectors, detracting 3.07% and 2.39%, respectively, during the period.
- In Industrials, Electronics as an industry fared the worst, detracting 1.26% from portfolio performance. In Electronics, the makers of advanced displays, both OLED and LCD, fared the worst, as concerns emerged about global device sales. Makers of smart meters also fared poorly, as some utilities dragged their feet on smart-grid integration, and sales were slower than expected.
- In Technology, Semiconductors were responsible for constructively all of the sector’s losses, detracting 3.26%. Makers of integrated circuits, chips, remote sensors, system-on chip designers and makers, and upstream capital equipment required to produce these items all suffered. The often cited reasons was a “secular slowdown” in chip demand, caused by perceptions of a globally slowing economy, along with mature device markets. These concerns may prove valid in the short-term, but in the long run, the global economy will need far more advanced chipsets, not fewer.
- Utilities was the portfolio’s leading sector, contributing -0.05%. Utilities was followed by the Financial Sector, which contributed -0.08%.
- In Utilities, the Water Utilities industry was up, adding 0.12% to overall performance, but the Electric Utilities industry was down and detracted 0.17%. Water as a theme held up well in 2018, as the importance of the resource became more frequently discussed and the proliferation of water-centered investment vehicles meant there were more dollars chasing the relatively small number of stocks in the space. Our electric utilities exposure didn’t fare as well, primarily due a large, solar energy based utility going private at an unfavorable valuation.
- In the Financial Sector, reinsurance lived up to its reputation for long-term stability and low volatility and added 0.09% to overall returns. The long-term emphasis on solvency and conservative nature of their capital requirements, combined with attractive dividend yields, no doubt gave investors the comfort they desired during a volatile cycle.
Next Economy Social Index
Green Alpha’s Next Economy Social Index returned -9.32%, gross of management fees, during 2018.
- Primary detractors during 2018 were the Technology and Industrial Sectors, detracting 2.92% and 2.89%, respectively, during the period.
- In Technology, Semiconductors were responsible for more than all of the sector’s losses, detracting 4.26%, offset by gains in Software. Makers of integrated circuits, chips, remote sensors, system-on chip designers and makers, and upstream capital equipment required to produce these items all suffered. The often cited reasons was a “secular slowdown” in chip demand, caused by perceptions of a globally slowing economy, along with mature device markets. These concerns may prove valid in the short-term, but in the long run, the global economy will need far more advanced chipsets, not fewer. Partially offsetting these losses in Technology were gains in the Software Industry, which added 2.32% to returns, led by a design and simulation software firm, a vehicle logistics and telematics company, and a 3D printing firm.
- In Industrials, Electronical Components and Equipment fared the worst. The makers of advanced OLED displays detracted 1.63%, as concerns emerged about global device sales. Also damaging returns from Industrials was the Machinery Industry, where a power infrastructure firm detracted 0.45%.
- Energy was the portfolio’s leading sector, contributing 0.61%. Energy was followed by the Basic Materials Sector, which contributed 0.36%.
- In Energy, a solar installer, a solar power inverter manufacturer, and a wind turbine maker combined to add 1.11% to overall performance, but this was partially offset by solar PV makers, which detracted 0.62%.
- In the Basic Materials Sector, a designer of biocatalysts, representing the Chemicals Industry, added 0.72% to overall returns. The only other representative of the Basic Materials Sector in the Social Index was a recycled steel company, which detracted 0.35%.
Sierra Club Green Alpha Portfolio
The Sierra Club Green Alpha strategy returned -11.73%, gross of management fees, during 2018.
- Primary detractors during 2018 were the Industrial and Consumer, Non-cyclical sectors, detracting 3.60% and 1.72%, respectively, during the period.
- In Industrials, Electrical Components & Equipment as an industry fared the worst, detracting 1.60%. Within Electrical Components & Equipment, a maker of advanced OLED displays detracted the most, as concerns emerged about global device sales.
- In Consumer, Non-cyclicals, the Food Industry, specifically natural and organic food as a group, were the main detractors, taking 1.57% from overall performance. Upstream, this was driven partially by slowing sales caused by a rising-tariff environment which damaged international sales, and downstream by increasing competition in the space squeezing margins.
- Financial was the portfolio’s leading sector, contributing -0.54%, followed by the Communications Sector, which contributed -0.87%.
- In Financials, the Investment Companies Industry contributed 0.17% to returns, as a venture debt firm, lending to innovative tech and biotech, returned significant dividends to common stock owners. The REITs industry within Financials detracted 0.71% from overall performance, with a wireless bandwidth leasing REIT being the best performer at 0.07% contribution. Data use and bandwidth requirements continued to grow in 2018, and providers were able to capitalize with advantageous pricing, which the market seemed to recognize. In addition, REITs and bandwidth providers as a group tend to have attractive dividend yields, which can attract volatility-averse investors.
- In the Communications Sector, the Internet Industry fared the best, with digital security making a positive contribution of 0.11%, while search detracted 0.08%.
Growth & Income Portfolio
Green Alpha Growth & Income fared the best of our strategies in 2018, and returned -6.90%, gross of management fees, during the year.
- Primary detractors during 2018 were the Technology and Utilities Sectors, detracting 2.28% and 1.37%, respectively, during the period.
- In Technology, Semiconductors as an industry performed the worst, detracting 1.51% from overall 2018 performance. Makers of integrated circuits, chips, remote sensors, system-on chip designers and makers, and upstream capital equipment required to produce these items all suffered. The often cited reasons was a “secular slowdown” in chip demand, caused by perceptions of a globally slowing economy, along with mature device markets. These concerns may prove valid in the short-term, but in the long run, the global economy will need far more advanced chipsets, not fewer.
- In Utilities, the Electric Utilities industry was down and responsible for most of the sector’s losses at -1.20%, primarily due to a large, solar energy based utility being taken private at an unfavorable valuation.
- Energy was the portfolio’s leading sector, contributing 0.14%, followed by the Consumer, Cyclical Sector, which contributed -0.15%.
- In Energy, a solar utility, a wind utility, and a wind energy equipment maker together contributed the entire 0.14% gain for the industry. The predictable cash flows and dividend-paying nature of utilities was probably part of the reason. The wind turbine manufacturer also had a year of record demand and increasing sales as the world’s energy grid converts to renewable energies, and wind continued to gain market share away from fossil-fuels fired electricity generation.
- In the Consumer, Cyclical Sector, sustainable Office Furnishings as an industry combined for the Sector’s entire -0.15% return. Of the two portfolio names from this industry, one was up and one was down, with the provider of slightly more affordable chairs and desks showing the positive return.
Next Economy Select
Next Economy Select fared the worst of our strategies in 2018, and returned -17.81%, gross of management fees, during the year.
- Primary detractors during 2018 were the Technology and Industrial Sectors, detracting 4.66% and 3.47%, respectively, during the period.
- In Technology, Semiconductors as an industry performed the worst, detracting 4.20% from overall 2018 performance. Makers of integrated circuits, chips, remote sensors, system-on chip designers and makers, and upstream capital equipment required to produce these items all suffered. The often cited reasons was a “secular slowdown” in chip demand, caused by perceptions of a globally slowing economy, along with mature device markets. These concerns may prove valid in the short-term, but in the long run, the global economy will need far more advanced chipsets, not fewer. Software as an industry was up for the sector during 2018, and contributed 0.14%.
- In Industrials, the Electronics and Electrical Components Industries fared the worst. In both cases, the makers of advanced displays, both OLED and LCD, fared the worst, as concerns emerged about global device sales. Makers of smart meters also fared poorly, as some utilities dragged their feet on smart-grid integration, and sales were slower than expected. Together, the Electronics and Electrical Components Industries returned -2.79%.
- Financial was the portfolio’s leading sector, contributing -0.33%, followed by the Communications Sector, which contributed -0.65%.
- In Financial, one firm from the Investment Companies Industry, a venture-debt company providing capital to innovative private companies in technology and medicine—was up, adding 0.12% to total returns. The firm has a high dividend yield, and as such, may have attracted new capital during the year’s volatility. Reinsurance lived up to its reputation for long-term stability and low volatility and added 0.03% to overall returns. The long term-emphasis on solvency and conservative nature of reinsurance’s capital requirements, combined with attractive dividend yields, no doubt gave investors the comfort they desired during a volatile cycle. The Diversified Financial Services Industry was down, as a sustainable finance company detracted 0.38%.
- In the Communications Sector, the Internet Industry fared the best, with digital security making a positive contribution of 0.12%, while search detracted 0.06%. Telecommunications returned -0.71%, as a provider of wireless communications equipment—the industry’s only representative in the strategy—was affected by the downturn in Semiconductors.
Green Alpha’s 2019 Outlook
In the near term, a lot will have to happen for markets to become less volatile. Markets thrive on political and economic stability, free trade, cheap capital, and stimulative fiscal policies, all of which are in question or even at bay as 2019 begins. Fred Smith, CEO of FedEx explained the situation in his firm’s most recent guidance commentary, saying, “issues we’re dealing with today are induced by bad political decisions.” Among these, he listed unilateral tariffs by the U.S., Brexit, and state-owned enterprise initiatives in China, all as “things that have created a macroeconomic slowdown.”
As stock prices have been declining, bond prices have been going up, which is what happens when equity markets begin to lose confidence and traders prefer the perceived security of debt instead. That means lower yields, but it also means cheaper borrowing for mortgages and for corporations looking to invest more in their businesses, so the rotation to bonds is not an unmitigated negative for the economy.
In the U.S., one of the key economic developments of 2018 was tax reform. Policymakers inarguably gave the American economy a short-term boost by lowering taxes. This break was primarily given to corporations, secondarily for wealthy individuals and families, and lastly (and not much) for average people. That boost takes many forms, including capital spending, increased consumption, more market liquidity, more corporate stock buybacks, mergers and acquisitions, and some dividend increases. In the early part of 2018, markets have responded accordingly, rising in Q1 and Q2, even in the face of political uncertainties and trade wars.
What about the long-term effects of tax reform? We see two probable, unfavorable areas of outcome. One, and the more serious, is the effect it will have in increasing the scope and intensity of structural wealth inequality—a dangerous systemic risk. Too much dynastic, unearned, concentrated wealth in the hands of too few does not tend to end well, historically speaking. The second negative outcome will be the effects of a growing national debt: potentially more interest expense, less capacity for expenditure where needed, and downgraded faith in our currency and debt instruments are the usual long-term effects of too much sovereign debt. As long as the U.S. dollar remains the world reserve currency, the debt and deficit risks can be managed fairly easily by money creation and productivity gains. But if global confidence in America diminishes, and as other currencies including sovereigns and cryptos become favored stores of value, the U.S. could face a real debt crisis. Think of Greece, but with an economy 954 times larger (in 2016 GDP terms). This latter risk isn’t likely to manifest in 2019, but the possibility is now visible. Not too long ago, it would have been unthinkable.
A meaningful socioeconomic indicator to keep an eye on in 2019 will be improving inclusivity in business. As our own portfolio results indicate, more diverse teams are associated with better business outcomes. They are more innovative, solve problems better, and have more desirable risk profiles. To look for progress, we can look at metrics like increasing women and minorities in leadership teams and on boards of directors. Diversity economics also encompasses less formal observations such as proportions of women invited to speak at conferences, women and minorities authoring papers and other influential content, and entry-level hiring statistics. As mentioned above, widening inequality is one of the primary risks the economy is facing, and de-fusing this risk is a clear way to both seek returns and lower the overall risk profile of the global economy, while preserving wealth and purchasing power overall.
What is likely in 2019 for the transition to the Next Economy? We expect that prices for wind and solar will continue to fall dramatically and record low cost-of-electricity contracts for power purchasing will continue to be announced. This will put coal and natural gas in a less competitive position, and 2019 won’t be close to the last year of this general trend. Corporations from transportation to utilities will continue to announce, work towards, and reach 100% renewable energy and/or zero emissions goals. These two effects are locked in a virtuous cycle: the more deployment of zero emissions tech, the less expensive it becomes, leading to more demand and still faster growth. Even in the event of slowing global economic growth overall, zero emissions tech will continue to gain market share from dirtier, riskier technologies like fossil fuels and internal combustion.
Economic, cultural, and technological change will continue to accelerate, as will the world’s system-level risks. We developed our Next Economy investment framework because of this confluence—because risks and solutions are peaking together, and it’s happening today. We invest in the Next Economy and de-risk our portfolios from risks like resource degradation and climate disruption. First principles requires us to evaluate the world as it is and act accordingly.
An understanding of the interconnectivity of risks and the powerful innovations that can address these risks has led us to construct portfolios of companies that can develop indefinitely. These companies aim to prevent large-scale risk while gaining market share away from their less efficient, risk-causing predecessors. That’s the essence of Next Economy Portfolio TheoryTM, and it is what we’ve practiced for 10 years now. We’ve always had a consistent process— no style drift—which is backed up by the fact that we have always had low turnover across all of our portfolios. We’ve always been fossil fuels free, because a first principles analysis indicated (and continues to indicate) that a carbon-based economy is unsupportable. By definition, the causes of our largest risks make poor long-term investments. Never having held fossil fuels, we never had to divest.
Up year or down, we always want our portfolios to provide growth at attractive valuations with less debt than most average benchmarks. This requires that we start by investing in companies that are focused on mitigating real-world risks through innovation, and gaining market share from legacy economy counterparts.
This past year—2018—marked our tenth year of investing in the Next Economy. We are grateful to every client, partner, and stakeholder for having confidence that Green Alpha’s Next Economics approach to public equity investing is the best long-term way to preserve and create wealth, while simultaneously driving capital toward a genuinely sustainable economy.
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.
At the time this commentary was written and published, Green Alpha portfolios did not have any positions, long or short, in the following public securities mentioned in this document: Audi (Audi AG), Mercedes-Benz (Daimler AG), BMW (Bayerische Motoren Werke Aktiengesellschaft), Nissan (Nissan Motor Co., Ltd.), Porsche (Porsche Automobil Holding SE), Kia (Kia Motors Corporation), Volvo (AB Volvo), VW (Volkswagen AG), and FedEx (FedEx Corporation).
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.