Clean And Alternative Energy Stocks - Momentum With A Strong Fundamental Tailwind

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Climate change and environmental pollution have been heavily discussed topics in the economic boom years of the last decade. Governments, primarily in the US and Europe, picked up the societal trend and promoted the substitution of alternative, environmental friendly forms of energy production (e.g. wind, solar) for dirty, polluting forms (e.g. coal, oil). Backed by enormous subsidies, a new industry with its own supply chain emerged. Overoptimism soon led to bubbles in publicly traded instruments that provided exposure to the industry and overinvestment in physical capacities. The excesses, visible in the form of overcapacities, slumping prices and unprofitability were revealed by the financial crisis in 2008/09 and have resulted in strong growth of defaults and consolidation within the sector on a global scope that is still on-going. Less surprisingly, investors have quickly dumped shares of companies involved in the industry as expectations soured.

Indeed, the abysmal performance of two diversified, popular investible indices on the theme since the financial crisis immediately reveals investors' pessimism. The respective indices are the S&P Global Clean Energy Index and the WilderHill New Energy Global Innovation Index. Both indices have performed miserably both on an absolute and relative basis over the last years (excluding the last year), have seen extreme drawdowns of around 80 to 90% from their peaks and show low valuation multiples. Additionally, profitability of most companies in the sector has sharply declined from the levels seen before the crisis, with most companies hardly making profits at all now. As in every maturing industry, consolidation has increased competition tremendously.

Such an environment of disappointing performance, low profitability and high uncertainty always leads investors to extrapolate and price in chaos. But contrary to what the majority of investors believe, the extreme performance of the indices mentioned above suggests that the probability is high that the worst may already be priced in. Hence, the alternative energy sector may actually be a contrarian situation that warrants a closer look.

A deeper analysis of the indices covering the sector reveals that the S&P is heavily tilted towards utilities in Japan, the US and China, i.e. the production and distribution of clean energy. In stark contrast, the WilderHill index is focused on technology and industrial companies in the alternative energy sector around the globe, i.e. the companies that produce the infrastructure for the production of various forms of alternative energy. A broad diversification across different segments within the industry ensures that no active bet on a specific technology is made, which is essential in an industry that is heavily influenced by politics.

Another essential difference is the number and weighting of index components. The largest company in the WilderHill index accounts for just 2,5% and comprises more than 90 companies, while the S&P index is heavily concentrated as companies have weights of up to around 10%. As the WilderHill index targets equal-weighting of its constituents, small and mid-caps account for the largest share in the index. Due to the high number of index companies and the resulting diversification, financial instability and defaults of single companies in the index should be no issue for total index performance. Moreover, the high share of small and mid-caps allows profiting from consolidation pressure within the sector as these types of companies are most likely to be taken over by the largest companies in the supply chain.

It should be safe to conclude that the S&P index is more correlated to the total demand for energy and the energy policy in the countries the index components operate in than to trends within the alternative/clean energy sector and poses high company specific risks. The WilderHill index on the other hand is a more direct play on the global trend towards alternative energy on an earlier stage in the supply chain. Buying the suppliers of the infrastructure clearly is more a global than a local bet, which, additionally, provides implicit leverage due to the larger size of the market. Indeed, whereas local politics may heavily impact the fortunes of producers of alternative energy, they have little impact on the leading producers of the infrastructure that sell their products globally.

The country allocation clearly shows that exchange rate movements are a minor risk when investing in the WilderHill index. The majority of the currency exposure is in USD, smaller parts in EUR and CNY, and a minor exposure is to different other developed and emerging market currencies. The USD/EUR exchange is highly unpredictable and seems to follow a random walk within a certain range. The CNY is strictly managed against the USD and on a slow appreciation trend. Consequently, at least a sideward trend can be expected, but more likely, further appreciation of the CNY following the trend. The remaining currencies are too numerous to make predictions, but their small share in the total currency exposure should ensure that returns in USD or EUR won't be impacted significantly.

As explained in the introduction, the alternative energy theme has been going through a boom and bust cycle from the years before the financial crisis up to now. Typically, after the inevitable bust, previous bubble themes are shun by investors for numerous years as they have to recover from their losses, a period in which the respective themes trend sideward with high intermediate volatility until they slowly start to recover. The exact same pattern is visible in the WilderHill New Energy Global Innovation Index. Since its low in the end of 2008/beginning of 2009, it has trended sideward with high intermediate volatility. But it seems that the eventual recovery has started now. With a performance of more than 50% since its low in November 2012 the index shows strong momentum on an absolute as well on relative base, being a global top performer. From the trend-following perspective, a substantial positive deviation from its 12 month SMavg is another favourable signal.

But support comes not only from the quantitative side but also from qualitative trends. The strengthening of the US economy over the last quarters and societal pressure in favour of clean energy as a result of the nuclear disaster in Japan combined with important (upcoming) elections have recently renewed pressure on politicians to act.

The European Union now targets a share of 20% renewable energy sources in total energy consumption by 2020, with different European countries setting even more aggressive targets, especially Germany. In the US, the Obama administration is now also heavily promoting renewables. The share of solar and wind energy in total US electricity consumption has already doubled over the last 4 years and another doubling is targeted by 2020 according to an Obama speech in June. Further stimulus comes from similar strategic targets in numerous Asian economies, especially China, India, Japan and Australia, with the first already being the largest wind power market in the world. But it's not only these few economies that promote renewable energies. Indeed, by early 2013 tax incentives were used in some 66 countries and renewable portfolio standards or quotas for a specific required minimum share of renewable energy now exist in 76 countries, states, or provinces. According to the International Energy Agency, this strong tailwind will cause power generation from hydro, wind, solar and other renewable sources worldwide to exceed that from gas and be twice that from nuclear by 2016. The strong growth in global renewable energy production should also benefit the companies in the WilderHill New Energy Global Innovation Index due to their position early in the supply chain.

Obviously, the outlook for the sector is strongly positive based on these projections. Nevertheless, it's crucial to understand the underlying assumptions behind the projections to identify existing tail risks. The most important driver behind the growth of the production of renewable energy clearly is governments' eagerness and financial ability to implement policies. Besides strict quotas and regulations, subsidies are crucial for these trends to actually realize. But politicians' willingness to implement these policy frameworks in turn is a function of society's acceptance and support for them. Clean energy clearly is a non-essential luxury good that could easily substituted by cheaper, dirty energy. As long as voters are willing to pay for these luxuries in the form of subsidies, politicians will be willing to act. But history has shown that long-term plans are regularly interrupted by unforeseen shock events. The most important event that would force the abandonment of plans towards clean energy is a global economic shock severe enough that it puts massive pressure on the budgets of the leading economies. A combination of extreme unemployment and constrained public spending capacities would undoubtedly tempt politicians to direct funds at short-term spending rather than long-term investments, repealing policies directed towards clean energy production.

What is more, besides subsidies, prices of fossil energy are a key determinant of prices of renewable energy as both are perfectly substitutes for each other. Rising prices of fossil energy increases the profitability of renewable energy utilities and vice versa, thus a strongly positive correlation with oil, gas and coal prices exists. The price of fossils in turn is determined primarily by global demand as supply is less elastic, at least in the short-term. Demand for fossil fuels in turn is highly dependent on economic growth. A severe global economic shock would consequently cause profitability of renewable energy producers to plummet and hurt companies earlier in the supply chain.

Hence, it seems obvious that the single most important tail risk is a shock in global growth. The WilderHill New Energy Global Innovation Index is therefore strongly positively exposed to global growth and energy price inflation. Consequently, any local and global development that causes an economic shock will channel through to the companies in the index. During normal scenarios, the primary risk clearly is politicians' eagerness to push towards clean energy production.

To sum up, the quantitative signals are supported by substantial longer-term fundamental trends that justify an extended continuation of the price momentum of the WilderHill New Energy Global Innovation Index seen recently. Indeed, it looks as if the boom and bust cycle that the sector has seen is coming to an end, entering a new bull period now. The preferred vehicle to invest in the index is the PowerShares Global Clean Energy Portfolio ETF (PBD). As intermediate setbacks are highly likely after a performance of around 50% seen over the last year, a lump sum investment is not appropriate here. Rather scaling into the position over a few months and after major setbacks from previous highs, i.e. intermediate drawdowns of approximately 10% or more, is the most promising entry strategy here to profit from the long-term bull trend.

The bull market will be supported by increasing media attention as soon as the public recognizes the substantial outperformance of the clean energy sector we have seen recently. Despite the strong returns recently, media coverage of the industry is still weak and it's not yet a 'hot investment theme' or recommended by investment banks' strategists, which makes me quite optimistic that there is still tremendous upside potential. Housing stocks and dividend stocks are the most recent examples here. After a strong year of outperformance that has been recognized only afterwards by mainstream media, these themes suddenly became hyped and have continued to show strong momentum as they became 'hot themes'. Similarly, backed by great long-term fundamentals, stories about the renaissance of the clean energy theme will soon be spun again and fuel the momentum we have already seen. Hence, I strongly believe that we are now just at the early stage of an extended bull market.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in PBD over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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