- The move toward green energy is here to stay, and renewables will see steady growth for years to come.
- Unfortunately, many renewable companies are highly speculative or too richly valued for many investors.
- We present our strategy for investing in the renewables market and highlight some of our favorite companies in the space.
- Looking for a portfolio of ideas like this one? Members of High Yield Investor get exclusive access to our model portfolio. Learn More »
Regardless of one’s political views on climate change, most of us can agree that governments and populations around the developed world are making an effort to go green as fast as they can.
You can try and deny the ESG trend, but the fact of the matter is that renewable energy continues to play a larger role in energy production. We can see this with the steady growth of renewable power capacity expansion:
But while we're believers in green energy over the long term, the renewable sector certainly has its fair share of hype and speculation. There will be huge winners, but the majority of companies will likely fall by the wayside.
So the question becomes: How can we get exposure to the upside of the industry, without taking on excess risk?
My own strategy is to look for “midstream” opportunities in the renewable energy market.
If you’re unfamiliar with the term, midstream, upstream, and downstream are categories I’ve borrowed from the oil & gas market.
Here’s a quick rundown:
Upstream companies engage in the exploration of new assets.
Downstream companies process, refine, and then distribute the commodity.
Midstream companies transport and store the commodity.
The reason I prefer the midstream business model is because it's the most stable in terms of cash flow, as midstream companies often have contracts extending years out into the foreseeable future.
When it comes to renewable energy, I like to think of midstream companies as the middlemen (and women) of the sector.
Midstream renewable companies are those that own stable, productive renewable energy assets, like:
Geothermal energy plants
Solar panel arrays
The biggest benefit of these companies is that they have long-term contracts with customers who have a constant need for energy, such as large corporations, utility companies, universities, governments, etc.
Below I’ll highlight some of the more specific advantages of midstream renewable energy companies, and then explore some of the best players in the space.
The Driving Forces Behind Midstream Renewables
Currently, the wind is behind midstream renewables’ sails. Specifically, we see four major tailwinds that will continue to push the market higher for years to come:
Growing Popularity of ESG: The US president is openly pro-renewables and wants to "achieve a carbon pollution-free power sector by 2035." Provisions in the new US infrastructure bill specifically call for funding and supporting clean energy.
Improved Battery Technology: As storage and capacity of batteries improves, midstream renewables are able to supply energy even when the wind isn’t blowing or the sun isn’t shining.
Carbon Neutral Targets: As governments, corporations, and utility companies continue to aggressively decarbonize, they will simply have to utilize more midstream renewables in the coming decades.
Innovation Lowering Costs: Midstream energy companies are developing greater economies of scale, leading to lower installation and production costs.
In this piece, we’d specifically like to dive a bit deeper into the falling costs for midstream renewables. Wind and solar are slowly becoming cheaper than other traditional energy sources, such as natural gas:
Source: Ramez Naam
Solar costs have already fallen faster than anyone could have predicted. We expect this trend to continue, as innovation and implementation in solar space are still just getting started.
This trend goes hand in hand with improved battery storage, as storage costs are also on the decline. Storage capacity continues to grow exponentially and meanwhile, installation costs of these battery systems were cut in half over a period of just two years.
We think it’s likely that battery storage costs halve once again from here, as further economies of scale are implemented.
Renewables produced just 11% of global energy consumption in 2019, meaning there is a huge runway for further growth from here. Investors like Jeremy Grantham think electric generation capacity will double again from here as we “electrify everything that can be electrified.”
Meanwhile, governments and large corporations are almost unanimously backing this green energy revolution. To reduce emissions by 80%, governments and private businesses will almost certainly need to make large investments into the midstream renewable space. There's simply no other way to replace that large amount of energy in so short a period of time. As governments and utilities rotate capital into the midstream renewable space, we expect valuations to continue to run higher over the coming years.
A Small Problem with the Midstream Space
Now that we’re clear on the opportunity in the midstream renewables space, how should investors capitalize on it? This is where we run into a small problem. The most obvious plays in the sector are unfortunately the most richly valued.
For example, the market leader in the space is Brookfield Renewable Partners (BEP). BEP has been active in midstream renewables for over two decades and has a large portfolio of diversified assets on several continents around the world.
Even though BEP has a great growth runway ahead of it, there’s a problem: Valuation. Its share price more than doubled over the past year and there's too much excitement baked into the share price, even after the recent decline:
Its valuation is no longer as extreme as back in January 2021, but it still isn't compelling enough to consider a position at High Yield Investor. The stock used to yield upwards of 5% but now yields closer to 3.4%.
How to Invest in Renewables
The way to play the midstream renewable space is to dig deeper and look for great companies that are smaller and receive less attention.
For example, a company like NextEra Energy Partners (NYSE:NEP) is certainly not cheap but is still a better value than something like BEP. It's managed by NextEra Energy, Inc. (NYSE:NEE), a fast-growing Florida utility company. NEP has been a great dividend grower, with annual dividend increases in the mid-teens since 2014. Management expects to continue to grow the dividend at this pace until 2024.
Another good example that used to be discounted is Clearway Energy, Inc. (NYSE:CWEN) (NYSE:CWEN.A). When the stock briefly cut its dividend due to the bankruptcy of a partner, it sold off heavily and that was a great time to build a position. Since then, it has nicely recovered and it now trades at new all-time highs.
What's today's value pick in the renewable sector?
Today, Algonquin Power & Utilities (AQN) is one of our favorite picks to gain exposure to the renewable sector at a discounted price. It has declined ~20% since February and now offers an attractive entry point.
AQN holds a 44% equity stake in Atlantica Sustainable Infrastructure (AY), a major green energy business that represents about one-fourth of its total enterprise value. The remaining three-fourths are mostly a regulated utility business and other renewable assets.
It has a solid investment-grade rated balance sheet, a solid track record, and a rapidly growing green energy business. Even then, it's priced at a 5% dividend yield, which it has grown for 11 straight years at ~10% per year. We currently own a large position at High Yield Investor.
The green energy trend is here to stay, but the sector will have its winners and losers. Our favorite way to play this market is with midstream renewable energy companies.
Unfortunately, the biggest blue-chip players in the space, like BEP, are currently too richly valued for the conservative investor.
Instead, we prefer double-digit dividend growers like AQN that offer both income and growth as the renewables market continues to grow.
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This article was written by
Samuel Smith is Vice President of Leonberg Capital, he has a diverse background that includes being lead analyst at several highly regarded dividend stock research firms. He is a Professional Engineer and Project Management Professional and holds a B.S. in Civil Engineering & Mathematics from the United States Military Academy at West Point and has a Masters in Engineering.Samuel runs High Yield Investor investing group. Samuel teams up with Jussi Askola and Paul R. Drake where they focus on finding the right balance between safety, growth, yield, and value. High Yield Investor offers real-money core, retirement, and international portfolios. The services also features regular trade alert, educational content, and an active chat room of like minded investors. Learn more.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of AQN either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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