Going Green When Oil Steals the Show

Oil and Renewables or Apples and Oranges?

“There are two things going on, because the time frames are perfectly misaligned,” explains Stevenson, lead manager of the fund and Calgary-based vice-president at 1832 Asset Management LP. Referring to the low point when energy companies tanked in the wake of the COVID-19 pandemic, Stevenson notes: “The hydrocarbon energy companies were left for dead. But they’ve come back from the point where they were treated as if their equity had no value because their debt was overwhelming their equity. Commodity prices were so weak and the outlook was poor because we were in lockdown and were massively hit because of the drop in demand for hydrocarbons.”

Contrast the oil doldrums with the anticipation around renewable stocks. Following the January 2021 inauguration of Joe Biden as president of the U.S., “Everybody was excited about the Build Back Better bill. There was a lot of euphoria in that space and as we went through economic lockdowns that space settled out to have a more reasonable view,” says Stevenson. “So energy crashed earlier and came back. Meanwhile, renewables went through a euphoria phase later and then levelled out.”

Renewables Down From Rally

If one takes a five-year view, adds Frank Latshaw, vice-president, and looks at the benchmark S&P Global Clean Energy Index, the contrast is stark. “Over the past five years, the index is up 155%. But the S&P Energy Index is up 15%.” Tellingly, the Clean Energy Index peaked in January 2021 at 965 points, just as Biden was sworn in as president. As of April 11, 2022 the index was 622 points. “If you look only at the last 12 months, that does give a completely different picture.”

Stevenson, who joined 1832 Asset Management in 2010, after spending 14 years in energy investment banking and on the sell-side and earning an MBA from the University of Alberta in 1994, says that Dynamic Energy Evolution focuses on sectors and companies that are part of the transition taking place in the overall energy sector. “Whether it’s renewable energy generators or companies that provide inputs to those generators, the fund considers a whole spectrum of companies involved in that business.”

Covering Renewables is Comprehensive

You can’t call renewables a niche. “It’s a big market. We have renewable power companies, utilities that are wind generators, solar companies, and industrial companies that provide the inputs to make all the components that renewable power companies and utilities are using,” says Stevenson. “If you look at the companies associated with the transition over time from hydro-carbon to renewables, it’s a massive undertaking. It’s global in scope.”

There is a cross-section of industries, adds Latshaw, who joined 1832 Asset Management in 2011 after working as an analyst for seven years with Scotia Asset Management and four years as a chartered accountant at Deloitte and Touche. As a consequence, it’s very difficult to put an exact dollar value to the clean energy sector. “The various sub-industries would include but are not limited to, areas such as residential solar, wind turbines, battery storage, solar panels and inverters, hydrogen fuel cells and electrolyzers, biofuels, wind and solar power generation geothermal and nuclear power, rare earths and materials. You got a whole range of companies there that belong to a variety of industries; whether it’s Honeywell International Inc. (HON) or Innergex Renewable Energy Inc. (INE) or NexGen Energy Ltd. (NXE). Each one of those companies has its own industry and sector that is a key contributor to clean energy.”

“But it may not be the only thing they do,” Latshaw says about the companies involved in clean energy. “In addition, it’s hard to isolate amongst all those industries and sub-sectors, what the top-line revenues or the size of their market share might be. It depends on how you define the space. But it’s a very large, and inter-woven, opportunity, which highlights how extensive this theme is.”

The Evolution of Energy

Importantly, although ESG (environmental, social and governance) is not in line with the fund's investment objectives, the fund does look to invest in companies that are enabling the gradual evolution of the energy sector towards net-zero carbon. But that doesn't mean the clean energy sector faces tougher challenges than the hydrocarbon industry. “This is technology that continues to grow and change,” says Stevenson. “But wind and solar power generation has been here for many years, which is why the costs have come down so that the technology is really attractive to install, either at the residential or utility scale. The growing societal focus on ESG-related issues, specifically concerns about energy security and the environment, give this sector a lot of tailwinds to continue to grow at a very rapid rate.”

The catch with the tailwinds, however, is that people want solutions today and they want them addressed in the very short term, Latshaw notes: “Physical constraints say you can’t do that. You can’t push the system faster than it can go. But they are looking at ways where they can speed up approvals and permitting. At the same time, there is a lot of work in the R & D space, whether it’s clean hydrogen or nuclear fusion. But they won’t happen overnight.”

Need to See Success and Scale

In searching for companies the managers follow the quality-at-a-reasonable-price philosophy used by the 20-plus person Equity Income team at 1832 Asset Management which oversees more than 40 mutual funds. “They have to be high-quality companies,” says Latshaw. “That means a good long-standing history of operations and excellent leadership in their field, good management and solid balance sheets and cash flow generation,” says Latshaw, adding that it’s not enough for potential portfolio candidates to meet ESG principles because they also have to generate high returns on capital. “These companies have to provide energy solutions, such as renewable power and related services. They have business models and technology that is proven. And they have to have scalable platforms.”

About 50% of businesses that make the cut are from the U.S., 24% from Europe and Australia, and 16% from Canada, as of January 31^st, 2022. There is also about 12% in cash. In terms of sector allocation, 34.5% of the fund is held in renewable power, 19.9% industrials, 8.9% materials, 7.9% solar, and 6.4% bio-fuels, with smaller weights in energy storage and wind. The fund has a dividend yield of 2.1%.

One of the top holdings in a fund with 30 names is Constellation Energy Corp. (CEG), which was spun out recently from a U.S. firm called Exelon Corp. (EXC). The firm is a multi-level utility in which half was a regulated transmission and distribution provider and the other half was a power generation company operating mainly in the Northeast. Constellation now owns the latter business.

A Nuclear Power Stock

“What is unique about them is that it’s as close as you can get to a nuclear power company that’s listed in the developed world,” says Latshaw. “Up until then, we couldn’t get something unique like that. Nuclear is something that offers climate change solutions in a number of ways, either through uranium or small modular nuclear construction companies, if they become public. The generation of nuclear power, until this company came along, was very hard to find. Nuclear is definitely what the market needs, and Constellation offers one of the largest fleets in the world.”

Constellation has a market capitalization of US$20 billion, is trading at 7-to-8 times normalized enterprise value (EV) to earnings before interest, taxes, depreciation and amortization (EBITDA). This multiple is based on a two-year outlook.

Solar Goes Micro

Another favourite is Enphase Energy Inc. (ENPH), a U.S. firm that provides solar systems for residential and commercial applications. “The unique thing about Enphase is a strong technology component,” says Stevenson. “They have the micro-inverter that is built into each panel. That makes the whole system much more efficient at generating electricity, versus having all the panels hooked up to one big inverter. They are constantly evolving the micro-inverter and panel technology and user interface technology. You can check your solar system on your phone and see how much power it’s generating and decide how much to send to your storage batteries or send it back to the grid. It’s an exciting solar business with real technology leadership.”

Acquired in October 2020, Enphase has a market cap of US$27 billion and growing at about 50% a year. Looking out several years, the managers see an EV to EBITDA multiple of 15-20 times. “Today, the multiple is not quite triple digits,” says Stevenson, noting that the stock has risen more than six-fold since early 2020. “But it’s up there.”