The energy transition lifted many boats in the years before the outbreak of the global pandemic. But not all companies are able to translate this growth into greater profitability. We speak to T Rowe Price’s Hari Balkrishna about the dangers of profitless growth and look at how impact investing can be applied to global equities.
The energy transition to renewable and sustainable sources of energy is a key development of global economies worldwide and is likely to be an important driver of economic activity in the years to come as it requires large investments into new infrastructure and technology.
But despite the importance of this development, investors can get a little bit too enthusiastic about the prospects of this transition.
Just before the coronavirus pandemic unleashed its full force across the world, listed companies that operated in any sector related to the energy transition were bid up to very high prices. So high, in fact, that you could say they were getting frothy.
“In 2020, the ICLN ETF (iShares Global Clean Energy Exchange Traded Fund) had probably the biggest flows of any ETF in the world that year. A lot of capital just flew into any renewable energy company with the word ‘green’ or ‘renewable energy’ attached to it,” Hari Balkrishna, Portfolio Manager at T Rowe Price, says in an interview with [i3] Insights.
“There even have been funny stories of companies changing their name, throwing in the word ‘green’, and then like the stock would be up 20 or 30 per cent the next day.
“You’ve got to be very careful here and that’s where I think not losing sight of the financial perspective is really important.”
“In 2020, ... a lot of capital just flew into any renewable energy company with the word ‘green’ or ‘renewable energy’ attached to it. There even have been funny stories of companies changing their name, throwing in the word ‘green’, and then like the stock would be up 20 or 30 per cent the next day.
Balkrishna runs a global equity impact investment strategy and is enthusiastic about the opportunities that stem from the energy transition. But he has seen his fair share of renewable energy companies that simply aren’t going to generate significant profits.
“Take solar panel manufacturers last year. They got bid up to astronomical valuations on the basis of the addressable market. But it is an end market with consistently deflating cost curves and declining margins,” he says.
“So they have a great top line, but you don’t see it in the profits. It is called profitless growth, effectively, and I have stayed away from those because that is where I think you see signs of overheating.”
The onset of the pandemic took some of this froth out of the market as sentiment changed from exuberance to cautiousness.
“In 2021, a lot of these companies’ stock prices have been cut in half and they haven’t recovered from that. So there is a day of reckoning for these kinds of stocks,” Balkrishna says.
This deflation in prices has created some interesting opportunities in the solar energy sector, and Balkrishna has been looking for companies that have healthy margins and prospects of further growth in the sector.
Often this means looking for companies that don’t roll out the main product, where there is risk from price deflation and competition, but rather those who supply essential parts to the sector and have a solid competitive moat around them, with expanding economic returns.
“I own a couple of high-growth solar companies, but they’re not solar panel manufacturers,” Balkrishna says.
“One of the companies is called Shoals Technologies and they make, what are called, eBOS (Electrical Balance of System Optimisation) systems for solar farms. This is the wiring that goes behind all the solar panels and they have a much more efficient solution. It can reduce your installation cost of a solar farm by up to 30 per cent.
“They have patents and IP and they have expanding margins and expanding growth. Now, they have sold off together with everything else in renewables this year, but that is one where I would say it is actually a real opportunity.
“So there was definitely a bubble in some of these solar companies in 2020, but I think there are some interesting opportunities with good management, good corporate governance and at a reasonable price.”
Other examples within the renewable space are those renewable generators where the returns can be preserved due to their scale and operating competitive advantages, like Brookfield Renewable Partners, which Balkrishna has a big bet in.
Early forms of impact investing took the shape of venture capital-type deals, where very specific social or environmental outcomes were set. But as asset owners around the world have developed comprehensive environmental, social and governance (ESG) policies, the demand for investments that align with these goals has increased.
This required investments that could be done at scale and today increasingly more investors are applying the principles of impact investing to listed markets. This is also the area where Balkrishna looks for opportunities.
“We are looking for investments that deliver a positive environmental and social impact alongside a financial return. Now, we start with the notion that every investment that goes into the portfolio has to have an impact that is material. It can’t be an oil company with five per cent in renewable energy. It has got to be something much more meaningful than that,” he says.
He looks for companies where the majority of its revenues or profits is derived from activities or products that align with social or environmental goals. This rules out about 2500 companies from his 3000-stock universe straightaway.
Volkswagen is primarily an internal combustion engine manufacturer, but it is playing a very meaningful role in bringing electric cars to the world. But it wouldn't satisfy our materiality threshold because electric cars make up less than five per cent of the company’s sales today
“Take Volkswagen – Volkswagen is primarily an internal combustion engine manufacturer, but it is playing a very meaningful role in bringing electric cars to the world. But it wouldn’t satisfy our materiality threshold because electric cars make up less than five per cent of the company’s sales today,” Balkrishna says.
“Then you have a company like Netflix. It is not a carbon-intensive operation at all; it actually ranks really highly when you look at externally rated ESG scores. But again, we are focused on what the impact of Netflix is and – I’m not making a judgment call on whether Netflix is good or bad – but it is hard to measure how Netflix is having a positive social impact.”
Some of the companies that make the cut do not necessarily score perfectly on every aspect. There are several companies in the portfolio that could be seen as carbon intensive, but still have a positive impact on social metrics.
“Let us take Linde, which is an industrial gases company that we own in the portfolio. It has a relatively carbon-intensive set of operations, but somewhere around 60 per cent of their revenues are derived from sustainable activities,” Balkrishna says.
“For instance, they transport oxygen for COVID-19 patients, they supply carbon dioxide for freezing food and provide the gas that goes between your double-glazed windows, which improves building insulation. They are also involved in carbon capture and hydrogen generation to enable the green hydrogen economy.
“And if you look at their products, they have three times the carbon efficiency of what they’re generating, so effectively they’re saving two times more carbon emissions than they’re generating themselves for their customers.
“And that number keeps growing because their carbon emissions keep reducing as they move to more renewable energy in their operations, yet the customer footprint keeps growing.”
The global pandemic has lifted many healthcare and biotechnology companies to prominence, but Balkrishna does not think this is a temporary fluke. Some companies already had excellent margins and good growth prior to the health crisis.
“I’m very excited about healthcare. The sector is a bit like what technology was in the period from 2010 to 2020; I think healthcare is the next shoe to drop,” Balkrishna says.
“I see opportunities in companies that are enabling the pace of healthcare innovation to accelerate, so I have a big bet in companies like WuXi Biologics, Lonza, Danaher and Thermo Fisher.
“These are companies that provide the life science tools, the equipment and a lot of the innovation ecosystem for biotech start-ups and for a lot of large pharmas to do research.”
They are exciting businesses from a growth perspective too, he says. “Take a Danaher or a Thermo Fisher and they can grow nine to 10 per cent top line, mid-teens earnings. WuXi Biologics can probably do 40 to 50 per cent top line. So we are talking really big numbers here,” he says.
“And from a financial perspective they are reasonably valued for what they do. Unlike investing in a very high-risk, binary biotech idea, where you can either lose 100 per cent or make 100 per cent, these are companies that I think can compound low to mid-teens for a very long period of time.”
He also sees opportunities in new ways of sequencing DNA. One of the companies he has invested in is developing a new generation of DNA sequencing of the human genome at a much lower cost, which opens markets that previously didn’t have access to the technology, including countries in Africa.
If you want to sequence an Ebola virus or a Zika virus, there is this company called Oxford Nanopore Technologies and the way I describe it is: we sequenced the human genome in 2004 with a supercomputer. This is the iPhone of DNA sequencing
“If you want to sequence an Ebola virus or a Zika virus, there is this company called Oxford Nanopore Technologies and the way I describe it is: we sequenced the human genome in 2004 with a supercomputer. This is the iPhone of DNA sequencing,” he says.
“This might be oversimplifying it, but I’m very excited about the future in this space.”
Many companies that classify as impact investments contribute to a better world and with asset owners increasingly being aware of their role as responsible agents in shaping the future of society, this area is set to grow.
But ultimately, impact investing just makes good financial sense, Balkrishna says.
“I firmly believe that we do not need a compromise on financial returns as a result of investing in impact, because ultimately I think they go hand in hand,” he says.
“If we can find companies delivering positive environmental and social impact, those are the companies with better top and bottom-line growth prospects, and I think those companies, over time, should outperform.”
This article is sponsored by T. Rowe Price. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.