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Does investing in the low-carbon revolution have to cost the earth?

18 Feb, 2021 | Return|

By Graeme Baker & Deirdre Cooper, Co-Portfolio Managers, Ninety One Global Environment Fund

With Tesla’s stock price increasing more than seven-fold in 2020 and stellar gains for some solar-energy equities, many investors are asking whether shares in companies linked to the green revolution have lost touch with reality. We manage an equity strategy that invests in companies we expect to benefit from efforts to tackle climate change, so we understand the concern.

We don’t hold Tesla in our portfolio. But we do own shares in other companies whose products help to avoid emissions from transport, as well as from electricity generation, factories, offices, homes and other sources. Fortunately, we think there are plenty of companies making the global economy more sustainable whose shares still represent good value. But it’s increasingly important to invest selectively.

Capturing growth

Conceptually, the case for investing in businesses whose products address the world’s carbon problem is straightforward. ‘Decarbonising’ the economy requires far-reaching changes to the way the world produces and consumes, which will present enormous opportunities for some companies. From an equity perspective, the idea is simply that these companies may be able to outgrow their peers, so their shares have the potential to outperform. The faster the low-carbon transition occurs, the more we’d expect these stocks to outpace the market.

Last year saw a big acceleration of decarbonisation, despite (and in some ways because of) the pandemic. Among the major developments, China, Japan and South Korea committed to ‘net-zero’; the EU put clean-tech at the heart of its COVID-recovery plan; and the UK adopted one of the world’s most ambitious carbon goals. Capping a breakthrough year in climate policy, Joe Biden’s US election win brought to power a president with a strong environmental agenda. Not surprisingly, this boosted the shares of companies seen as well-placed to benefit from the low-carbon transition.

Varied valuations

Given governments’ determination to reduce emissions – coupled with consumer preferences for sustainable products, and the fact that green technologies are becoming better and cheaper – we think the rationale for investing in decarbonisation is stronger than ever. But are the shares of ‘carbon-avoiding’ companies now overpriced?

It’s certainly true that shares generally became more expensive last year. The strong gains for global equities in the latter part of 2020 were accompanied by an increase in the price-earnings ratio of broad benchmarks like the MSCI All Countries World Index (ACWI).

The companies we focus on (again, which don’t include Tesla, but all of which help avoid emissions) were no different. Their average valuation also increased, but only in line with the MSCI ACWI’s valuation gain, although their share-prices went up by more than the index. In fact, the gap between the two valuations, which is usually fairly slim anyway, narrowed slightly.

Clearly, for the difference between the two price-earnings ratios to remain stable, the above-market price increases of the decarbonisation stocks must have been accompanied by correspondingly higher earnings.

What does this tell us? First, it shows that investors are no more excited about some stocks with the potential to benefit from decarbonisation than they are about shares generally. We think this is because the market is yet to grasp the economic transformation that tackling carbon emissions requires. A few green-tech companies and sectors dominate the headlines, but the low-carbon revolution occurring across industries is still largely being overlooked.

Second, we think it confirms that a selective approach to investing in decarbonisation is crucial. Some low-carbon areas look expensive to us, including some hydrogen and residential-solar businesses. But parts of the electric-vehicle supply chain, for example, are still being priced in line with the traditional auto sector, rather than tomorrow’s transport system (and nowhere close to Tesla’s lofty valuation).

Of course, whether any stock represents good value depends on how successful you think the respective company will be. But we might all agree that there are multiple ways for investors to align a portfolio with the low-carbon growth trend. And they needn’t come with a hefty price tag.

All investment involves risk; losses may be made.

We seek to lead the conversation on sustainable development, assisting our clients on their journey towards sustainable long-term investing. For further insights, click here.

 

No representation is being made that any investment will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided.

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