Clean energy’s robust fundamentals and long-term secular growth outlook have been temporarily obscured by sentiment-driven capital flows

Introduction

You will recall that we published a paper in February ‘The case for investing in clean energy’, in which we:

• Attributed the root-cause for the drawdown in the clean energy sector to rising interest rates (the fundamentals of clean energy stocks make them highly sensitive to interest rates);
• Provided an update on the industry fundamentals, which supported our thesis that the fundamentals remain in good health with a very bright outlook; and
• Shared example stock case studies, demonstrating fundamentally attractive bottom-up opportunities.

In this paper, we will:

1. Illustrate how negative sentiment has obscured improving fundamentals at sector level – valuations have improved through the compression of valuation multiples and earnings growth;
2. Demonstrate that clean energy has compelling valuation multiples in both absolute and relative terms in addition to higher earnings growth expectations;
3. Highlight that this situation is not actually unique; and
4. Provide two case studies of what a recovery has looked like in sectors which share many of the same attributes – material drawdowns in niche but vital sectors have previously been followed by stunning reflation.

We acknowledge the work of others investing in clean energy, including Norges Bank, AXA, GMO, Sprott, et al, in bringing these issues (and opportunities) to wider attention.

Note. References in this paper in relation to ‘small caps’ are not referring to Australian small caps. We are referring to companies with market capitalisations less than US$10-15 billion, typically listed in the United States (US) or other major equity markets.

 

1. Sentiment driven capital flows have obscured clean energy’s solid fundamentals

Negative sentiment has been the overwhelming factor on stock prices. While clean energy stocks have experienced significant drawdowns (as negative sentiment has compressed valuation multiples) overall company fundamentals within this space have continued to improve.

Figure 1 – Dissecting the clean energy sector’s performance drivers (from 31 December 2021 to 30 April 2024)

Source: Bloomberg, T8 estimates

Key points

• Since the end of 2021 (immediately prior to the interest rate hiking cycle), clean energy stocks have fallen 54% while global equities have rallied by 6%.
• The performance of global equities was a product of 6% earnings growth and little change to its valuation multiple.
• Small caps experienced a 2% earnings contraction over this period as well as a small decline in its valuation multiple which resulted in the sector’s 9% contraction.
• Notwithstanding the drawdown, the earnings of clean energy companies actually increased by 10% during this time, exceeding the growth experienced by global equities.
• The driver of this dichotomy was negative sentiment which saw clean energy’s price-to-earnings multiple compressed by nearly 50% (or approximately 15 times earnings).
• You will recall that we fully decomposed the drivers of negative sentiment in the above mentioned research paper.

 

2. Clean energy stocks have compelling valuations

Clean energy’s price-to-earnings multiples are attractive in absolute terms as well as relative to broader equity indices.

Key points

• Major US indices are expensive relative to global equities. They are also expensive on a forward earnings perspective (not shown on this chart) in the context of their forecast earnings growth rates. They are also expensive relative to their 5-year average valuation multiples prior to the interest rate hiking cycle.
• Small caps are trading at a discount to global equities, especially when considering their forecast earnings growth rate. The multiple is attractive in absolute terms.
• Clean energy (a segment within global small caps) is trading on a similarly attractive multiple to small caps, although at an even deeper (and significant) discount to its 5-year average valuation multiple prior to the interest rate hiking cycle. The multiple is attractive in absolute terms, especially in the context of its forecast earnings growth rate.
• Solar is the most compelling industry segment within clean energy based on the same factors as clean energy overall.

Figure 2 – Comparison of index price-to-earnings multiples (trailing 12-months to 30 April 2024)

Source: Bloomberg, T8 estimates

It is well appreciated that global small caps have the capacity to remain ‘cheap’ (relative to broader equity indices) for periods of time.

As a segment of global small caps (where the median market cap is approximately US$2 billion), we observe that clean energy stocks have approximately double the number of research analysts covering them relative to stocks which are not associated with the clean energy sector. This means that their fundamentals and valuations are unlikely to go unnoticed indefinitely.

 

3. Is this situation unprecedented? (a niche but vital sector trading at a significant discount)

No. Clean energy’s situation has all the characteristics of a sector dislocation. Dislocations typically represent an opportunity to participate in their ultimate normalisation (recovery).

 

4. Case studies highlight that recovery is inevitable with the potential for it to occur much more rapidly than the market might anticipate

History is littered with comparable case studies which increase our confidence that the recovery of the clean energy sector is not only inevitable but has a strong potential to be both powerful and rapid when it does occur.

We believe that when it recovers, the clean energy sector will rebound by the ‘elevator’ rather than by the ‘stairs’.

We observe that each case study shares some important key ingredients, including:

• High industry technical complexity;
• Above average cyclicality;
• Below average correlation to major indices;
• Immaterial representation in major indices; and
• Above average volatility.

These ingredients are all present within the clean energy sector.

 

A case study on a comparable situation in the metals and mining sector (2016-2021)

Key points

• A cyclical downtrend in industrial metals prices saw metals and mining stocks drawdown by roughly 70%.
• Culminating towards the end of 2015 and early 2016, mining stocks were being valued as if metals prices would never recover (and in many cases priced for material equity dilution).
• From early 2016, this critical sector generated significant outperformance for the following 5-years.

Table 1 – Metals and mining (2016-2021)

	Returns
	2011 to 2016	2016 to 2021
Metals and Mining	-67%	319%
Global Equities	29%	119%

Source: Bloomberg, T8 estimates

 

A case study on a comparable situation in the oil and gas sector (2020-2022)

Key points

• Falling oil and gas prices combined with expectations for an unrealistically rapid energy transition resulted in oil and gas producers falling nearly 70%.
• From 2020, this vital sector recovered, outperforming global equities by more than 3 times over a 2-year period. We observe that the rebound was by the ‘elevator’ rather than by the ‘stairs’.

Table 2 – Oil and gas (2020-2022)

	Returns
	2014 to 2020	2020 to 2022
Oil and Gas	-62%	252%
Global Equities	14%	71%

Source: Bloomberg, T8 estimates

 

The case study on the clean energy sector is only half written (2024-)

Key points

• Clean energy’s situation has clear parallels with the first half of the case studies above and the sector shares many characteristics with the industries examined.

Table 3 – Clean energy (2024-)

	Returns
	2021 to 2024	2024 to
Clean Energy	-68%
Global Equities	31%

Source: Bloomberg, T8 estimates

In clean energy’s circumstances, smaller market capitalisations (clean energy is a segment within global small caps) is an additional factor which has most likely contributed to its drawdown.

The above-mentioned factors have made it possible for generalist investors (such as pension funds and broader market benchmark equity managers) to avoid (if not totally ignore) the clean energy sector.

 

Conclusion

We strongly believe that clean energy is an opportunity hiding in plain sight.

Recalling that perfect timing is impossible, being under-exposed to this sector at the present time carries risk to those who are looking for an attractive entry point to a long-term investment with secular tailwinds.

 

Footnotes

Indices referenced

• Global Equities (NDDUWI Index)
• Small Caps (RU20INTR Index)
• Clean Energy (comprises equal weightings to SPGTCLNT Index and ECOTR Index)
• Metals and Mining (NDLCMMIN Index)
• Oil and Gas (NDUWOGAS Index)
• Solar (SUNIDX Index)