Edward Guinness: A Portfolio Approach to Alternative Energy
Source: Brian Sylvester of The Energy Report 01/11/2011
Edward Guinness, comanager of the Guinness Atkinson Alternative Energy Fund, says countries will use a portfolio mix of resources to meet their power needs. Investors in the alternative energy sector are advised to take the same approach to investing in the sector. In this exclusive interview with The Energy Report, Edward tackles the skepticism about climate change, cost, volatility and liquidity and offers advice for skittish first-time investors in the sector.
The Energy Report: When we spoke with you in September 2010, you said the Alternative Energy Fund had been through a rough ride but, given the low valuations of the stocks in the fund, you were excited about the next 18 months. Are things headed in the direction you expected? What's your outlook now?
Edward Guinness: Since September, we have seen a strong run followed by a pullback. The move up was particularly pronounced for the solar names, demonstrating well the upside potential from the solar sector. Valuations remain low and with earnings estimates increasing, the multiples on which stocks trade are declining further. Our outlook now is as positive as it was in September, with the added plus that we're beginning to see a move up in conventional energy prices. This is a positive for the alternative energy space. In our opinion, the oil price has moved toward the top of the trading range and there is a chance it will move up through US$100 again. That will be supportive of the alternative energy sector.
Separately, in the U.S., the natural gas price had been weak for much of 2010; but the price has bounced off its lows and we expect it to make further gains in 2011. Again, this is supportive of the stocks in the alternative energy sector.
TER: What's your pitch to investors who may be skeptical of alt energy?
EG: The important thing to remember when investing in alternative energy is that there are a number of key drivers. The three drivers, as we see them, are: rising energy prices, energy security and climate change. People who have doubts about the sector seem, first, to be skeptical about climate change and second to believe alternative energy is too expensive to work. So far, no one seems to worry that energy security isn't a valid driver.
The problem with climate change is that because it has such a long-term effect, it is going to be easy for doubt in the likely scale and impact of climate change to develop. As a result, political support for it is sentiment-driven. Public and political support for climate change policies remains strong, though the recent resurgence of the Republicans in the U.S. gives us some concern. At the international level, we haven't yet seen any major progress beyond Kyoto. Copenhagen was a disappointment but with Cancun, we're starting to see some international cooperation. The broad scientific consensus remains that climate change is not only happening but will have a negative impact on global quality of life and, therefore, should be addressed.
Another concern of skeptics is that alternative energy is too expensive. Today, however, a number of technologies are competitive on a cost basis-and even those that aren't today are seeing dramatic reductions in cost. Geothermal, hydro or onshore wind can all generate electricity at prices that are broadly competitive with fossil fuel power stations. New coal and natural-gas power plants now cost considerably more than they have, historically; those likely will become even more expensive as regulatory requirements increase and construction costs advance ahead of inflation. Solar has fallen dramatically in price over the last three years and is now at a new price point wherein solar costs are the same as retail electricity costs in a growing number of markets. Eventually, it will be the retail price that is the benchmark for solar because solar can be generated at the point of demand. Other technologies like tidal and wave energy are still in their infancy and don't form a part of our portfolio today.
Another concern often voiced relates to the intermittency of alternative energy. As wind turbines can generate electricity only when there is enough wind and solar panels work only when the sun shines, many critics dismiss them as a source of electricity. However, you need to look at the alternative energy technologies as part of a portfolio of electricity sources. If wind is 25% of the capacity in a region or country, the grid can be adapted to provide reliable on-demand power. It is only if wind or other intermittent sources of electricity become a majority of the electricity supply, and if no energy storage is developed, it is not a viable part of the solution. With wind representing a very small part of world electricity generation today, there is room for considerably more growth from here until we meet those technical constraints. In determining the form of the eventual portfolio, each country will be able to maximize whatever resources they have-one standard global solution isn't likely.
The skeptics about peak oil claim that we will always continue to discover new sources of oil and gas (O&G) and, therefore, shouldn't worry about dwindling reserves. We've seen peak oil production in the U.S. and a number of other countries. No large fields have been discovered in the last 10 years that compare with the major OPEC fields. Our view is that the world will be able to keep increasing production in the near term, but that will lead to increasing prices. Ultimately, we will see peak production-though that could be extended as higher O&G prices make more marginal reserves viable. But whatever happens, we think that rising fossil fuel prices are highly likely.
TER: You were bullish on solar power when a lot of analysts and fund managers were shedding their solar holdings or steering clear of them altogether. Even now, about half the weighting of the Guinness Atkinson Alternative Energy Fund is in solar companies. Why do you remain bullish on solar?
EG: First, I think in the next five years solar will have highest potential growth of any of the alternative energy sectors. Second, the valuations in the sector are incredibly compelling. We're able to buy low-cost Asian solar panel manufacturers at single-digit earnings multiples, which we think is incredibly attractive. It's a tricky area for very short-term investors to get their heads around because the sector has declining ASPs but rising volumes. It's a bit like the semiconductor industry. You have to look at it as a question of whether volume increases outweigh price reductions and whether or not the manufacturers will be able to maintain their margins. However, we've seen a big fall in price over the last three years. We're still seeing the demand response; and with recovering global economies, there is significant potential for volume increases without the same levels of price reduction required.
Volume increases over the next five years will significantly outpace price reductions. And the progress companies are making on the cost side and the broad availability of the raw material-silicon-mean margins can be maintained. In a funny way, the industry has become a bit of a victim of its own success. The fact that the solar sector had a bumper year in 2010-going from 7 Gigawatts (GW) to about 14 GW in a year-means investors are now more concerned about governments reducing subsidies more than expected. From our perspective, it doesn't make sense that valuations should be so punished when the strong growth is so far ahead of expectations.
TER: Some people who say it takes a very large amount of space to generate a relatively small amount of electricity. What do you say to those who believe there are more cost-effective, space-efficient ways to generate power?
EG: I don't think the space argument is that important to the market. It might be relevant in rooftop electricity generation. Today, however, enough electricity can be generated from the space available on an average house to power that house; so you're not constrained by space available. Utility-scale solar installations offer the potential to use very marginal land, particularly in hot dry arid areas, where space doesn't form the constraint and the most important aspect for developers is total cost of generating the electricity. In the long run, as in Germany, the market is likely to be much more rooftop-based as this provides the benefits of distributed generation above and beyond the non-fossil fuel electricity.
The third area that has been reasonably successful to date is commercial rooftop installation. For example, big box retailers in the U.S. are putting panels on their rooftops-space that is entirely underutilized now. Again, for these types of development, the solar panels are providing incremental returns and space is not the main constraint.
TER: And the future of this industry is in rooftop cells?
EG: I think in the long run, yes. In the short run, I think there's going to be strong growth in utility installations in the U.S. and, possibly, China; that's how a lot of markets get kick-started. But in the long run, I think rooftops will be the mainstay of the market. They have the benefit of electricity being generated at a point of demand, so you cut out huge amounts of costs.
TER: A number of your fund's top-10 holdings have changed since September. You've added Itron, Inc. (NASDAQ:ITRI), SunPower Corp. (NASDAQ:SPWRA/SPWRB), LDK Solar Co. Ltd. (NYSE:LDK), LSB Industries, Inc. (NYSE:LXU), Clipper Windpower, Inc. and Iberdrola Renovables SA (MSX:IBR). Why such a dramatic change in just one quarter? Also, what do these companies bring to your fund that some previous companies like JA Solar Holdings Co. Ltd. (NASDAQ:JASO) and Phoenix Solar AG (Fkft:PS4) did not?
EG: We run the fund by having 30 equally weighted holdings that we rebalance. Looking at changes in the top 10 is more of an indication of how our latest rebalance went and the short-term performance of those stocks, rather than demonstrating actual changes made to the portfolio. I think the most significant change we made to the portfolio was acquiring Itron, which is in the smart grid-technology space. The company makes meters and meter-reading systems. It's beginning to pick up some largish utility contracts.
TER: What are some catalysts for growth there?
EG: The main catalysts for growth are the contracts utilities are awarding to Itron. The drivers for the contracts are mandates from regulators and the utilities' own efforts. We're seeing a big push for utilities to implement smart-metering technology across their entire customer base.
TER: Can you talk about some of the companies that are now in your top 10 that weren't there before?
EG: If you look at the stocks that are there now, LDK Solar has had a very strong run. It's one of the leading Chinese wafer-manufacturing companies that's moved into polysilicon manufacturing. With a leading market share and a low cost base, the company is very well positioned, and it trades on a valuation that reflects historic concerns that the company was overburdened with debt.
LSB Industries is a very interesting company. It is one of two efficiency plays we have in the portfolio; the other is WaterFurnace Renewable Energy, Inc. (TSX:WFI). Both manufacture ground-source heat pumps, which I think will be a very attractive area when the U.S. housing market picks up.
TER: What are ground-source heat pumps?
EG: A ground-source heat pump takes the heat from underneath your garden or from a nearby source of water; by using compression, it provides heating or cooling for buildings. This uses the same heat cycle as a refrigerator. When we do the math, it's the most cost-effective way to reduce the energy use of newly built housing. Today there is a reasonably small market for ground-source heat pumps in the U.S., though it has held up reasonably well even through this downturn. We think when you start to see new-build housing return to a normal level, there will be a disproportional demand for ground-source heat pumps as new buildings are designed much more often with energy in mind.
TER: Any other newcomers to the top 10?
EG: Clipper Windpower has been in the portfolio a little longer. It did well in the last quarter as Clipper was acquired by United Technologies Corp. (NYSE:UTX), which had previously acquired a 50% interest in Clipper and has now acquired the remaining 50%.
TER: You must've done pretty well on that.
EG: I'd love to say it was a big win, but it's an example of the type of company that has been particularly caught out in the downturn and the acquisition was at a very low price. Clipper's original management founded the wind turbine manufacturer Zond, which was acquired by GE and now forms the core of GE's wind turbine business. It was doing pretty well but had some quality problems and had to recall some of its blades. When we saw much lower demand in the wind turbine market, Clipper really struggled to pick up new orders. The actual product was good, but the market became considerably softer.
We're a little saddened that United Technologies is taking the stock over at such a low price, but we've spoken with Clipper management very regularly in the last six months. Our message to management was that if they were going to sell, they should only sell if they weren't going to bring in new orders before the end of 2010. Clearly, that was the case and the company took the offer from UTC. If it'd been able to deliver new orders by the end of the year, I think it would've been at a much higher price.
TER: You talked about rooftop panels being the future of solar power. A big component of SunPower's business is rooftop panels. What's your investment thesis with that company?
EG: SunPower is well positioned-it's got product differentiation and the most efficient solar modules on the market today. The company also has very good project pipelines in the U.S., which is one of the key markets over the next five years. At the same time, SunPower is trading at what I consider incredibly low multiples. It's one of two U.S.-based solar companies. It does its manufacturing in Asia, so the company is able to be cost competitive while having the advantage of access to what we foresee as an important market in the U.S.
TER: So, about a third of your fund is U.S.-based companies?
EG: Yes. We also have around 18% of the portfolio in China-domiciled companies. If you look through all of our solar holdings, almost all of the manufacturing plays now have manufacturing facilities in Asia. Being cost competitive is the most important attribute in the solar industry, ahead of technological advantage. And to be cost competitive, you need to be in Asia.
TER: Why are you invested in LDK?
EG: LDK was on a lot of investors' worry list; it was reasonably highly leveraged. Going into 2008, LDK had committed to a very expensive new polysilicon plant. One of the reasons we think it's attractive is that the financing for all of the China-domiciled companies is backed by the Chinese government. Second, LDK has successfully restructured the holdings of its polysilicon plant to free up additional capital. Third, the company has been very effective at growing sales. Being a cost leader, LDK was one of the big winners in 2010, in terms of market share. It has such big scale that for someone to come in and be competitive now would now be quite challenging.
TER: Alternative energy is still a nascent sector. You have certainly experienced the dramatic ups and downs that come with investing in the sector. What advice would you give those looking to invest in alt energy now?
EG: First, I think you have to look at the volatility. This will continue to be a volatile sector. Now is a reasonably good time in the cycle to consider buying alternative energy, as you're not buying at a time when sentiment is positive toward the sector. And you're not buying at a point when valuations are factoring in the potential growth. Second, consider this as a long-term hold. With the sort of volatility in the sector, buying and selling is quite difficult. As a long-term hold, I think this is a very attractive place to buy the fund.
That said, in the medium term, we do expect the volatility to decrease a little. The end market for alternative technologies is moving away from being led by one or two countries. In five years, we expect there will be much more of a balance. Therefore, you're less exposed to policy changes in the largest countries. That should produce more of a portfolio effect for the revenues of international manufacturing stocks like the wind turbine and solar module manufacturers.
TER: Is there enough liquidity in alternative energy?
EG: Absolutely, we are asked that question often. We have about 55% of the portfolio in companies with more than a US$1 billion market cap. In our experience, liquidity is not a major concern when trading the fund. There are 150-200 companies with more than a US$1 billion market cap in the sector.
And to get back to your question about advice for new investors, my final point would be that we expect to see more of a move away from reliance on government subsidies. That may sound crazy, but you are within a year or two of solar in Germany being at the same price as retail electricity. Once you start moving below retail solar prices, you can think about it in terms of unsubsidized economics.
TER: To follow up on that, with the belt tightening in Germany and the broad cuts in your country, do you expect subsidies to be cut to solar infrastructure? And is that going to hurt in the short term?
EG: That is an important issue. There is major uncertainty over what's going to happen in Germany in response to the fast growth of the market there. However, it's important to remember that the solar subsidies are not paid for by the government. They're paid for by electricity consumers as an incremental levy on their electricity bill; so the cost is not directly borne by the state. Germany's support of solar over the last 10 years is the reason the industry got to its present scale, both in installations and manufacturing. It will not want to destroy the industry and expertise that has built up. I think the German government is more long sighted than people give it credit.
If Germany was to pull the rug out from under the industry, you could have a situation like that in Spain. The Spanish government put in place an attractive subsidy regime about four years ago that was much more successful than it could ever have imagined. In response, the government slashed the subsidies and killed Spain's domestic solar industry. Today, solar installation activity is at a low level in Spain. I think the German government will want to avoid that.
TER: Edward, thank you very much for talking with us today.
Edward Guinness joined Guinness Asset Management in 2006. Mr. Guinness is comanager of the Guinness Atkinson Alternative Energy Fund. Prior to Guinness Atkinson, Mr. Guinness worked for HSBC in corporate finance beginning in 1998, and then in 2003 joined Tiedemann Investment Group, New York, in merger arbitrage. Mr. Guinness graduated from Magdalene College, University of Cambridge, with a Master's degree in engineering and management studies in 1998.
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1) Brian Sylvester of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None.
3) Edward Guinness: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None.
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