Investing in long-term secular trends to transition to a more sustainable society is an example of “doing well by doing good.” But when the market seems to turn against an investment thesis, it is time to question whether the thesis remains intact. If so, the situation represents a buying opportunity. Understanding how asset managers deal with these situations is critical for asset owners when choosing suitable managers for long-term investments.
Renewable energy, especially solar energy, is a clear example of a long-term investment trend. Global and national agencies such as the International Energy Agency and US Energy Information Agency (EIA) forecast strong growth in the solar sector brought on by rapid technological development, government support, innovative financing models and the growing interest in clean, resilient and cheap energy systems. Investors in US-based companies such as First Solar, SolarCity and SunEdison are looking to support and profit from the growth of this industry.
However, as investors, how do we cope with short-term fluctuations that seem to contradict our view? For example, during the 2014-15 oil price decline, shares in a number of US-based solar companies plunged an average of 40%. Commentators stated that the plunge should not have occurred because “solar fundamentals are largely unrelated to oil prices.” Since 2010, solar share prices (represented here by First Solar and SolarCity) exhibited no meaningful relationship with crude oil prices. However, for a brief period between October 2014 and February 2015, solar share prices for these companies and oil prices moved downwards in parallel as shown in Figure 1.
Figure 1: First Solar and Solar City share prices vs. crude oil prices
Source: Bloomberg, 2015, Cornerstone Capital Group
One possible interpretation of this brief but significant parallel movement is that the market assumed a relationship between the future cash flows of solar companies and falling oil prices. However, our analysis did not find a fundamental link between lower oil prices and lower solar future earnings. The only sector where oil and solar compete directly is in power generation. The amount of petroleum-based generation in the US has decreased continuously since the 1970s and currently accounts for less than 1% of US power generation (Figure 2). A decrease in oil prices, leading to a decrease in petroleum prices, has little or no impact on the US power generation market.
Figure 2: U.S Power Generation
Source: EIA, 2015, Cornerstone Capital Group
The development of future solar projects depends on wholesale and retail electricity prices as well as the costs of production and installation of solar panels, both of which are unaffected by oil prices.
Municipal, state, and federal government subsidies also support solar generation in the U.S. Currently, these include a federal investment tax credit (ITC), worth 30% of a project’s equipment and construction costs, and state-based Renewable Portfolio Standards (RPS), which set legislated targets for renewable energy generation. In addition, President Obama’s Clean Energy Plan establishes new regulations and rules to drive renewable energy development across all states.
The ongoing reduction in the cost of solar panels (shown in Figure 3) should continue to improve the economics of installing solar systems at utility or commercial/residential scale.
Figure 3: Average U.S PV Price Forecasts
Source: US DOE, 2014
It is critical to understand how good managers typically manage short-term challenges when asset owners are seeking long-term returns. It’s most important to understand what the portfolio manager is trying to do and how—a critical element of manager due diligence. Some specific items that may be useful in differentiating managers and approaches include:Given our analysis on a potential linkage between solar and oil, we maintained our thesis that the market’s reaction presented a good buying opportunity for solar for long-term, high-conviction investors. Further challenges may emerge for the share prices of solar companies; and the prudent long-term investor will assess each challenge in the context of the long-term time horizon.
Turnover vs Time Horizon. Either of these items individually may be of limited use but together they can be instructive. Does the manager’s turnover result align with what they say their investment time horizon is? For example, if a manager states that they see renewable deployment and growth as a 5-10 year theme and their turnover is 100% per year, that strategy would be less likely to have a substantial and consistent exposure to renewables.
Quantitative vs Qualitative. It is rare to find an investment strategy that is completely one or the other, but the balance between the two approaches is usually telling. A bias towards quantitative data means the strategy is less likely to be taking long-term bets on macro themes. Where there is a significant qualitative focus or overlay, the exposure to megatrends may be more pronounced and intentional.
Results vs. Process. It is relatively easy to determine a portfolio’s exposure to a certain theme or sector by reviewing its holdings. However, without understanding the process for generating ideas, and for constructing and managing the portfolio, it is impossible to know why the portfolio looks the way it does and whether or not it will look similar tomorrow. Inquiring about portfolio managers’ views on issues and trends one views as material is an important part of this process. Understanding how those views impact investment decision-making is a crucial aspect of manager due diligence.
Sebastian Vanderzeil is a Research Analyst with Cornerstone Capital Group. He holds an MBA from New York University’s Stern School of Business.
Craig Metrick is Director, Manager Due Diligence and Thematic Research at Cornerstone Capital Group, where he oversees the firm’s manager and fund outreach and review process. Previously, Craig was Principal and US Head of Responsible Investment at Mercer, working with a variety of public and private clients.