The Green Bubble?

COVID-19 has left its impression on the last ten months like no other, and while there have been many losers, be it in terms of personal wellbeing, or the global economy, there is little doubt that there have been more losers than winners. However, the financial markets, ESG companies and instruments, and those focusing on the ‘Environmental’ in particular, have been one of the few bright spots, highlighted by the parabolic nature of the increase in valuations within this sector.

A notable example of this trend is highlighted by the WilderHill Clean Energy Index. At the beginning of 2020, the index sat at 72.1. By the middle of January 2021, however, that figure reached 260, with a forward price to earnings ratio of 123x, demonstrating the huge influx of capital into companies which provide goods and services in that sector. Here, we dive into the rationale, and (pardon the pun) sustainability of this thus far lucrative rally.

What is a Bubble?

A bubble is generally characterized by excessive speculation within a specific, or across several assets, seeing the valuation of the asset, be it a company, commodity, or any other tradable security reach heights far beyond the tangibility that underlies. Such tangibility has traditionally, in value investing terms, generally refers to a company’s cashflows, and how much one is paying per unit of a firm’s earnings, as well as other fundamental aspects such as its competitive advantage and the future viability of the market it operates within, among others.

Of course, it is not the appreciation of asset prices which are the cause for concern, but what many would cite as the inevitable and dramatic collapse in those prices and the huge sums of wealth that disappear with this, when the bubble pops. Notable examples of the past include the Dutch Tulip Bubble of the 1630’s and the South Sea Bubble of 1720, as well as more recently, the Dotcom bubble of the 1990’s and the Housing Bubble of the early 2000’s, a pre cursor to the 2008 Financial Crisis.

One common and perilous trait of bubbles, however, is the ability of some at the time to rationalize and justify it. In the 1990’s, many cited the valuation of companies which earned little or no money as justified, on the basis that the technological advancement generated by these companies and their growth prospects could not be rationalized by historic metrics. The outcome spoke for itself.

In short, while bubbles may appear absurd and obvious in nature with the benefit of hindsight, history would suggest that in the midst of the frenzy, they are anything but.

How Green Became Expensive:

The unique nature of the last twelve months has not been overlooked by the market. The swift enaction of lockdown restrictions following the outbreak of COVID-19 and the increased reliance on technology and firms who provide it, proved key in catapulting the value of these companies to new heights. Such firms also happen to be kinder to the environment than most. Among these include some that have become household names, Zoom among others, as well as cementing the positions of behemoths such as Amazon and Microsoft, all of which find themselves nestled within the portfolios of the top performing ESG funds of 2020. It could be hypothesized that investors are treating such companies as a safe haven as sorts, proving themselves a hedge against potential pandemic related risks which had a significant impact on other sections of the market such as oil and gas.

Record amounts of stimulus courtesy of both fiscal and monetary policymakers have also led many to suggest that a potential green bubble is only a small part of a dangerous and excessive speculation across equities as a whole. With $5.6tn of stimulus, and counting, sloshing around within US economy alone, as governments attempt to stave off a deflationary cycle and prevent their vast sums of debt from increasing in value, coupled with the ‘TINA’ effect brought about by the monetary policy’s version of the new normal- QE. This has seen many of these new fiat units find their way into equity markets. Such activity is evidenced by retail friendly exchange-traded funds in the green energy space, which have skyrocketed both in number and value, seeing inflows tripling in 2020 on what one could argue is a momentum basis, driving up prices of companies held within those securities.

However, not all rationales deserve such skepticism. With the likelihood that either today’s companies or those like them within the climate friendly space, likely to be at the forefront of a movement which is gathering pace at a frantic pace (taking the EU’s pledge to be carbon neutral by 2050 and Joe Biden’s $2tn green energy pledge as notable examples), it makes sense that such a movement is popular among investors with a long-term outlook. Such a movement some argue is part of a wider group of firms cited as ‘disruptors’, innovating at the margin to bring about a new era of prosperity and productivity driven by technology. In turn, the argument could be made that higher valuations could be justified given the earning potential of such firms, as they are increasingly leant on by society as a whole.

However, the argument that such investments will future proof portfolios may start to carry less weight when valuations are stretched well beyond historic levels. With each passing month, comes another story of how companies which make next to no money, have been appreciated by some lofty multiple. Whether it be Blink Charging Co., DoorDash, or (dare I say it), Tesla, such froth across companies which fall under a remarkably similar banner should at least give cause for curiosity, if not concern.

In fact, thus far we have observed a gradual rotation back towards cyclically based companies ravaged by the pandemic, as many predict that inflation is ready to make a return from its decade long absence. In turn, companies which have pricing power, or what followers of the ‘Oracle of Omaha’ refer to as a ‘moat’, tend to perform well in such environments, with the energy sector being the standout performers during period of inflation in the past, and thus far in 2021. Such a theory makes sense: companies who have the power to pass on their higher costs to consumers stand to see their healthy profits remain so.

Green energy stocks on the other hand have suffered. The iShares Global Clean Energy ETF has fallen 24.5% in the last month, after appreciating by over 225% from March 2020 to its peak in January 2021. Meanwhile, traditional energy stocks such as Exxon, which trade at lower multiples relative to their growth counterparts, have outperformed by the S&P500 five times over, year to date.

E, S and G? Pick One

ESG’s connotation has in the past decades gained much importance in the financial sector and investors have found a new source or way of value investing. It is effectively a new tool to consider when investing in a company. Environmental, social, and governance (ESG) criteria help investors find companies with values that match their own. What does it consider?

Environmental: This criterion investigates how a company’s use of energy, waste, pollution, natural resource conservation and treatment of animals. It brings a bigger picture of the environmental risks that a company faces and how it manages them.

Social: Here, it focuses on the business relationship between a company and its suppliers regarding their values, the charity aspect, and the overall working conditions of working at the firm. The focus is put on the healthiness of the atmosphere in the workplace and the conditions.

Governance: In the governance criteria, it is the transparency of a company which is put on the table. Accuracy and transparency in the accounting department are sought as well as an opportunity to raise an opinion and vote on critical issues. The governance criteria will also make sure there are no conflicts of interest within a company from the choice of its board members, political contributions, and of course illegal practices.

Having discussed the criterions of an ESG firm, you may be wondering what companies constitute exactly ESG ETF’s and Indexes. Through ESG scores and systems ratings, ESG index provider put together a list of companies that they believe best match their “sustainable” vision.

The first ever ESG index was the MSCI KLD 400 Social Index (USD) and was launched by KLD Research & Analytics in 1990. This might come as a surprise as it can be argued that ESG has only gained the attention of investors and the industry in the past 10 years. Today there are over 1000 ESG indexes, reflecting the growth of demand of investors for ESG products and the need for measurement tools that represent the objectives set by sustainable investors.

Since its launch, the MSCI KLD 400 Social Index has managed a 6.83% annual return, smaller than the 8% given by the S&P 500. We will analyze the constituents of such index to understand the basics behind it and see through the “marketing” of ETF’s and Indexes.

If we have a closer look at its distribution, we can see that the main constituents are tech related securities. Indeed, out of the 400 stocks, information Technology and communication Services form 31.62% and 13.45% respectively. In turn, one could be forgiven for considering “ESG” Indexes as a derivative of a technology index, which have also seen record inflows in 2020 and thus far in 2021. When looking at these companies, it could be construed as difficult in determining the ESG criteria and the “good” they bring in terms of sustainability. Facebook and Google, but to name a few, have had their fair share of the public abashment, be it regarding taxation, censorship, or political bias, yet it they fit into indexes supposedly prioritizing high quality corporate governance and social responsibility. This is a glimpse that depicts the ambiguity behind these decisions and the classification of a company’s ESG score.

Such hypocrisy has also recently surfaced with Tesla investing 1.5B of their cash in bitcoin. The “sustainable” seeking EV company has come under fire for investing into an asset class which consumes as much electricity as Mexico.

From the graph which depicts investment growth of MSCI KLD 400 Social vs S&P 500, we can observe that the scattering moves almost together. The reason behind this is that most constituents of the index are similar to the one of S&P 500.

To further depict this similarity in constituents we will directly analyze S&P’s ESG Index with the S&P 500. The S&P 500 ESG Index claims to be a broad, market capitalization-weighted index that seeks to measure the performance of securities that meet sustainability criteria, maintaining industry group weightings like those of the S&P 500. As you can see, 6 out of the 10 main constituents of the indexes are the same thus explaining the similarity in performance for these two indexes.

S&P ESG Index

S&P 500

As more investors are attracted to this idea of sustainable investing, experts warn of a potential bubble forming in the ESG ETF fund category. Indeed, ETFs related to ESG have attracted a record of $85 billion across Europe and the US in just 2020, and the funds keep on coming in according to Bloomberg. As so much money has been injected into these strategies, the company’s stocks in these sections are now trading at valuations that are difficult to justify. According to the Director of Global Equity at Eaton Vance, “there is a risk that holdings that populate ESG funds have become overvalued”. Such comments can reflect the position of popular stocks such as Tesla which is trading at a P/E of 156, a multiple value investor would balk at, while some companies make nothing whatsoever. In a sign of the times however, Cathie Wood of ARK Investment Management, recently used the drop in the company’s share price to double down on her bet on the electric vehicle producer.

As a result, there is a legitimate concern that investors chasing the ESG trend could end badly. With the proliferation of free trading platforms resulting in the ‘democratisation’ of the financial markets (something Ken Griffin is no doubt greatly appreciative of), coupled with COVID-19 forcing us to stay at home, many millennials have taken an interest. However, a combination of the misleading assumption that abnormal returns can be generated with ease merely by selecting one asset class, coupled with the encouragement of passive investing, may result in investors blindly placing capital in securities such as ETFs, under the misplaced assumption that they both can generate market beating returns and reflect their ‘woke’ sentiment. This is without recognizing the risks involved with the companies invested through the fund, or little/anything at all about the holdings of such funds.

Passion Valuation, a new model?

With the multiples well within bubble territory in some sections of the market, the term “passion valuation” can be interpreted as a new model. Investors have started looking beyond the fundamentals and aligning themselves with companies they like, or they feel represent their values. This is not only for young investors but also professionals. However, young investors like the idea of owning stocks like “Tesla”, “NIO”, “Palantir”, “GameStop” merely due to the popularity they have and a fear of missing out on easy money. The question is, how sustainable this is in the long run and will it stand the test of fluctuations in the business cycle/when monetary policy tools are less accommodating? We don’t know, but probably not. Although the incredible potential of some of these companies cannot be denied, it is too early to have a full understanding of their growth and prospects, based on fundamentals at least.

Recently, the Gamestop frenzy has shown us how powerful retail investors can be against the industry itself. This may be a sign of what is to come: elevated price-to-earnings ratios as a result of the flood of new retail investors taking their skills and money into the markets with the help of digitalization. But with rising prices come rising risks, thus the importance of transparency and requirement for the right analysis before making decisions. And while it could be argued such instances are insignificant regarding their systemic context, the feedback loop, if it does spill over, could be deadly. In turn, the promotion of ETF’s themselves is not the right tool to assess investment, and it could be argued that funds have opted to sit under the ESG banner for the sole purpose of attracting consumers.

The Value Left Behind

It is also worth noting that while many will lose as a result of such euphoria, it is not all bad news. History shows that those who survive such bubbles tend to be the fittest and most able, and that they may have never got their start at all had it not been for the rampant enthusiasm from investors to back those companies at the time. Granted, many who were backed have fallen on challenging times, with the likes of Flooz and theGlobe to characterize that. However, it is also important to remember that out of those ashes emerged of the biggest companies we have ever seen, namely Amazon, along with household names such as eBay, Qualcomm, and Cisco.

Therefore, while much suffering is guaranteed, there will be beneficiaries. The prices of some notable green energy firms may be stretched to some degree, but this does see them all destined to fail. In fact, any of them could well be the innovators of tomorrow, right at the forefront of a newly emerging trend, just like the internet was in the 90’s.

When will the bubble pop?

If only money came that easily! And while some assets in recent weeks would suggest that outperforming the market is perhaps simpler than history suggests, the jury appears to be out on the extent of the issue we face. On one hand, it could be suggested that the current fiscal conditions are a framework which has enabled the speculation we are currently observing within the financial markets. In turn, it would make sense that when this is removed, and the scarring from the COVID pandemic is laid bare, potentially in the form further economic distress, and when those currently engaged within the financial markets are required to make withdrawals, it will be the companies with the extreme multiples which go first.

In both 2008 and 2000, the catalyst was the tightening of monetary policy, and with record low interest rates and capital flowing with ever more irrationality into equities, and green energy companies in particular, this may once again be the case. However, with central banks committing to low rates for the next twelve months at least, knowing they cannot simply turn their backs on those to whom they promised cheap borrowing costs, these may be here to stay.

However, inflation is the word on the lips of many an economist, as well as those selling Treasuries at a frantic pace. Such an eventuality may give policymakers little option other than to break that pledge if demand does pick up and meets the record levels of liquidity currently observed within the economy, harming the highly levered growth stocks so common within the green energy indexes. And while the Fed are playing it cool for now, some day, inflation will once again have a say in equity valuations, perhaps sooner rather than later if Joe Biden is successful in his bid to add a further $2tn to the debt pile. A steepening yield curve also sees an alternative to equities emerge once again, giving investors a long-awaited excuse to take their thus far healthy profits, and run, either into bonds, or rotate into other unloved sections of the market similar to what we have seen earlier in the year.

So, is there a bubble? Probably, but only tomorrow’s history knows the answer to that. Will there be good that comes out of it? Almost certainly. But if it is indeed a bubble akin to those of the past, the returns of tomorrow will be the opportunity cost of today’s exuberance.

Thank you to Craig McAuley and Maximilian Morte Von Jacobs for your in-depth analysis!

47 views0 comments

Recent Posts

See All