WorldWatch
2023 has been a perfect storm for environmental equities generally, and our investable universe in particular. But as we head into 2024, many of these headwinds are easing and a far brighter outlook beckons. In this piece we outline why, before illustrating that we have record-high upside in our portfolio by discussing five holdings that we believe could double over the next three years.
The most challenging factor in 2023 was undoubtedly the continued rise in bond yields, which intensified over the summer, causing a substantial derating for many Growth equities. Whilst we are proactive in diversifying the portfolio’s factor exposure, environmental equities are inherently skewed towards Growth, irrespective of how the universe is defined.
The second major headwind has been the economic cycle. As a solutions strategy, our universe has significant exposure to industrial companies that are manufacturing products to solve environmental problems. Although these industrial businesses have structural growth drivers, they also often operate in cyclical end markets that have been weak amid a general economic slowdown. For example, the compelling environmental benefits of insulating buildings should be a structural tailwind for insulation producers, but these companies also tend to operate in construction markets that have been impacted by the sharp rise in interest rates.
Meanwhile, within the Industrials sector the strategy has been overweight Europe, where economic activity has been the weakest, while being underweight the US, where the economy has thus far been more resilient. The rationale for this positioning is that valuation discounts in Europe are substantial relative to the US, often for higher quality businesses, but it has been a drag on performance in the near term.
Finally, there has been sharp underperformance of small- and mid-cap equities versus large- and mega-caps. Although we are an all-cap portfolio, we typically find the most exciting structural opportunities in the smid-cap space, which has been hit disproportionately hard by rising rates and a mega-cap dominated market.
So why are we more optimistic about 2024?
Whilst we can't state definitively that we have witnessed the peak in bond yields in this cycle, we can assert with some confidence that the worst is behind us, given that US 10-year yields have risen from 0.5% in the summer of 2020 to 5% in October of this year. In fact, as economic and inflation data begin to soften, bond yields have already started to ease back. This is a trend that may well continue, which would be positive for equities in general, and particularly for valuations of Growth stocks in the environmental universe. We also believe that stable yields could help reverse the aforementioned underperformance of smid-caps versus large- and mega-caps.
It is a similar story with regard to the economic cycle. Although we may not be entirely out of the woods, the downturn in Europe – where our exposure is greatest – is well advanced. This means that earnings expectations have already recalibrated at a far lower level to factor in the weak macro backdrop. Moreover, many valuations of cyclical stocks are at trough levels. A trough in both valuation multiples and earnings often precedes a period of very strong investment returns as share price appreciation is driven by a concurrent rerating and earnings recovery. We see plenty of such opportunities in the portfolio right now.It is not just traditional
cyclicals that have seen negative earnings cycles. For example, there are many ingredients names in our universe, some of
which we own, that tap into environmental themes such as food waste.
Traditionally the ingredients space has displayed relatively low cyclicality as
it sells into defensive end markets such as consumer staples. However, over the
last 12-18 months the sector has seen a major inventory cycle. Following covid,
businesses looked to build buffer stocks amid challenged supply chains, but
more recently as bloated inventories met weaker demand, there has been
substantial destocking. Ingredients companies have therefore seen volume
declines that eclipse those experienced during the Great Financial Crisis.
Again however, this challenging trend has now largely played out.
This leaves us in a situation where headwinds appear to be easing, and valuations across our entire universe have seen a very material decline. We track the average upside to price targets across the portfolio and it has never been higher, averaging over 50%, and these are price targets that have already incorporated a permanently higher cost of capital and tough macro backdrop.
The disconnect between current and intrinsic valuations looks even more irrational when you consider that the structural outlook for our investment universe has never looked brighter. Indeed, there is a growing awareness of the need to accelerate every aspect of the green transition, reinforced by substantial environmental policy support that has been put in place over the last few years.
To give you a flavour of the upside we see across our portfolio, we have picked 5 stocks below that we believe have the potential to double over the next 3 years. To be clear, we could list many more portfolio holdings that also fulfil that criteria, but have selected these names to showcase the breadth of the current opportunity set across different industries, regions and styles of investment.
KWS
What does the company do?
Founded in 1856, KWS is one of the few remaining independent seed technology companies in the world. It is the market leader in sugarbeet, with a global share of over 65%, and correspondingly high margins and returns on invested capital. In addition, it has profitable niche presences in cereals (rapeseed, rye, barley) and corn (particularly in Brazilian ‘safrinha’ crop corn). Seed development is a lengthy process, with new varietals often taking a decade to come to market; KWS’s family ownership and commitment to R&D (spending is typically in the high teens as a percentage of revenue) make it well placed to prosper in such an industry.
Why can the shares double?
KWS is trading at approximately 11x
forward earnings, compared to a 5-year average multiple of 16x. Moreover, as
KWS restores profitability in corn, builds out its nascent vegetable seeds
business and consolidates in cereals, we expect improving margins to drive
earnings growth and improving ROIC. The stock has derated largely due to
unfavourable market conditions for small-caps, as well as negativity toward the
agri
sector, given deteriorating farmer economics. This is despite the fact that KWS’s core end crop, sugar,
remains at very healthy price levels.
How does it help the planet?
KWS’s products have a number of environmental benefits including: consistent agricultural yield enhancements; reduced chemical applications; and climate adaptation. KWS’s yield enhancements have allowed productivity to increase by over 1.5% per annum due to seeds alone. This in turn is helping to reduce the acreage required for sugarbeet planting, whilst output continues to rise. KWS’s Conviso SMART sugarbeet seed has been developed to require significantly fewer chemical applications, while new products such as ‘Maruscha’ are Virus Yellows tolerant. The EU aims to reduce chemical inputs by 50% by 2030, which requires increasingly sophisticated seeds to respond to biotic and abiotic threats. KWS is well placed in this regard as it aims to spend over 30% of its R&D budget on targeting the reduction of inputs. Its hybrid crops such as hybrid-rye are proving very popular because of their drought resistance, allowing farmers to attain acceptable yields even in a more climate-stressed world.
What’s the biggest risk?
A sharp deterioration in sugarbeet grower economics would limit their willingness and ability to pay higher prices for improved seed varietals.
Serena
What does the company do?
Formerly Omega Energia, Serena operates 2.4 Gigawatt (GW) of renewable energy capacity, with a further 0.35GW under construction. The vast majority of this capacity is onshore wind, with the balance being solar. Brazil benefits from some of the most consistently high onshore wind speeds in the world, supporting project profitability; Serena’s recent Assurua 4 project has an anticipated load factor of above 60%. The company benefits from long-duration, inflation-linked contracts covering over 96% of its output until 2032. We believe that Serena’s contract structure is almost without parallel amongst its renewable genco peers. Anticipating the liberalisation of the Brazilian energy market, Serena has been building a trading and sales platform, and aims to reach 20,000 customers by the end of 2025, up from 1,000 currently. Serena’s largest shareholder is private equity group Actis, which completed its purchase through a primary capital raise in December 2022 at a premium of over 60% to the current share price.
Why can the shares double?
Serena is emerging from a period of intensive capital deployment; the company will end 2023 with 2.75GW of operating capacity, having begun the year at below 2GW. As such it is entering a phase of rapid deleveraging; Net Debt/EBITDA at the consolidated level (including debt for pre-operational projects) declined to 6.2x in 3Q23 from 6.8x in 2Q23. We expect it to continue falling to c.4.5x by the end of 2025 as capex declines to near zero and EBITDA inflects to c.BRL2bn per annum. At the current share price, we see Serena trading on 7x EV/EBITDA (forward) versus a 5-year average multiple of 11.4x. The shares therefore currently appear to be pricing in an extremely attractive real equity IRR in the low-teens.
How does it help the planet?
Serena exclusively develops 100% renewable energy projects and has been instrumental in building out Brazil’s onshore wind industry. The company aspires to continue growing at a 20% volume CAGR in the future. MSCI gives the company an ‘A’ ESG rating.
What’s the biggest risk?
Brazilian interest rates remain high, and could rise further if US rates do. This would disproportionately impact the valuation of long-duration, leveraged equities like Serena.
Cadeler
What does the company do?
Cadeler was established in 2008 and operated under Swire Blue Ocean from 2010-2020. It owns and operates a fleet of self-propelled jack up vessels with the ability to install wind turbines and foundations. These unique maritime assets can also be deployed for maintenance work on turbines. Cadeler operates in a major bottleneck for its clients, providing mission-critical installation that has substantial time value for customers due to the long-lived nature of the infrastructure being installed (>20 years). The company’s track record and relationships within the industry make it the supplier of choice for almost any offshore wind farm developer, and it is widely recognised as having not only the best assets, but also the best team that deliver the desired outcome at a lower risk. This team is led by CEO Mikkel Gleerup and backed by BW Group owner and Cadeler Chairman Andreas Sohmen Pao. Since its establishment, Cadeler has installed 8.3GW of wind power, comprising 528 foundations and 668 turbines.
Why can the shares double?
Cadeler is trading at a discount to NAV of over 60%, despite its NAV being backed by Free Cash rather than accruals. In fact, we estimate that by 2026, Cadeler will offer a 70% Free Cash Flow Yield. We believe that a powerful mix of operational and financial leverage will drive accelerated growth in the equity, with Cadeler being net cash in 2028 and having a negative Enterprise Value by 2030. In our view, the current valuation is discounting business outcomes that are far too pessimistic. The price appears to reflect an existential crisis in the future of offshore wind. However, the reality is that offshore wind remains a viable and necessary part of the electrification agenda. Whilst the froth of aggressively priced contracts and reckless risk taking by overzealous developers is being washed away, disciplined capital continues to be deployed. Meanwhile, power prices are being reset in favour of the developers in major markets, and political commitments are likely to be upheld as they will remain under the microscope during a very busy election calendar in 2024. This confluence of sentiment- and market-based factors creates an exciting backdrop for Cadeler at a very discounted valuation.
How does it help the planet?
The offshore wind industry cannot grow and help the planet decarbonise if there are no vessels to install the turbines and foundations they rest on. At the leading edge where windfarms are moving further offshore towards greater wind resources, using larger turbines and operating at greater seabed depths, the pool of capable players that can conduct installation work is very limited, with Cadeler being the clear leader. The company is a key facilitator of wind power, and is addressing an acute bottleneck for the industry, helping it to achieve its potential.
What’s the biggest risk?
Competitors place orders for an excessive amount of vessels. Whilst this would require enormous capital outlays ($400m per vessel) and a long lead time for construction (currently 4 years), eventually it would undermine Cadeler’s captive market and reduce earnings power and cash flow in later years.
Smurfit Kappa
What does the company do?
Smurfit Kappa is one of the leading providers of paper-based packaging in the world, and Europe’s largest producer of corrugated packaging. The company has an excellent track record of returns, and has seen margins and ROCE improve through the cycle as it has continued to restructure the business, improve productivity and efficiency, and deployed organic capex at attractive returns. Smurfit has recently announced a combination with US peer WestRock. This should provide an opportunity for Smurfit’s highly regarded management team to enhance returns through synergies and operational improvements.
Why can the shares double?
On a proforma basis, including announced cost synergies, the combined entity is trading close to a trough multiple for Smurfit Kappa of around 5.5x EBITDA. This is at a time when profits are cyclically depressed, given declining volumes on both sides of the Atlantic, caused by a combination of slower demand due to weak economies and industry destocking, as well as a partial unwind of the sharp price increases seen in recent years. A trough in both valuations and earnings often precedes a period of very strong investment returns as share price appreciation is driven by a concurrent rerating and earnings recovery. Putting the stock on a 10-year average multiple in 3 years’ time would deliver >100% total shareholder return over that period, although one could argue that a 10-year average multiple is conservative, given the structural improvement that the business is seeing.
How does it help the planet?
Smurfit’s products are 100% renewable and produced sustainably. They provide an important alternative to plastic packaging, which is highly damaging to the environment. Paper-based packaging has the highest recycling rate of all packaging materials, and as part of the paper supply chain, Smurfit is heavily involved in recycling. Recycled fibres make up 76% of Smurfit’s primary raw material, with the remaining 24% being sustainable virgin wood fibres, and Smurfit handles 8 million tonnes of recovered paper and board each year.
What’s the biggest risk?
Integrating WestRock clearly comes with execution risk as this is a combination of two large businesses focussed respectively on Europe and the Americas.
Infineon
What does the company do?
Infineon is a German semiconductor company that was spun off from Siemens AG in 1999. Its products serve a number of end markets such as automotive, industrial power, communications and consumer electronics. Infineon is known for its expertise in power semiconductors, which are crucial for controlling and managing power in various electronic systems. Power semiconductors account for ~55% of group revenues, placing Infineon as the clear global market leader, with over 20% share in power discretes and modules.
Why can the shares double?
Infineon is trading at approximately 14x forward earnings, compared to a 5-year average of 20x. The stock has derated largely on macroeconomic concerns and a perception of excess inventories in the semiconductor supply chain. However, we believe this view fails to reflect the strong competitive positioning and structural growth drivers in the Infineon portfolio. As these growth drivers become a larger proportion of group earnings, the stock should trade in line or at a premium to its historic valuation. Moreover, these growth drivers such as e-mobility, renewables, ADAS and AI should enable Infineon to grow group revenues at over 10% through the cycle, with correspondingly higher margins. The combination of multiple rerating and significant earnings growth should enable the stock to double.
How does it help the planet?
Infineon’s products are critical in enabling electrification for applications such as renewable energy generation and electric vehicles. Revenues from these two sources currently account for ~20% of turnover, but are expected to increase to more than a third over the next few years. We are particularly excited by Infineon’s silicon carbide portfolio. Electric vehicle inverters using this technology will have superior energy efficiency, resulting in emissions savings and fast charging capabilities, which should help drive further penetration of EVs. We believe that there is a strong possibility that Infineon can replicate the success it has had in silicon insulated-gate bipolar transistors with its SiC portfolio. MSCI gives the company an ‘AA’ ESG rating, supporting our view that Infineon is contributing to a sustainable society.
What’s the biggest risk?
China accounts for approximately 25% of Infineon’s revenues as it has a strong position in power semiconductor solutions for automotive and industrial applications in the country. Chinese domestic manufacturers of semiconductors are attempting to ramp up and increase the quality of their solutions, which could lead to market share loss for Infineon, particular as China encourages domestication of strategic supply chains. This would lead to earnings shortfall risk, as well as a potential multiple derating as Infineon’s growth prospects are reappraised.We hope that the examples above
illustrate how optimistic we are on the portfolio in the medium term. If you
would like any more information on the strategy, please get in touch with your local relationship manager
using the contact details below.
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