Essex Global Environmental Opportunities Strategy (GEOS) January 2023 Update
To say 2022 was a difficult year for the global capital markets would be an understatement. The fourth quarter of 2022 was off to a better start, with positive returns for October and November. With December came selling pressure as the market focused on macro factors versus corporate fundamentals, exacerbated by technical trading and tax loss selling. As we enter 2023, while the global macro environment remains uncertain, we are constructive on our Essex Global Environmental Opportunities Strategy (GEOS) investment objective as we happily close the proverbial books on 2022.
2022 was an eventful year for ESG investing. The SEC proposed two ESG-related rules, with one focusing on corporate climate disclosures and the other seeking to enhance ESG disclosure transparency for ESG funds. It is still unclear how the climate-related disclosure rule, which attracted thousands of comment letters, will address scope 3 emissions, but both are expected to be finalized in 2023. ESG investing became a common topic in political discourse throughout the year as well. Republican lawmakers and attorney generals pushed back against ESG integration by asset managers, framing ESG investing as sacrificing performance to advance social goals. This led to several states, including Texas and Florida, proposing rules that restrict state pensions from doing business with asset managers that integrate ESG factors or have associations with certain ESG organizations. On the other end of the spectrum, Democrats challenged asset managers for not doing enough to push companies to reduce greenhouse gas emissions and transition away from fossil fuels. Finally, the 27th Conference of the Parties, or COP27, was held in Egypt in November. COP27 was framed as the “implementation COP”, a reference to the Conference’s focus on ensuring countries work to achieve their previously announced net-zero goals and climate financing commitments. While there were fewer headlines from COP27 compared to COP26, we believe countries and stakeholders should focus on achieving their previously announced net-zero goals in 2023 using the cost-effective clean technologies available today.
We believe GEOS is well positioned despite the scrutiny of ESG investing in 2022. Our approach is intentional and clear: we identify and invest in companies providing environmental solutions that positively impact society. Our thematic ESG approach is differentiated compared to most ESG strategies available since we explicitly focus on solutions to environmental challenges and do not use ESG ratings. Many other ESG strategies only integrate ESG factors, frequently using ESG ratings, to mitigate potential risks, but fail to adequately consider the investment opportunities associated with the low carbon transition. We believe companies providing environmental solutions will grow revenue and earnings faster than the market and view the low carbon transition as the investment megatrend of our generation. To highlight our differentiated approach, we published several insights and white papers throughout the year on various topics including managing portfolio climate risk (link), sustainable agriculture (link), and climate adaptation (link and link).
The GEOS team engaged with many portfolio holdings on ESG issues throughout 2022. While we believe all companies in our portfolio are well positioned to capitalize on environmental opportunities, strong management of internal ESG issues like human capital management, diversity, and physical climate risk are important to maximize long-term financial performance. Engagements provide an opportunity to convey our view of material ESG issues that companies should prioritize. In addition, engagement dialogues facilitate opportunities to learn from companies about how they are managing ESG issues and improving ESG performance. As we have often stated, there is no perfect company, and ESG progress is a long, intentional journey.
As we look to 2023, one could easily get caught up in the consensus forecast that global economies are headed to recession, the result of central bank engineering to slow inflation by raising interest rates. We know that liquidity has been squeezed rapidly from financial systems – easy money is a thing of the past. That does not mean one should put their head in the sand and avoid investing in equities. What is not obsolete is the ability for differentiated companies to drive growth – this is the case across market environments yet is dependent on several factors:
Commercial viability – we have often stated that we don’t invest in lab experiments. A company with commercial viability has a differentiated technology or service which is experiencing adoption because it makes economic sense. The offering is scaling because it saves resources – money, or inputs such as less energy, materials, water or labor. GEOS invests in clean technologies, which we have described as “doing more with less”, enabling our economies to scale with fewer resources. If a company provides a commercially viable technology, growth and profitability should result with strong financial discipline.
Discipline – we have emphasized the importance of financial discipline and look to a firm’s returns on investment. A company which is struggling to scale may have to constantly find capital in the forms of loans or equity offerings which dilute shareholders. Ineffective capital discipline could cause excessive cash “burn”, which, when coupled with a technology which is struggling to scale commercially will cause an excessive debt burden and leverage. Effective discipline leads to optimal allocations of capital – a balance between investing for growth, such as research and development, or hiring, versus capital retention for periods of uncertainty, such as longer sales cycles. Discipline can take the form of capital and financial discipline, but also strong operational governance – knowing how to bring a new offering to the right market is key, and avoids expensive missteps. The clean tech arena is littered with companies that have strong potential offerings yet may stumble when trying to scale manufacturing.
Catalysts – this is more than being in the right place at the right time. What is the market dynamic? What is the global, federal or local regulatory environment? What are consumer or demographic trends?
We believe we are entering an exciting era for clean technology investment. As we reflect on the decade+ we have been focused on GEOS, we have experienced some companies that are not commercially viable, with some execution problems exacerbated by a lack of catalysts and discipline. This experience is what makes a portfolio manager, and an investment strategy. Our GEOS investment objective and process has been consistent. What we have honed is using our experience to further focus on companies providing profitable growth across our nine GEOS themes. As the market stares into the abyss of 2023, we have never been more constructive and excited on the opportunities for clean tech. Our companies are experiencing commercial viability – the offerings reflected by the GEOS holdings are taking share and growing because they are solving problems from water to electrical grid quality. Currently more than ever, discipline matters. We believe strongly our companies can execute in this competitive arena. And lastly, the catalysts for clean technology have never been stronger. We believe the IRA plan (link) here in the U.S. or the energy-crisis induced RePower E.U. plan provide strong and long-term incentives to enable the new energy economy. We look forward to meeting with you this year, to provide many examples of our GEOS holdings that we believe meet this key criteria.
Disclosures:
This commentary is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. The opinions and analyses expressed in this commentary are based on Essex Investment Management LLC’s (“Essex”) research and professional experience and are expressed as of the date of its release. Certain information expressed represents an assessment at a specific point in time and is not intended to be a forecast or guarantee of future results, nor is intended to speak to any future periods. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties.
This does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product, nor does it constitute a recommendation to invest in any particular security. An investment in securities is speculative and involves a high degree of risk and could result in the loss of all or a substantial portion of the amount invested. There can be no assurance that the strategy described herein will meet its objectives generally or avoid losses. Essex makes no warranty or representation, expressed or implied; nor does Essex accept any liability, with respect to the information and data set forth herein, and Essex specifically disclaims any duty to update any of the information and data contained in the commentary. This information and data does not constitute legal, tax, account, investment or other professional advice. Essex being registered by the SEC does not imply a certain level of skill or training.
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