Cleantech Index weathers stormy market

The first quarter of 2008 saw the global equity market correction that began in the autumn of 2007 accelerate. The turmoil in the global credit markets and resurgence of both inflation and fears of a recession continue to push global debt and equity markets sharply lower, especially in January and February.

Especially hard hit were the technology, financial, and housing-related sectors, as well as emerging markets such as India (-28.6%) and China (29%) where bears are officially on the prowl. Even Germany (-19%) and Japan (18.2%) approached bear territory.

Of course, the Cleantech Index (CTIUS) was not immune to such macro forces either, and slid 13.6%. Yet despite having only 46 stocks and significant technology sector exposure, CTIUS outperformed the NASDAQ Composite Index (down 14.1%) and outperformed nearly all the ‘alternative’ energy indices which fell approximately 18-30%. The S&P 500 was down 9.9% and the Russell 2000 Index fell 10.2%.

I credit the ‘outperformance’ primarily to two factors: diversity and quality. I'll detail both of these, below. But first, some specific performance notes.

Power Flickers

The quarter saw the solar sector give back hefty of some of its incredible 2007 gains, though they began to rally strongly in late March.

This was particularly true for solar photovoltaic stocks such as Suntech Power (-50.7%), LDK Solar and SunPower (-59.2%). LDK has since turned in very strong earnings. Thin-film solar stocks First Solar (-13.5%) and Energy Conversion Devices (-11.1%) fared considerably better as it has become increasing apparent that the market demand for thin film solar will far outstrip supply for the next several years—which is a more promising forecast that for traditional solar PV sector.

Newly public demand-response/energy management companies EnerNOC and Comverge had a dreadful quarter, plunging 76.8% and 67.2% respectively. Both companies began to project that profitability will be significantly lower or further away than investors expected and EnerNOC, in particular, has displayed some difficulties managing its rapid growth.

In addition, growing concerns about barriers to entry and the relative value of demand response and aggregation solutions compared to energy-efficiency investments seems to have knocked the froth off the market. This is not to say it won’t be a good market, but companies will now have to deliver strong results to appease investors.

Primarily due to its floated market cap decline, EnerNOC was dropped from CTIUS at quarter end and replaced by Spain’s Telvent. Telvent not only provides exposure to the IT services needed to manage energy transmission, but also to intelligent transportation systems, real-time environmental monitoring, water management and other niche cleantech IT services.

Also leaving the Index were International Rectifier (-36.7%) primarily due to corporate governance concerns, and Power-One (-19.5%) due to capitalization and worsening earnings prospects. These companies were replaced in CTIUS by Power Integrations, which we feel has a better strategic position in the power electronics/efficiency business and better represents the cleantech growth trend.

Yes, There Were Winners

The common factor driving strong performance of the CTIUS’ top gainers was the delivery of impressive earnings results: Lindsay Manufacturing (+50%), Polypore (+24.6%), Clean Harbors (+25.7%) and Martek Bioscience (+4.8). That the quarter’s winners were in completely different businesses again points to the value of diversification.

Long-term Index Strategy

CTIUS’ diversity and quality helped it do relatively well in a declining stock market relative to narrow alternative energy ETFs. Its controls on company weights and quarterly rebalancing also helped keep it from being over-exposed to previously hot stocks or sectors such as solar photovoltaics.

As a caveat, I don’t assert that CTIUS-based funds are always the best choice. For investors that seek a high correlation with the movements of a narrow industry subsector and high volatility, CTIUS-based investments are probably not ideal. In comparison to some of the narrow alternative energy sector indices, CTIUS is not as well-suited for basing short-term investments or short selling, which would explain some of the popularity of the alternative energy ETFs, among others.

I assert that the long-term advantage of CTIUS over narrowly-focused alternative energy indices is based on our active screening process and historic parallels. Actively screening for the best companies—those most likely to survive, drive and profit from innovation/change across all sectors—not only leads to an Index with higher investment merit, but also an index that tracks the global cleantech growth trend and not the fate of a narrow sector.

High-growth markets and those with rapid technological advances and changing standards typically have many initial companies, but few survivors. For example:

• During the roaring ‘20s, there were hundreds of U.S. & British automakers, yet by mid-1929 more than 70% were gone. A composite or broad index of the entire automaker sector would have faired poorly. The same could be said about makers of mainframe computers, PCs, Internet service providers, B2B procurement software, etc. As a result, the performance of winning companies was offset by the losers and the huge growth of the auto sector was not reflected.
• It would be naïve to assume that booming subsectors such as solar photovoltaics and biofuels won’t follow a similar path. Despite the massive market ahead, most companies will either not survive, or not earn good returns. A few will likely be very profitable.

Actively screening for the best companies is essential. Investments based on narrow sector or sector composite indices make unattractive long-term holdings.

Moreover, many of the narrow subsectors, whether it be water or alternative energy, lack sufficient quality and diversity of companies to build a usable index. This pressures index managers to include a number of lesser-quality companies, ones with limited sector exposure, or even ones that are environmentally harmful (e.g., grain ethanol.) When the narrower sectors consolidate, those pressures soar.

Industry subsectors run hot and cold, but the demand growth for cleantech solutions to address the massive problems the planet faces is not only unstoppable, it’s accelerating.

To apply the momentum investor’s motto more accurately, I would say “the trend is your friend.” So by tracking cleantech growth trend and not a narrow sector, I expect to deliver investors better risk-adjusted, long-term returns.

Thoughts or theories to the contrary? I'm all ears.

Rafael Coven is Index Advisor and Managing Partner of Cleantech Indices. He runs the market-leading Cleantech Index (CTIUS) of publicly-traded cleantech companies, tracked by the PowerShares Cleantech Portfolio and KSM Cleantech Index exchange-traded funds (ETFs). View the historical performance of the CTIUS Index here. Rafael has spent most of the last 21 years in cleantech as a manager, entrepreneur, equity investor, and management consultant.