Picking ESG stocks right can create Generational Wealth (and Generational Good)
ESG can be messy yet not all ESG investing is the same. Some offer profitable, once in lifetime opportunities.
ESG is messy. I will keep this simple. F** the Cynics and Analysts. They think they are so much better than you. ESG can make you Rich.
ESG or Environment Social and Governance is a recent theme that is seen as frivolous by "serious men” in Ivory Tower Finance, forgetting that it makes amends for "serious mistakes" made by you Boomer sirs your mistakes.
To understand ESG you need to understand two drivers:
Global Warming as an Extinction Event
New Economics of Welfare Capitalism
ESG is more than a theme or a balanced scorecard or even a disclosure requirement. It is a mega-trend.
And mega-trends make money. M-o-n-e-y. We will discuss finally how to Profit from this megatrend.
Global Warming as an Extinction Event
I am sorry but Global Warming is real sirs. That is not even the issue. The issue is it is coming on really fast. Thanks for nothing.
The global response in turn has taken many confused decades to form a weak consensus, starting with a carbon credit economy, to the focus on per capita carbon and more recent banking rules to maintain a Green Asset Ratio of loans made for sustainable economics versus the bank’s overall lending.
This is a significant subsidy to make credit cheap for ESG companies. But we need to do more. The world over, Capex in renewables is coming online at a feverish pace. The old German carmakers are jostling to get control of Cobalt Mines in DPR Congo, key to the novel Lithium-Ion battery.
New Economics of Welfare Capitalism
“One of history’s few iron laws is that luxuries tend to become necessities and to spawn new obligations.”
― Yuval Noah Harari, Sapiens: A Brief History of Humankind
Under the spectre of Climate Change, Central Bank controlled economies, ageing demographics and the death of Old Capitalism represented by Big Oil, the world order is re-arranging itself into a marriage of Scandinavian Socialism and North American Capitalism, i.e. Welfare Capitalism.
Just see how indoor heating is considered a basic human need in OECD (read rich) nations. Heating has a large carbon footprint, yet remains essential to western civilization. So it is either shifted to renewable energy sources or Greenwashed.
Yes, this is recent. You saw a trailer of Helicopter Money during the Pandemic. As demographics are changing, more people depend on pensions and welfare and automation replaces jobs: people will be paid to play video games and maybe even paid to buy zero-emission Teslas. Honk Honk. Welcome to Clown World.
Welfare Capitalism is here. The next step in social evolution.
The Economics of Welfare Capital will not, can not be ROE or bottom-line driven.
The companies in this new economy will be heavily subsidized, enjoy tax credits, supporting tax regimes in return for “sustainable” carbon-neutral growth aligned with OECD (read rich countries) government policies.
What does all the word spaghetti above mean for the more visio-spatially and numerically inclined?
While Old Economy Profitability was :
Net Profit = Revenue - Operating Expenditure - Depreciation - Interest - Taxes
Giving rise to metrics like EPS and ROE. The New Economy Profitability may be thought of as :
Profit = Projected Annuity Revenue - Operating Expenditure (Subsidized by structural incentives) - Depreciation (Subsidized Capex) - Interest (Subsidized Loans) - Taxes (Subsidized by lower rates)
Note the emphasis on the word Subsidized that we say again and again? This is a new normal and a competitive advantage for many years to come.
Of course in the early years, Depreciation and Interest will be aggressive with the new Capex on Electric Vehicle and Renewable Energy. This will cause poor optical profitability. This is the stage we are at currently.
We are in the Growth stage, which is why Old Ivory Tower Finance that uses residual valuation of projects is lifting their noses at high project costs.
But as discussed before Lending is going to be increasingly subsidized and ring-fenced for Sustainable Business Models, as Banks open the lending tap and Government provides incentives on Taxation and structural changes cause Operating and Capital Expenses to become increasingly economical and on the other hand, Transactional costs will also be subsidized, together with large strategic shifts in industry structure and market share, as we explain in the following section.
Drivers of Wealth Creation
The cost of setting up solar panels has dropped up to 70% in the last decade and 90% in 2 decades. The cost is expected to decline a further 15-20% with economies of scale in production and economic subsidies.
As Electric Mobility replace ICE, the demand for electricity grids and power generation will also increase in turn, which increases demand and the electricity clearing prices, thus improving profitability for renewable power companies.
The situation with high Electric Battery costs is similar and will evolve with battery swaps and other innovations in clean storage and chemical technology.
Early Strategic Size leads to Future Barriers to Entry
Capex is being front-loaded, due to increasing producer confidence that the supportive tax and policy environment will continue. The early movers will enjoy significant advantages not just in cost and tax structures but also in stealing market share from non-ESG compliant incumbents as more and more customers shift to ESG compliant vendors. I am not even talking about lower eventual transaction costs as the ecosystem gains scale and markets are de-regulated, as seen in power trading.
With regards to stealing market share, Tata Steel could better serve Green Steel requirements of European car and appliance manufacturers, and First Solar (NASDAQ: FSLR) solar modules have cash-rich Apple and Microsoft as customers.
Any capex should therefore be seen as a strategic expense.
You can’t “import” renewable energy and utilities will remain an attractive recession-proof and annuity business as renewable energy companies reach steady state.
“Creative Destruction” and “Value Migration”
ESG is New that replaces the Old. Schumpeter’s theory of “Creative Destruction” therefore applies, for example where current Oil and Coal capacities for heating are being replaced completely by Renewable Sources of Energy, and the replacement of ICE engines and platforms by Electric batteries and powertrains.
Global Electricity Distribution and Component Market USD 250 billion.
Global Auto Market USD 2000 billion
Studies show that in the long run, the process of creative destruction accounts for over 50% of productivity growth. This restructuring or value migration from old to new technologies accelerates during recessions, like the one we saw during the Pandemic.
What are we trying to say? While at outset the CAPEX costs and debt may look huge and uneconomical you must think of the opportunity size they are looking to replace and permanently capture.
What to Avoid. The 3 Rules
ESG can be messy. Carbon offsetting is like promising to have a baby for every person you murder.
Rule 1: Avoid ESG Indices. Avoid ESG Funds and ETFs. They are NOT ESG
In the absence of uniform consensus rules and policies, it is a wild-west out there, and sustainability indices are funds are pliable to manipulation.
Rule 2: TRUST NO DEFINITION OF ESG BEYOND *MEMORIZE THIS* ELECTRIC VEHICLES, RENEWABLE ENERGY, RE-CYCLING
Anything else I missed to include into ESG which they say is ESG? Well …
Rule 2 (Our Golden Rule) includes companies across the Renewable, Electric Vehicle and Re-cycling supply chain. Renewable Energy theme includes solar, wind, hydropower, biofuels; Electric Vehicles theme includes battery technology, fuel cells, smart grids, while Re-cycling theme includes battery, rare earth metal and electronics recycling.
If you do not prefer Direct Equity exposure, you can also buy fractional asset ownership in the above themes.
Rule 3: ESG companies with parent companies that are not ESG, and sell stuff like Tobacco, Alcohol, Cola, Natural Leather .. UNLESS They are (Remember Rule 2) Re-cycling it
No ITC. No Philip Morris. Selling cancer sticks with ESG messaging is Hypocrisy, not an ESG.
For their small section of the total listed counters, ESG stocks have outperformed in the last 1 year.
The trend is accelerating. Within the last 6 months, the below Renewable Energy companies feature amongst the top 20 gainers.
Over a much longer timeframe also stocks like Adani Green Energy and globally Tesla have created generational wealth, and over a much shorter time frame, 12 October 2021, to 15 January 2022, as of the date of writing of this piece, Rule 2 stocks have outperformed.
Why is this significant?
Because the Nifty 500 Index has made near 0% gains in the same rough and wobbly period. See a sample of outperformance below:
NOTE: We do not own or recommend these stocks. It is a random sample of names across the market cap spectrum. Point we are making is of the clear, emerging long and near-term outperformance and divergence versus the Index, which suggests their (probable) evolving nature also as defensive stocks in bad periods.
It has been a long argument in writing. In parting
What you must know
Clearly a mega-trend is at play. And the big boys/reptilian/Q/clown world elites want it to continue.
Don’t fret over Investment Accounting. Rule 2 ESG companies are a Liquidity Game, not a ROE Game. They are defensives.
Don’t fret over cash flow investing. Debt and Capex is strategic and will translate into future revenues.
Terminal value of Rule 2 projects will be high as there will be a very liquid market for M&A and PE funding and a large industry life-cycle.
Why you must be careful about
Track receivables and cash flows to the point of liquidation. They are going to be stretched until the companies emerge out of the investment stage.
Land acquisition and project costs. Companies setting up power plants outside the core business of making, say turbine panels or solar components to sell on Amazon.in are going to be subject to vagaries of real estate businesses. Debt should not be focused on real estate or old economy business.
Valuing EV companies on DCF. It is going to be hard to project growth, cashflows, given the early investment stages and also the terminal value. It is preferable to use Sum of the Parts or closely track multiples in private market deals.