Sustainability – Washington Square Capital Management

2019 Investment Themes: Bear Market Blues

By subir | January 10, 2019

Dear Friends,

We hope you’ve had a restful holiday season with family and a pleasant start to the New Year.

The fourth quarter of 2018 saw steep declines in US stocks, with certain indices entering bear markets (20% below their highs). Amid these moves, the Federal Reserve followed through on broadly held expectations and raised its benchmark Fed Funds rate to 2.5%. Taking a longer view, it’s clear the post 2000 era has been unusual. From 1962 to 2000, the Federal Reserve had never lowered rates below 2.5%. Since 2000, rates have remained below 2.5% for 15 of the last 18 years. Extremely low interest rates were made feasible by the near disappearance of inflationary pressure in the US. Prices for most manufactured goods have been kept low for over two decades as manufacturing was outsourced and large Asian populations were integrated into global industrial production. This multi-decade trend has allowed US and European central banks keep interest rates at historic lows without triggering inflation. Absent a dramatic reversal in global trade policy, we do believe this long-term trend will continue. In the near term, the Fed chairman has signaled two more interest rate hikes are expected in 2019 which would take the benchmark rate to 3%. We believe the Fed is more likely than not to follow through on these hikes, for two reasons:

1. Q4 saw unprecedented pressure from the White House on the Federal Reserve to avoid a rate hike. This included rumors that the president had sought to dismiss chairman Powell in an attempt to influence interest policy. The White House does not have the authority to dismiss the chairman except for cause, and we believe the Fed will be keen to demonstrate its independence by following through on its previously broadcast intentions.
2. Fed governors are well aware that recessionary risks are high in 2019. If the Fed Funds peaked at 3%, the Fed would have more room to respond to a downturn using rate cuts alone. We believe Fed governors would prefer to use interest rates to respond to the next recession, rather than a revival of the unprecedented Quantitative Easing (QE) program put in place in 2008.

Normalized rates, trade disputes, a faltering Chinese economy, and concerns about asset valuations in a long-running US bull market combined to deliver a very volatile stock market in December. Stepping back to get a wider perspective, we are nearly ten years into an exceptionally long bull market. Several risks to economic growth materialized over 2018. Central banks globally have pulled back from the exceptional liquidity programs adopted after the financial crisis. These factors combine to create a less forgiving investment environment and makes a so-called soft-landing less likely. In our view, the underlying risks to the US and global economy advocate for continued caution on the part of investors. As always, long-term opportunities will present themselves in choppy markets and we intend to capitalize on them when they do.

We have enclosed our 2019 investment themes as well as a review of our 2018 themes. We hope to have an opportunity to discuss them with you in the near future.

Regards,

Subir Grewal, CFA, CFP Louis Berger

2019 Economic Themes: Return of the Bear

Bear Market Comes out of Hibernation. 2018 saw a major speed bump in the nearly 10 year global bull market run in stocks. We contend this reversal gains steam this year as stocks globally will finish 2019 in firmly negative territory. Trade wars, rising interest rates, inflated asset valuations, and a general slowdown in economic activity will contribute to a “risk-off” environment where investors prefer protection over speculation.
Peak Interest Rates. In December of 2015, after seven years of 0% interest rate policy, the Federal Reserve shifted course and slowly began to raise interest rates in 0.25% increments. At the start of 2019, the effective target rate stands at 2.25%-2.50%. While the Fed has signaled a continuation of rate hikes this year and into 2020, we think rates will peak in 2019 and the Fed will pause before potentially cutting rates if/when a recession materializes. We do not think the Fed will raise past 3% in this year.
Unemployment Rises. 2018 saw the US unemployment rate reach a 49-year low of 3.7%. The US economy has come a long way since unemployment peaked at 10% in October 2009. That said, this expansion cycle looks due for a reversal and we expect the unemployment rate will climb back over 4% in 2019.
Investors Want Value. Since 2009, US growth stocks have outperformed US value stocks in seven of those ten years (including three of the last four). We believe value will outperform growth this year as economic expansion slows and investors shift investment capital into more defensive sectors.

The Unwinnable War. Despite rhetoric from president Trump that trade wars are “easy to win” and a March 1 deadline to resolve the US/China trade dispute, we see no quick and easy resolution to this fiasco. We see 2019 ending with some measure of tariffs still in place, continued global hostility towards the Trump administration and ongoing damage to the US reputation and economy.
Real Estate Reckoning. 2018 saw residential real estate prices finally eclipse the peak reached before the credit crisis. The S&P/Case-Shiller 20 City Composite Home Price index peaked in April 2006 and didn’t reach a bottom until March 2012. Since then, it has seen a nearly 7 year uninterrupted run-up of higher prices. We think this streak comes to an end in 2019 and the index will finish the year lower.
Oil Prices Flounder. After peaking at $86.07 on 10/4/18, Brent Crude oil prices tanked in Q4, finishing the year at $51.49 per barrel. While there may be a short term bounce in prices to start the year, we believe Brent Crude will dip below $50 per barrel and finish the year under that level as global trade slows and energy consumption slackens.
High Times for the Cannabis Industry. In recent years, marijuana has made a steady push into the mainstream as several US states and a few countries have passed legislation to legalize recreational consumption. A nascent industry has emerged to service this growing demand. Many of these companies are small, regional operators, but recently, larger and better-financed corporations have entered the space with many becoming publicly traded entities. While the road has been rocky and the sector has seen large price swings, we think this is an industry poised for long term growth. We expect 2019 will bring more legislation to expand the recreational market and more investments from multinational conglomerates (2018 saw Altria and Constellation Brands invest in the space). We expect publicly traded marijuana stocks will outperform consumer discretionary stocks in 2019.
China Stumbles. Over the course of 2018, we saw several worrying signs that the Chinese economy is slowing. Property prices, which have propped up all other assets for years have slowed, and there are numerous reports that several non-bank lenders have halted redemptions. The trade war with the US has also been a major drag on the economy. 2018 was a terrible year for Chinese stocks — the S&P China Composite index returned -27.82% — and while some investors expect a bounce-back year, we believe 2019 will continue to be a flat to negative market for Chinese equities. The Shanghai Composite remains around 2,500. This is less than half the 5,178 level reached in 2015, which was lower than its all time high of 5,800 in 2007.
Battery Power. A long-term trend we are highlighting in our thinking for 2019 is the growth of plug-in electric vehicles. Roughly 2 million four wheel electric vehicles were sold in 2018. US sales of EVs represented over 1% of total vehicle sales. In California, the largest passenger vehicle market, EV were 4% of all vehicles sold spurred by tax incentives and emissions targets. When we include plug-in hybrid electric vehicles, EV sales account for over 7% of all vehicle sales in California. These figures portend a long-term shift in the transportation industry, of the same degree as driverless cars. 10 years from now, we expect 25% of the world’s vehicle fleet to be battery powered. Over the long-term, this implies a very difficult environment for the oil and gas industry. We expect EV sales to continue to grow in 2019, and global liquid fuels growth to be below 1.3%.

Review of 2018 Investment Themes

By subir | January 10, 2019

2018 was an uneven year for our market predictions. We were right on six calls and wrong on four calls. While we were right about the general market direction, a few of our sector specific calls were off the mark.

Slow But Steady Rate Rise: We expect the Fed to maintain the normalization plan and continue tightening rates in 2018 with the Fed Funds rate ending the year in the 2%-2.5% range. The Fed started 2018 with a target interest rate of 1.25%-1.50%, raised rates four times by 0.25% to finish the year with a target rate of 2.25%-2.50%. This was precisely in the range we expected.
Year of the Donkey: We expect the mid-year election of 2018 to mark a sharp reversal for Republicans, who currently control all three branches of federal government. The 2018 midterm elections resulted in a sharp rebuke to the Republican agenda. Democrats won the House popular vote by a whopping 8.6% and had a net gain of 40 House seats, taking back control of the House of Representatives. They also had a net gain of seven governorships and six state legislative chambers.
The Bull Runs Out of Steam: We expect 2018 to be a difficult year for equities markets given the extremely high levels attained over the past two years. After a fast start in January, 2018 turned into a down year globally for stocks. In the US, large caps fared best as the S&P 500 index finished the year at -4.38%. Mid caps were hit harder as the S&P MidCap 400 index returned -11.08%. Small Cap value stocks brought up the rear in the US as the S&P 600 Value index returned -12.64%. International stocks lagged the US as the FTSE All World (Ex-US) index returned -14.13%.
Rise of the Machines: As we did in 2017, we expect AI/Automation stocks to outperform consumer discretionary stocks. While we strongly believe Artificial Intelligence and Automation companies will be integral to the global economy in years to come, 2018 saw stocks in this sector hit a speed bump as investors sold off more speculative technology names. The Global Robotics and Automation index finished the year at -20.92% while the S&P Global Consumer Discretionary index returned -6.24%.
International Beats Domestic: We expect international stocks, especially European markets, to outperform the US in 2018. We were flat out wrong on this call. International stocks fared worse than US stocks in 2018, with European stocks performing particularly poorly. The S&P 500 index posted a return of -4.38%, the FTSE All World (Ex-US) index returned -14.13% while the MSCI EMU index returned -16.90%.
Bitcoin Bust: Bitcoin prices themselves are in a speculative bubble which we expect will reset in 2018. Bitcoin’s meteroic rise in 2017 saw a sharp reversal in 2018 as speculators fled en masse. Bitcoin opened 2018 at $13,444.88 per coin, but finished the year at $3,880.15 per coin, a drop of 73.70%.
Renewables Redux: 2017 saw renewable energy YieldCos outperform conventional fossil-fuel based electric utilities. We expect this trend to continue through 2018. While we strongly believe in the long term prospects of renewable power, YieldCo stocks trailed conventional utilities for a variety of reasons: energy prices fell (because of higher up-front costs, YieldCos tend to be more attractive when energy prices are high) and a flight to safety from investors (conventional utilities are a popular safe haven in times of market volatility). The INDXX Global YieldCo index finished the year -4.98% while the S&P Global 1200 Utilities Sector index was up 1.69%.
Organics Go Mainstream: We think organic food stocks will outperform conventional food stocks this year. 2018 was a tough year for packaged food stocks across the board. That said, organic companies performed notably worse than conventional food companies. The MSCI World Food Products index returned -12.99% while the Solactive Organic Food index returned -26.61%.
New Dawn of Space Race: 2018 will see a number of commercial space ventures mark milestones, including manned-flight into low-earth orbit and potentially a lunar orbital space tourism mission. 2018 saw several space related milestones. The highest profile was a successful test launch for SpaceX’s Falcon Heavy rocket, which placed a car in a helio-centric orbit that takes it past Mars. Virgin Galactic completed testing a craft designed for sub-orbital space tourism flights. The most interesting project is the Japanese Hayabusa2 mission. Hayabusa2 successfully rendezvoused with the asteroid Ryugu and placed multiple rovers on the surface. The spacecraft will return a sample from the asteroid to Earth. This mission provides a viable template for future space based mining endeavors. These technological advances will take a decade or more to reach industrial scale, but once they do we believe they will significantly alter the nature of the mining industry.
Net Neutrality Fallout: Telecommunications firms have risen in the past month as a result of this ruling, but we believe the medium and longer term prognosis is less rosy, with the prospect of new entrants and even more consumer dissatisfaction. 2018 did see a backlash against the major telecom companies and the net neutrality ruling certainly didn’t help to reverse the cord-cutting trend. Telecoms underperformed the broader market in 2018 as the S&P 500 Telecom Services Index returned -7.20% while the S&P 500 index returned -4.38%.

Income inequality is rising in America, and corporate boards are to blame.

By subir | February 15, 2018

That’s what I read into the comprehensive analysis of individual income tax returns by Bakija, Cole and Heim. The Washington Post has coverage of their work. The work is a damning indictment of the manner in which corporate boards have abdicated their responsibility towards shareholders to rein in excess corporate compensation. The compensation process is run entirely by alpha-CEOs and compensation consultants who understand which side their bread is buttered. The board is a rubber stamp.

The paper also throws cold water at the various excuses presented to justify sky-high executive compensation. High-paid sports professionals, doctors or lawyers are not nearly as numerous as high-paid executives.

Review of 2017 Themes: The Doldrums

By subir | January 5, 2018

2017 was an uneven year for our market predictions. We were right on five calls, half right on one call and wrong on four calls. Continued bullishness and investor support for the Trump administration (despite abysmal poll numbers) torpedoed three of our calls.

? Fed stays the course: We expect the Federal Reserve will continue to raise rates as stated. We expect the Fed-Funds rate to rise above 1.5% over the course of 2017. The Fed started 2017 with a target interest rate of 0.50%-0.75% and finished the year with a target rate of 1.25%-1.50%. While the Fed raised rates, they met but did not exceed 1.50%, so we’re giving ourselves half a point on this one.
× Equities Caution: We continue to advocate for a cautious allocation to stocks and expect to see negative returns for US equities this year. We were dead wrong on this call as US equities continued their bull market run through year eight.
? Artificial Intelligence: We expect performance for companies providing intelligence features in devices to outpace the consumer durables index over the next three years, we will evaluate ourselves annually on this call. Artificial Intelligence-related companies had a very strong 2017 as the Global Robotics and Artificial Intelligence Index was up 57.62%. Comparatively, the S&P 600 Consumer Discretionary Index was up 17.13%.
? Continental shifts: Over the next several years, we expect Indian markets to outperform those in China and the developed world. We were right on year one of this call. The S&P BMI India Index was up 29.56% in 2017. This compares to 26.67% return for the S&P Greater China Index and 21.83% return for the S&P 500 Index.
× European upheavals: We believe European stocks to be more attractively priced than US equities…we expect European stocks to outperform US equities. While European stocks performed in-line with our expectations — S&P 350 Europe Index was up 10.75% on the year — the unexpectedly strong performance of US stocks (21.83% return for the S&P 500 Index) easily outperformed this total.
× Dollar strength continues: We expect the dollar to remain strong against major currencies worldwide. Despite rising interest rates, the USD weakened against a basket of international currencies in 2017.
? Drones are going to be delivering much more than bombs: We expect companies building these technologies to outperform the freight and shipping transportation companies. While we view this as a long term trend, 2017 saw drone-related companies outperform. The Solactive Robotics and Drones Index was up 38.7% while the S&P 500 Transportation Index was up 23.52%.
? Renewable Utilities: Though the incoming administration is not supportive of renewables, we think renewable utility companies or YieldCos will outperform conventional, fossil-fuel based utility stocks. YieldCos saw a strong rebound in 2017 and handily outperformed traditional utilities. The Global YieldCo Index saw returns of 22.87% while the S&P 1500 Utilities Index returned 12.16%.
? Retail Real-Estate: We expect real estate companies that own large portfolios of malls and brick and mortar stores to underperform other real estate investments. This prediction came to fruition as brick and mortar stores, and particularly malls, continued to see a decline in foot traffic and a loss of market share to online shopping in 2017. The FTSE NAREIT Regional Malls Index was -2.68% and the FTSE NAREIT Shopping Centers Index was -11.37%. Meanwhile, the FTSE NAREIT Composite was up 9.29%.
× Optimism about Trump presidency short-lived: We expect any investor-optimism surrounding the Trump presidency to evaporate rather quickly in 2017 as markets find he is unable to follow through on his lofty campaign promises. As we expected, President Trump has been unable to follow through on his campaign promises, and his approval ratings are among the lowest ever recorded for a first year presidency. However, a strong economy, robust corporate profits and the prospect of a tax cut allowed investors to shrug off his policy failures, chaotic management style and a criminal investigation to send equity markets to all-time highs.

Powering down the Fed’s bond buying engine.

By subir | October 10, 2017

We trust you’ve had a restful and enjoyable summer.

This was a difficult hurricane season for many of our fellow Americans, especially those in Puerto Rico and across the South. A number of category 4 and 5 hurricanes made landfall in the US, causing enormous damage in Puerto Rico, Houston, Florida and the Virgin Islands. Several Caribbean islands have suffered almost complete devastation. Aside from the enormous human toll exacted by the loss of lives and homes, the hurricanes have also impacted US industry. Several sectors were impacted, including tourism, oil and pharmaceuticals (Puerto Rico is home to several pharmaceutical plants). Many hourly workers missed work for days or weeks, affecting their earnings. The impact is visible in the September jobs report, which shows a loss of 33,000 jobs.

This loss breaks a consecutive streak of 83 months of employment gains, stretching back to 2010. Markets largely shrugged off the terrible jobs report due to these effects, which are believed to be temporary. We expect October’s report will be skewed in the other direction as many workers head back to work.

Taking a longer term view, it seems clear that man-made climate change leads to warmer ocean and air temperatures. These conditions produce larger, more destructive storms which arrive with greater regularity. In the West, we have seen a series of destructive forest fires this year. Climate change has also expanded the range of invasive insect species which have killed off large stands of trees in our forests. Under hot, drought conditions brought on by global warming, these dead trees become kindling for forest fires. Our changing climate will pose major issues for insurers/re-insurers and local governments, particularly in flood and drought-prone areas. Communities will have to review zoning regulations in the face of these fires and storms. The cost of adaptation and recovery will be high, and doubtless some communities will be unable to recover fully.

The Fed has signaled it will treat the September jobs report as an outlier and stick with its plan to normalize monetary policy. This is almost certain to include one more interest rate hike before year end, likely in December. The Fed has also indicated it will proceed with its plan to reduce its 4.5 Trillion dollar holdings in bonds. These were purchased between 2008 and 2014 as part of the “quantitative easing” program, in an effort to stabilize financial markets. Based on its published plans, we expect the balance sheet to shrink by 250 Billion in 2018 and up to 400 Billion in 2019 and subsequent years, depending on economic conditions. These are substantial numbers, and we expect them to maintain steady upward pressure on interest rates across the maturity curve. We expect Janet Yellen will be replaced as Fed Chair when her term ends at the end of Jan 2018. This raises critical questions about the Trump administration’s ability to nominate and confirm a candidate who is credible and seen as independent of political pressure.

Stock markets continued their upwards drift, hitting new highs this quarter. These moves were supported by steady economic numbers, including GDP and employment. Corporate earnings have also remained steady, though insurance sector earnings are expected to be down significantly in the third quarter. Gains have been led by the technology and financial services sectors, which have grown to become the largest components in the S&P500. Both sectors are cyclical, and in our view a long expansion and the increasing ubiquity of technology has driven some of these stocks to unsustainable levels.

The market seems to have largely ignored Washington, tuning out several dramatic weeks in Congress as major legislation to transform health-care, infrastructure and deregulation have stalled or collapsed. A Republican effort to pass a tax reform bill is still underway, but it looks increasingly unlikely that this effort will pass either. The tax reform package proposed has not been scored by the CBO, but most analysis indicates it will add to the deficit. The proposal includes several modifications to deductions and tax brackets. Overall, its impact would be to reduce the tax burden on the very wealthiest of Americans, and shift some of those charges on the poorest and on Americans earning less than 400k a year. The scale of the proposal, the major uncertainties involved, and the haphazard manner in which it was developed lower the chances of passage. We do not believe the tax reform proposal will be enacted in its current form. At best, we believe the administration may be able to pass a severely watered-down bill.

Looking ahead to the end of the year, we expect equities markets to largely ignore Washington DC, unless the administration managers to pass significant legislation. The prospect of interest rate hikes and the Fed’s plans to shrink its balance sheet are likely to exert downward pressure on stocks. We continue to maintain our defensive positioning, with lower than average allocations to higher-risk assets like stocks and long-term or high-yield bonds.

Regards,

Subir Grewal, CFA, CFP Louis Berger

2017 Q1 letter: Renewable energy in the Trump era

By subir | April 21, 2017

Dear Friends,

The first quarter of 2017 was full of eventful news for markets. We saw a Fed rate hike, record low unemployment rates, all time highs for US equity markets and a new administration sworn in, with Republicans now in full control of Congress. In our view, this likely marks an inflection point for the current business cycle and market levels.

Since the election, we have received several queries from our socially responsible investors about the fate of environmental and climate change regulation under the Trump administration. We understand and share many of their concerns. We hasten to add, however, that infrastructure spending and projects are usually undertaken with long time frames in mind. Enterprises making decisions about what kind of power plants to build will consider the costs over a long term. They are well aware that the current administration and its policies are not set in stone.

We do not expect a raft of coal plants to be built over the next four years — in fact, 2017 has seen an acceleration of the closure of several legacy coal plants. Large plants typically take 3-5 years to build and operators have to factor in the possibility that they will face a changed regulatory environment just as the plants come online. Natural gas prices are likely to play a much larger role in determining what resource mix generates our electricity. The cost of utility scale renewable solar power continues to fall, and though it is not yet competitive with cheap gas, it is not far off either. The IEA estimated the average capital costs of photovoltaic solar plants under construction to be 35-45% higher than natural gas plants per unit of energy produced. An array of tax credits make solar competitive with gas. though the precise economics are driven by regional factors and weather. Wind and hydroelectric power are already competitive with natural gas.

At the risk of appearing sanguine, we think that technological advances, consumer preferences, and the economics of scale have brought us to the point where renewable energy will be competitive with conventional electricity generation going forward. Installed renewable capacity will continue to increase, with or without incentives. If fuel costs move higher, renewables will be become very attractive.

In our view, purchasing certain sectors based on the administration’s stated policy preferences is unlikely to lead to consistent gains. Our reasoning is based on the Trump administration’s penchant for changing direction at the drop of a hat, and secondly on the opposition to various aspects of their policy agenda from either side of the aisle in Congress. In the medium and long-term, valuations and the business cycle will determine investor success. Neither looks particularly fortuitous at the moment for risk assets (equities, or long-term/lower-quality bonds). We continue to recommend a defensive shift for clients based on these factors.

Regards,

Subir Grewal, CFA, CFP Louis Berger

United For Action SRI Presentation

By louis | September 5, 2016

Louis will be speaking about Socially Responsible Investing at the monthly United For Action meeting this Thursday, September 8th from 6:30-7:30. United For Action is Non-Profit organization comprised of volunteers who shape public policy decisions by organizing and mobilizing groups of like-minded citizens to promote public health and sustainability. The meeting is open to the public and will be held at the New York Society for Ethical Culture. Further details about the event can be found here.

2015 year-end review of themes

By subir | January 19, 2016

Overall, we did well on our call for 2015. We were right on six, half right on three others and had one wrong. In general, the year lived up to our expectations of a low return environment with the anticipated Fed rate hike being the biggest influence.

~ If not now, when? If not the Fed, who?: We expect the Federal Reserve to raise interest rates in 2015. We expect rates to gradually rise to a 1.0%–1.5% target, which would still be historically low. We were right on this call, but the Fed chose to wait till December to raise rates to 0.50%.Though the Fed has signaled rates will be raised to 1.25-1.50%, we are calling this one half-right.

~ No one rings a bell at the top of the market: […] we expect major US indexes (S&P 500, Dow Jones, Nasdaq) to finish the year in negative territory. We were mostly right here, two out of the three indices ended down. The S&P500 ended 2014 at 2,059 and 2015 at 2,044; the Dow Jones dropped from 17,823 to 17,425; but the Nasdaq rose from 4,736 to 5,007.

+ Emerging troubles: Emerging economies will continue to stumble in 2015, this includes resource dependent countries such as Russia and Brazil which have run into roadblocks as energy prices have fallen dramatically. […] We expect emerging market stocks and bonds to underperform developed markets this year. The MSCI Emerging Markets Index ended the year down 17%. The Chinese markets ended the year down over 10%, Brazil was down almost 16%, Russia down over 6%, and India down over 2%.

+ Commodities weighed down: […] We see commodities finishing the year flat to negative. The Goldman-Sachs Commodities Index ended 2015 down over 30%.

+ The trouble with oil: We do not expect oil prices to substantially recover in 2015. […] We expect brent crude prices to remain under $60 by year’s end. Brent crude started the year around $57 and ended 2015 around $37.

+ Playing defense: For US equities, we believe defensive sectors, including healthcare and utilities will outperform others over the course of 2015. In any sort of correction, we expect enterprises providing essential goods and services to maintain profitability and revenues. Over-levered companies that have benefitted from speculative euphoria in recent years are particularly vulnerable to sell-offs in our view. We were half right on this call as healthcare outperformed the S&P 500 Index in 2015 (S&P Healthcare Index +5.8%) while utilities lagged (S&P Utilities Index -7.9%).

+ Euro Crisis, back to the future: […] Depending on outcomes, another round of brinksmanship will likely begin between Greek politicians, the markets and EU officials. Over the past few years, attitudes have hardened and we believe there is a real chance that Greece may be forced to, or choose to leave the Euro. Over the course of the year, we saw another round of concerns about Greece that led to weeks of tense negotiation. The Euro ended the year down about 10% against USD (from 1.20 to 1.07) partly s a result of continued concern about the longer-term prospects for the Euro-zone. Though economic issues have faded from view as a continuing refugee crisis absorbs headlines, we do not believe the Euro-zones strategic challenges have been dealt with.

+ Junk bonds get kicked to the curb. […] With rates rebounding (even marginally), we believe investors will find the reward that comes with high yield bonds no longer worth the risk. We were correct on this call as high yield bonds suffered their first down year since 2008. The Barclays High Yield Bond Index was -6.77% for 2015.

× Growth in Renewables: […] With oil prices falling again, we’ve seen many renewable stocks follow suit, as sort of a knee jerk reaction by investors. We think this provides a tremendous buying opportunity, particularly in the YieldCo space where, like utilities, companies own a portfolio of newly constructed power projects with long term power purchasing agreements in place. We believe we’re a bit early on this call, but for year-end list-scoring purposes we were wrong. Renewable energy stocks had a negative return for 2015 impacted by falling prices for conventional energy. Renewables did however, outperform traditional fossil fuel energy stocks. The Nasdaq Clean Edge Green Energy Index was -6.21% while the S&P 500 Energy Index finished -21.12%.

+ The Russian question: […] We are bearish on Russia and expect the Russian market to underperform in 2015. The Russian market ended the year down 6%.

Climate Action Panel

By louis | January 30, 2015

Lou will be speaking on a Climate Action Panel titled “Local Climate Action in the Age of Big Fossil” sponsored by Greater NYC For Change, 350NYC, Manhattan Young Democrats and United For Action this Tuesday February 3rd starting at 6:30pm. The event will be held at St. John’s Church meeting room located at 81 Christopher Street. Space is limited, so if you are interested in attending, please RSVP on Facebook or via emai to dale.corvino@gmail.com Hope to see you there!

2014 Themes: Year-End Review

By subir | January 10, 2015

2014 Themes: Year-End Review

× The bond decline continues: …The 20 year treasury began 2013 at 2.63% and ended the year at 3.70%. We wouldn’t be surprised to see it exceed 4.50% by the end of 2014…. We were flat out wrong on this prediction. Increasing uncertainty overseas drove demand for treasuries that was not countered even by the unwinding of the Fed’s bond buying program. 20 year treasuries ended 2014 at 2.49%, while the 30 year was at 2.76%.

× Equities: Last Call at the QE punchbowl …These will put a lot of pressure on stock prices. With multiples at cyclical highs, conditions are ripe for a significant correction, especially in US markets. We advise investors to avoid complacency and prepare for a potential 20%+ correction in 2014. We were wrong on this prediction as well. The S&P 500 ended the year up almost 13% and earnings were at an all-time high for the index.

? Bitcoins backlash: …Despite the concerted efforts of many conspiracy theorists, we do not see a major reckoning for fiat currencies in the offing and therefore continue to caution against allocations to alternative or commodity based currencies. We were right on this call. Bitcoin prices fell from over 750 at the beginning of 2014 to start 2015 under 300.

? Social Media Mania: …We are long-term believers in the transformative potential of technology, but do not believe current valuations are anywhere near reasonable. Investors will have to be a lot more selective in 2014 if they are to avoid the kind of fall we saw in the early 2000s. We expect to see several of these high-flying tech IPO darlings come back to earth this year. A number of 2012 and 2013’s high-flying social media IPOs saw prices collapse, this included companies like Twitter, Yelp, Zynga, Groupon. Others like Facebook and LinkedIn retained or regained their heights.

? Go Global or Go Home: …We believe media companies with strong properties are on the cusp of another period of growth in market-share. At reasonable valuations, they represent an attractive long-term investment. At the same time, we believe strong regional, cultural media properties will also find traction in their home markets and any areas with affinity. This is more of a long-term prediction and we expect to evaluate it over time.

? Commodities Wane: Commodities, for the most part, have been in a relatively flat holding pattern since the 2008 bubble. We expect commodity prices to remain weak or stagnant throughout 2014. We do not anticipate large rises in economic activity in the offing, which means commodity prices will remain depressed. We do not expect gold or other precious metals to recover and anticipate further declines. We were right on this call, almost spectacularly so on oil, which fell almost 50% to under $60 a barrel. Gold was largely flat. The S&P/Goldman Sachs Commodity Index lost 35% over the course of the year.

× Wages and Profit: The past few years have seen corporate earnings rise while average wage income has stagnated along with labor costs as a portion of GDP. We expect 2014 to reverse some of this trend as a declining unemployment rate and an evolving political climate make for higher wages and a higher minimum wage floor. We believe this will put pressure on industries and companies that rely on a large, low-paid work-force. After-tax corporate profits as a percentage of GDP rose to over 10% during 2014. This is higher than at all previous periods in US history. The last period that came close was 1929, the eve of the Great Depression when they reached 9.1%. Pre-tax corporate profits hit 12.5%, tying the prior high set in 1942 when companies benefited from increased demand for industrial goods as the US entered World War II.

? Health-Care Strengthens: Gains in the Health-Care Index have outpaced that in the broader markets by about 10% in 2013. 2014 is the first year the impact of the Affordable Care Act will be felt in revenues of insurers and health-care providers. We expect health-care revenues will rise and the sector will continue to outperform the broader market this year as well. The S&P healthcare service index rose over 24% during 2014. The healthcare equipment index rose over 18%. Both handily exceeded the overall S&P gain.

? Atlantic tug of war: The Euro has appreciated against the Dollar over the course of 2013, as the European fiscal crisis has been pushed off center stage. We believe the Fed’s tapering will reverse this move and we will begin to see the dollar appreciate as rates rise in the US. We were right on Euro valuation, the Euro fell over 12% during 2014 to end the year under 1.20.

? Water Works: We have been concerned about water-related infrastructure for a number of years. Most population growth is occurring in regions with limited access to large quantities of fresh water and this problem is more acute than any issues with power generation. We believe consumers and regional planners have begun to appreciate this as well and we will see a rise in investments directed towards water infrastructure. Major engineering companies and water utilities should benefit, as will firms with consumer products that improve efficiency. While we view this as a long term investment trend, 2014 saw US water-related stocks substantially outperform the S&P 500 index. The Dow Jones US Water Index was up 24.67% for the year.

Sustainable Investing Panel Discussion

By louis | November 17, 2014

Louis will be speaking on a sustainable investment panel with the Portfolio Director of the Acumen Fund next Monday November 24th at the Center For Social Innovation. The panel starts at 6pm and it should be an interesting and lively discussion. If you would like to attend, please reserve a spot by clicking on this link.

Understanding the Risks of Crowdsourced Clean Energy Investing

By louis | September 22, 2014

Below is an article written by Louis about the recent trend in clean energy crowdfunding. It was first published by Green Tech Media and the original article can be found here.

For clean energy investors, Title III of the JOBS Act could change the game.

Prior to its implementation, investing in clean energy startups or small-scale utility projects has been a pursuit reserved mainly for venture capital and private equity firms investing on behalf of their institutional and high-net-worth clients. The barrier to entry into these funds is high, with six- to seven-figure minimum buy-ins typically the norm. But in a post-JOBS Act America, we’re entering a crowdfunding-inspired era where barriers to entry are crumbling.

Take Mosaic, for example, where an investor with as little as $25 and an internet connection can fund a portion of a solar project via an online investment platform.

Sounds great, right? Well, it is. But as with any other investment opportunity, putting money to work in crowdsourced clean energy projects comes with risks. And as crowdfunding gains in popularity and scope, these risks may be glossed over or simply ignored by an enthusiastic investing public eager to put their money where their eco-conscious mouth is.

So what are the risks, exactly?

Let’s take a closer look at Mosaic — not because its offering is especially risky (compared to other crowdsourced investment opportunities, it’s not), but because it’s currently the poster child for this new business model.

In a nutshell, Mosaic helps investors of any size lend money to small-scale solar projects in need of capital. As a result, the solar projects get financing, Mosaic is paid a fee, and investors earn interest on their loan. Think of it as Kickstarter meets Kiva for solar project financing.

Here’s Mosaic’s pitch, in the company’s own words, taken directly from its website: “Mosaic connects investors seeking steady, reliable returns to high-quality solar projects. To date, over $5.6 million has been invested through Mosaic and investors have received 100% on-time payments.”

Below this statement is a list of Mosaic’s projects (all of which have been fully funded) showing annual payments of 4.5 percent to 5.5 percent. This number is net of Mosaic’s annual 1 percent management fee on loans that mature in five to twelve years.

Steady and reliable returns of 4.5 percent or more per year on your investment, plus pride in knowing your money is supporting a clean energy project. Sounds terrific. Everybody wins.

So what’s the catch? Is there a catch?

To answer this question, we have to take a closer look at Mosaic’s prospectus, a densely worded document that lays out the deal terms and accompanying risk factors in explicit detail. After all, the language found on the website is meant to sell prospective investors on Mosaic, not scare them away.

So, onto the prospectus, where on page 2 of the offering memorandum, in capital letters, we get this: “These are speculative securities. Investment in the notes involves significant risk. You should purchase these securities only if you can afford a complete loss of your investment.”

Speculative securities; significant risk; complete loss of your investment. Not quite the sunny language we found on the website. So what exactly are investors getting themselves into here?

It turns out these loans are not made directly to the solar project. Rather, they are funneled through an intermediary (Mosaic), which deploys capital to the projects on behalf of investors. So when an investor lends money to one of these projects, what they’re actually getting is an unsecured note issued by Solar Mosaic LLC, which is meant to “mirror the terms of the corresponding loan.” This is an important distinction, as certain bondholder rights are lost in this structure.

This leads us to the most important risk factor for investors to consider.

Default risk

What’s the risk that the issuer will fail and be unable to make interest payments or pay back your principal? Unlike bank CDs (insured by the FDIC), Treasury bonds (backed by the full faith and credit of the U.S. federal government), or municipal bonds (which often carry third-party insurance), Mosaic notes are uninsured, unsecured corporate bonds.

The repayment of principal with interest hinges on the success of the solar project and its ability to generate the necessary cash flow. Because of the way these notes are structured, investors will have two entities to worry about: the borrower (solar project) and the issuer (Mosaic). If the solar project fails, the investor will not receive interest payments and risks losing the invested principal. If Mosaic goes bankrupt (even if the solar project is successful), the investor also may not receive interest payments and risks losing the principal.

Oh, and by the way, if things do go south, the investor “will not have any recourse to the borrower under the loan.” If the solar project fails, you’re relying on Mosaic to recoup your principal through litigation, and the investor “will not have any security interest in any of MSI’s (Mosaic Solar Investments) assets.” That means if Mosaic goes belly up, don’t expect its other assets to cover your losses.

Since the performance of each note is tied directly to the success of the individual solar project, the next factor to consider is credit risk.

Credit risk

How can you quantify which projects are in the best position to repay the loan? Remember, if the project fails, it’s the investor’s capital at risk, not Mosaic’s (although the company’s reputation would likely take a hit). Most publicly traded bonds carry a credit rating from one or more of the major ratings agencies like Moody’s, S&P or Fitch. While these ratings should not be considered gospel (just ask anyone invested in “AAA”-rated mortgage-backed securities in 2008), they can provide a useful marker to help investors gauge the default risk of the borrower.

While Mosaic is working with Standard & Poor’s via truSolar to develop a scoring system for solar bonds, there currently isn’t any third-party analysis of the credit quality of the borrowers. Investors can conduct some limited due diligence on their own, but most will be relying on the judgment of Mosaic’s underwriting team, which have only been at this since 2012. So while there may have been 100 percent on-time payments to date, this is based on a very limited track record.

Since the notes are only available on Mosaic’s platform, another factor to consider is liquidity.

Liquidity risk

What happens if you need access to your principal before the loan matures? With publicly traded bonds (treasuries, corporates, municipals), there’s a secondary market where investors can sell their bonds prior to maturity. With Mosaic’s notes, there is no secondary market. Also, there isn’t a mechanism in place for investors to redeem their notes prior to maturity. So if your note matures in twelve years, your money will be tied up for the duration. Think of it as a bank CD: you’ll be able to withdraw interest payments, but your principal is illiquid.

This lack of liquidity on a longer-term bond can expose investors to interest rate risk.

Interest rate risk

Right now, we’re living in a time of historically low interest rates. As anyone who holds money in a checking or savings account can tell you, yields on cash are virtually nonexistent. This is a result of the federal funds rate (the rate at which banks borrow money from each other) being set at essentially 0 percent. This impacts rates across all loans, keeping them low — until rates go up again.

And make no mistake, rates will rise. It’s not a question of if, but when and by how much. A twelve-year Mosaic note paying 5.5 percent per year may look great today, but if interest rates are substantially higher a few years from now, you’ll be stuck in an illiquid investment paying below-market rates.

In addition, there are a few other risks to consider.

Technology risk

Will the solar technology being used in this project still be viable twelve years from now? What happens if there’s a major breakthrough in panel performance that causes the panels used in your investment to become obsolete? Or what happens to the warranty on the solar panels if the manufacturer goes out of business?

Catastrophe risk

With climate change impacting weather patterns, what happens if a natural disaster (hurricane, tornado, flood) wipes out the solar farm you’re invested in? Mosaic requires borrowers to carry property insurance, but how would the lack of cash flow during repair work impact interest payments?

Do all these risk factors mean investors shouldn’t put money to work into Mosaic or other crowdsourced clean energy projects? Not necessarily. In fact, these types of investments can make a nice addition to a diversified portfolio. And Mosaic deserves a lot of credit for successfully building out this business model and proving it’s viable, not to mention wildly popular amongst clean energy investors.

However, just like any other investment opportunity, investors need to carefully consider all the risks involved prior to putting their money to work.

2014 Q2 Letter: Are US Equities Reaching a Top?

By louis | July 19, 2014

The second quarter of 2014 saw global markets rise after shrugging off a number of geo-political concerns clustered primarily around the middle-east (Ukraine, Egypt, Turkey, Iraq, Palestine). Stocks and bonds in the US have continued their march upwards with the S&P 500 and Dow Jones indices scaling all-time highs. There is some speculation that turmoil in Asia and Eastern Europe has driven investors to seek the relative security of US-based assets, including stocks, bonds and real-estate. While this is anecdotal, we do see signs of foreign investments boosting asset prices in each of these markets.

We continue to advise caution to equity investors. The S&P 500 is trading at 19 times last year’s earnings, while the Nasdaq composite index is over 23. Longer term measures of value (such as the Cyclically Adjusted P/E) are close to levels reached at the peak of 2007. Though it is not possible to say exactly when a decline might begin, hazard signs are clearly visible and we think risk should be considered when looking at portfolio allocations.

Stocks have been buoyed by the low-interest rate policies still being followed by most central banks. With short-term rates close to zero, holding cash remains an unattractive proposition for investors and has led many to conclude that stocks are a relative bargain, even with very small anticipated returns.

Bonds offer little respite for investors. Due to continuing loose monetary policy by central banks, interest rates are close to historic lows. Long term bonds offer very little by way of return potential. 30 year treasuries are offering a 3.4% yield and 10 year treasuries are at 2.58%. These are meager returns for considerable risk since we anticipate the Fed will continue to reduce bond purchases and begin raising rates next year. Long term bonds perform very poorly in a rising rate environment.

So where are the investment opportunities? There aren’t many areas where we see a lot of value. We continue to prefer high quality, dividend paying stocks both domestically and internationally. For bonds, we prefer short term and floating rate issues as well as certain foreign sovereigns. There are a few general investment themes that we still find compelling like alternative energy, energy efficiency, water resources and healthcare-related companies. But, in general, we think an allocation weighted towards asset preservation is advisable.

In other news, Louis had a second article published by Green Tech Media on the topic of clean energy YieldCos. You can read the article here.

What You Need to Know About How Clean Energy YieldCos Work

By louis | July 15, 2014

If you follow the clean energy investment space, you’ve probably heard the term “YieldCo” thrown around quite a bit in recent months.

YieldCos have burst onto the investment scene and quickly become the company structure du jour for publicly traded power producers looking to capitalize on their renewable energy assets.

In the past year, we’ve seen a flurry of activity in this space as companies such as NRG, TransAlta, NextEra, and Abengoa have spun off the renewable portions of their power portfolios into separately held YieldCos.

Following their lead, SunEdison plans to spin off 524 megawatts of solar farms across the U.S., Canada, the U.K. and Chile into a YieldCo called TerraForm Power later this month.

The YieldCo structure has become so popular that analysts at Deutsche Bank expect as many as six more entities to become publicly traded in the coming twelve to eighteen months. And even private equity behemoth KKR is getting into the act by acquiring a 33 percent stake in Acciona with the goal of cashing in on a future YieldCo spin-off.

So what exactly is a YieldCo, why are companies suddenly attracted to this corporate structure, and most importantly, should you consider investing in one?

Let’s start with the basics. YieldCo is shorthand for “yield company.” In the investment world, yield is synonymous with income. So, essentially, a YieldCo is a corporate structure where the income component (generated by the underlying assets) is emphasized.

YieldCos are similar in concept to an MLP (master limited partnership) in the oil and gas sector or a REIT (real estate investment trust) in the real estate sector. All three investments are designed to provide a dependable stream of cash flow to investors.

Whereas MLPs use oil or gas pipeline income and REITs use commercial real estate lease income, YieldCos use completed renewable energy projects with long-term power purchase agreements in place to deliver dividends to investors.

So why are so many companies embracing this new structure? The primary reason is to unlock shareholder value. By spinning off their renewable power assets into a separate, high-yielding entity, power producers are attracting interest from two types of investors who may not have been interested otherwise: socially responsible investors and income investors.

The SRI investor

Prior to creating a YieldCo, most power producers commingled renewable energy assets with their other businesses. For example, in addition to wind and solar, NextEra has exposure to natural gas, nuclear and oil-fired power plants. A purist socially responsible investor may have avoided buying NextEra stock specifically because of this exposure (even though NextEra has long been a leader in the renewable energy space).

By creating a YieldCo, they were able to segregate their renewable power assets from fossil fuel and nuclear power plants while still retaining ownership in both. The same purist SRI investor who may have balked at owning shares in NextEra’s entire power portfolio (via the parent company) can now invest in a pure-play renewable company via NextEra’s YieldCo.

The income investor

In addition to being renewable, YieldCos by design are created to house completed power projects with long-term PPAs in place. This means the more capital-intensive, less cash-flow-positive business units like R&D and construction can be retained by the parent company. Without these capital-intensive units under the YieldCo’s umbrella, a higher portion of the profits can be paid out to shareholders via dividends rather than reinvested back into the company.

Given the current historically low interest rate environment, many income investors (who are traditionally more risk-averse compared to growth investors) have been pushed out of their bonds-and-blue-chip-stocks comfort zone and forced to find yield elsewhere. Enter the YieldCo, which, like MLPs and REITs, emphasizes cash flow over growth and owns a portfolio of lower-risk assets.

Now that we’ve established what a YieldCo is and why companies are creating them, the question remains: are they worth investing in? Like any other investment, a YieldCo has pros and cons that an investor should carefully consider before putting any money to work.

Pros

YieldCos provide SRI investors with a pure-play clean energy investment vehicle (while a few may contain fossil-fuel exposure, most are 100 percent renewable).

Since they are consist of completed projects with long-term PPAs in place, YieldCos are less speculative and carry lower risk relative to other clean energy stocks (such as biofuels, solar panel manufacturers, etc).

Unlike other clean energy stocks (which are growth-oriented), YieldCos are designed for predictable income via dividends.

A YieldCo will provide a geographically diverse portfolio of several power projects.

Unlike energy MLPs, cash flows from YieldCos aren’t dependent on fossil fuel prices, so they don’t carry a commodity price variable.

Cons

YieldCos will likely be vulnerable to rising interest rates. Low rates have allowed power producers to borrow money on the cheap to build and acquire new assets. Higher rates will mean that these activities will become costlier. Also, while historically low rates have drawn income investors into alternative asset classes, higher rates will mean they can return to the safety of bonds.

For growth, YieldCos will be dependent on having a pipeline of new projects to add to their portfolios. This means risk exposure to future legislative and tax policies (which are currently favorable toward renewables), which could adversely impact the costs associated with construction and acquisition.

YieldCos are equity investments, so they will tend to trade with the movements of the stock market, which means they are susceptible to stock-market volatility.

Utility-scale solar and wind power are still relatively new sources of energy, so it’s a bit of an unknown what the life cycle of these assets will be. It’s difficult to project what maintenance costs will be twenty to 30 years from now. Will energy production (from solar in particular) degrade over time, and if so, how will this impact cash flows?

On balance, for an investor comfortable with stock market volatility and looking for a pure-play renewable investment that provides income and is less speculative than many other cleantech investments, YieldCos will likely make a nice portfolio addition.

That said, valuations for several YieldCos seem quite rich at the moment. Yes, it may be an exciting space to be in, but just like any other stock investment, you need to pick your entry point carefully. As always, the fundamentals of investing still apply.

This article originally appeared on Greentech Media.

Commodity supercycles, Windup Girls and Family Farms

By subir | September 7, 2013

In our SRI portfolios, we screen companies and industries for those actors who run sustainable businesses. Their usage of resources and fulfillment of broader responsibility counts as much as their financial prospects. Ocassionally, we step back from our narrow interests in a specific company or industry to look at the broader picture.

We did that recently while reviewing the latest quarterly letter from Jeremy Grantham at GMO. In a note last year, Grantham had highlighted the impact that intensive conventional farming practices can have on the quality of soil. Healthy soil takes many, many decades to develop and the intensive use of pesticides and fertilizers can destroy microbial life in topsoil. Once that happens, it requires a continual regimen of fertilizers to make the land productive. Intensive commercial farming techniques have killed life in the top soil, and this will have a long-term impact.

Those who’ve read Michael Pollan’s Omnivore’s Dilemma might remember the section on Polyface Farms. Pollan describes Salatin’s effort to rescue a ravaged industrially farmed tract using a complex crop and animal rotation regimen. It requires prodigious knowledge of the local environment and intellectual rigor on the part of the farmer. The level of effort is a couple of magnitudes greater than that required to flood a field with fertilizers, pesticides and irrigation.

If intensive, fertilizer based farming permanently damages our agricultural production, this will have long-range impact for us. What does the steady depletion of our ability to produce food mean for the economy and our race? The first impact will be felt by the world’s poor, who will be priced out of food. This would lead to a rush to accumulate scarce resources and political unrest, possibly more revolutions like those we are seeing in the middle east. Since the industrial revolution, the effort we have expended to raise crops and feed ourselves has steadily declined. In the mid-1800s, fully three-quarters of all American workers lived and labored on farms, that number is under 3% today. The story of progress in the 20th century has to a large extent been driven by the unshackling of vast numbers from the plough. A world where more human effort is required to raise the same amount of food would be one with lower growth, fewer advances and less comfort.

While, we’ve been thinking about these big trends, we’ve been following the Olympics, and the incessant ads reminding us that “luck” had no role to play in the success of any athlete. The truth, however, is that luck plays a large role. Most of the successful olympic athletes were lucky to be born into families or in nations where they were assured a consistently high caloric intake, access to a top-notch training program, and institutional support from their countries and employers. Meanwhile, many, many people in poorer parts of the world will never have that opportunity. The lottery of birth is truly amazing.

Life occasionally imitates art. For a dystopian vision of where intensive commercial farming and climate change might lead us we would recommend reading The Windup Girl, Paolo Bacigalupi’s richly imagined novel about a world ravaged by climate change, genetic modification and crop failures. Robert Heinlein’s book, The Moon is a Harsh Mistress tackles similar topics, from the standpoint of a colony on the moon. Of course, our salvation may lie in the exploration of our solar system, which is rich in resources. But the space program has been as underfunded as investment in training farmers to use organic practices.

2019 Economic Themes: Return of the Bear

Default risk

Credit risk

Liquidity risk

Interest rate risk

Technology risk

Catastrophe risk

The SRI investor

The income investor

Pros

Cons

An important notice