It's been a long time since the outlook for global equities in certain energy markets has been as attractive as it is right now. The next 12 months look promising across the energy efficiency, renewable energy, water and waste recovery sectors, buoyed by a broad-based cyclical recovery from the deepest downturn in living memory.
That said, there is much more at play than a cyclical pickup. Away from the headlines, the last few years have seen the ratcheting up of building regulations and energy efficiency standards, and the continued tightening of pollution limits. Earnings of companies exposed to these themes are starting to rise as the global economy recovers and new houses get built, automobiles roll off the production lines and long-delayed infrastructure projects move forward.
The above-trend growth we anticipate in subsectors such as water treatment, pollution control and energy efficiency is not dependent on costly government subsidies. The growth is based on improving technologies and new, rapidly expanding sources of demand. Opportunities are emerging to invest in companies that are developing technologies or services by leveraging these rapidly developing markets through the deployment of proven business models.
Even in renewable energy — the subsector most assumed to rely upon government subsidies and an elusive international climate change agreement — the picture is finally starting to brighten. The policy uncertainty of recent years that has blighted renewables investment has faded. Substantial consolidation has also improved equipment makers' pricing power. But most of all, we see unsubsidized demand for renewables driving the sector's long-term development, as the technologies involved simply get better and cheaper.
CHANGES IN CHINA
One place where bold policy is changing the investment landscape is China. Proposed reforms announced at the Third Plenum in November offered additional support for resource efficiency and environmental markets. The government is focused on tackling the country's increasingly dire pollution problems, creating opportunities across the board, for example, in catalytic converters, urban transport, natural-gas infrastructure and water treatment.
This illustrates another attractive element of allocating to global equities in the resource optimization and environmental markets: an emerging-markets kicker. The continuing improvement in the economic outlook, particularly in Asia's developing economies, is making capital available for substantial, and overdue, investments in environmental protection.
We expect emerging markets to continue to contribute to further upside across the water sector in 2014. Water stocks also are set to benefit from increasing demand in the U.S., where a more buoyant economy has led to higher-than-expected investments in water infrastructure as well as rapid growth in water treatment companies, and in monitoring and equipment manufacturers. We also see interesting opportunities in irrigation equipment, where we believe that bearish sentiment — triggered by bumper U.S. harvests and therefore low prices — is overdone.
For stocks in the food and agriculture markets, we believe the outlook is somewhat uncertain; however, the fall in food prices bodes well for the margins at processing companies, and — medium-term — the secular trend is compelling. By the end of 2014, there will be approximately 75 million more mouths to feed than at the start, and demand in China is only going in one direction. A weather event or two that affect supply could quickly alter the outlook for stocks linked to this theme.
Overall, these markets provide opportunities to invest in high-quality businesses with long-term secular-growth strategies and midteens returns on capital that offer the greatest opportunity to deliver consistent, positive returns.
We continue to remain more cautious than many of our peers over “blue sky” opportunities such as fuel cells, energy storage, second-generation biofuels and electric vehicles. There are undoubtedly companies within this investment universe that will enjoy enormous success bringing these technologies to market or will be acquired at attractive valuations along the way. However, we don't believe that listed equity is the place to invest in unproven technologies, preferring to look for road-tested business models, where we have good visibility over the future earnings that will drive performance. That's why we didn't catch a lift with Tesla Motors Inc. (TSLA) on its roller coaster ride.
The gradual technological and regulatory advances we've described are turning once-speculative plays into stable, viable businesses, and the initial public offering markets are reawakening for environmentally themed firms. Meanwhile, established companies are looking to resource efficiency and environmental protection — either acquiring existing firms or investing internally — to tap into these growth markets.
Although we're not taking anything for granted, we enter 2014 with more optimism and confidence in our investment themes than at any time in the past five years.
Ian Simm is the founder and chief executive of Impax Asset Management Group, an investment manager with $4 billion in assets under management.