The biggest opportunity (and risk) of our lifetimes

Patrick Poke

Livewire Markets

Investing is mostly about getting a lot of small things right. Buy quality companies for reasonable prices, hold them for a long time, and you'll probably do pretty well. But every once in a while, an issue pops up that can dwarf all the small things. Being on the right side of that trade becomes essential, regardless of other factors. 

For investors in the 70s, it was inflation and oil prices. In the 90s, it was the tech bubble. Today, that issue is climate change. 

The threats of stranded assets, carbon taxes, and regulatory action are real and cannot be ignored. Even if one does not accept the science of climate change, governments, corporates, and consumers are decarbonising regardless. 

However, it's not all about risk. Climate change presents significant opportunity too. Estimates of the amount of investment required to mitigate climate change range as high as $50 trillion over the next two decades. Opportunities abound in electric vehicles, solar and wind energy, but also less 'sexy' industries, such as steelmaking and methane-capture.

Over the past decade or so, Lucas White from GMO Investment and Asset Management has focused his energy on exactly these issues. With the GMO Climate Change Trust having just launched in Australia, I took the chance to gather some of the deep insights he's picked up in that time. 

We discuss how he finds cheap stocks in a sector with a reputation for high prices, he shares some of the best lessons he's learned from working alongside Jeremy Grantham for 15 years, and we hear about some of the stocks and commodities best placed to benefit from this theme. 

I understand you had a pretty broad mandate when you started with GMO, all the way back in 2006. How did you end up working on the climate change strategy?

When I was initially working on our Quality strategy, which is still one of our biggest strategies at GMO, we invest in mega-cap blue-chip companies that have some sort of sustainable competitive advantage, that allows them to be excessively profitable for years or decades, or even more, at a time. These are companies like Proctor & Gamble, Microsoft, Google, Unilever, et cetera, et cetera. We also had a long, short variant of that, as well, that I was working on.

But from around 2007 to around 2011, Jeremy Grantham, one of our founders, spent a lot of time researching the dynamics in the natural resources market. And Jeremy ended up developing a thesis surrounding resource scarcity, that commodity prices would rise in the decades to come. And we had a lot of investors.

Jeremy was just out there, talking about what he was doing research on, and what he was excited about. But we had clients who came to us and expressed an interest in investing in natural resources, on the grounds of Jeremy's thesis, and asked us how they should do it.

I was lucky enough to get tapped on the shoulder, to work with Jeremy and others at GMO, to design a strategy, figure out how we would capitalise on rising commodity prices. And we ended up launching a natural resources strategy.

In the midst of launching that resources strategy, I spent a lot of time researching and thinking about the risks to a long-term investor in the resources sector. There were a lot of risks that you could diversify away, and a lot of risks that you could wait out with a long term time frame, let's say 10 years or more, on your investment time frame.

The one exception was really climate change risk. If climate risk is real, if climate is as bad as it appears to be – and you have to put yourself back in 2010, 2011, when we were designing the strategy, and even back then we thought this was a huge risk to the world, and the global economy and everything else – then climate's something you have to manage.

In designing that resources strategy, we've historically had much lower energy exposure than some of our competitors. We've always excluded coal, tar sands, heavy oil, fracking companies that have the worst emissions profiles. We've always targeted some of our energy exposure to be to clean energy, wind, solar, clean power generation, biofuels, and so on, and so forth. It was really that investment that we were doing in clean energy circles, that evolved into this climate strategy that we launched back in 2017.

Having spent 15 years working alongside Jeremy Grantham, I'm sure you've picked up some amazing lessons and experiences along the way. Could you share one of your favourite lessons from Jeremy?

Jeremy's the real deal. There are a lot of big names in the industry who probably aren't that impressive in real life, but I will say Jeremy is a very, very impressive guy. He's in his early eighties, still sharp as a whip, incredibly knowledgeable, incredibly smart, so he's a pleasure to work with.

I've learned a million things from him. But in terms of big picture, high level principles that are important, one is to think independently.

Jeremy is an incredibly independent thinker. It's really probably his biggest strength as an investor. He doesn't follow the crowd. He doesn't really pay attention to the crowd. He's aware of what the crowd is thinking and doing, but he's focused on what he thinks is right. Sometimes that's what the crowd thinks, and sometimes it's not what the crowd thinks, but that independence of thought, and not follow the herd – he talks a lot about career risk, and how the biggest risk that most investors feel is the risk of being wrong, when you're doing something different from what everyone else is doing. 

So it's much easier to be wrong and doing what everyone else is doing. It's very difficult to be wrong while doing something different.

The lesson that I've learned from him is, you have to think independently, because the opportunities for really producing superior investment results are from doing something different. If you're doing what everyone else is doing, how are you ever going to sustainably outperform a passive exposure, what your colleagues or competitors are doing? That's one of the big lessons.

There's lots of interesting stats and charts and figures around climate change. I was wondering if you could share one of your favourites with us.

Climate is very well known now as an issue. It wasn't necessarily 10 or 20 years ago, but now it's generally well accepted, and increasingly so, with every passing month or quarter.

Two things about climate that are still not well understood, are that climate change isn't just happening, it's accelerating. When you look at carbon dioxide concentrations in the atmosphere, when you look at global temperatures, it's not just that they're rising, it's that they're accelerating upwards, which is, of course, extremely scary for those of us who pay attention to the climate science.

As of 2020 | Source: NOAA

Another thing about climate change that isn't well understood is that climate has been impacting the environment for many decades now. So the media would lead you to believe that the recent hurricanes and wildfires and floods and everything else, these are the first signs of climate change impacting the world in some dramatic fashion. But the historical record is very clear.

We have data going back to the 1950s. If you go decade by decade, by decade, there has been, not just a rise in every extreme weather event of note – hurricanes, floods, wildfires, extreme downpours, extreme temperature events, you name it. They've increased in frequency and severity. But once again, that acceleration that I was talking about can be seen in every single one of those time series, as well.

Source: Centre for Research on the Epidemiology of Disasters (CRED)
So climate change is scarier than people realise, and it's been impacting the world in a dramatic fashion for much longer than people are really aware of.

When I spoke with Jeremy back in May, he expressed somewhat of a bias towards value and cyclical stocks. And he was quite averse to high price growth equities. Many of the equities which are exposed to climate change themes, however, are trading at exorbitant multiples. How do you deal with this apparent contradiction?

Well, we have a unique strategy. Not to talk my own book, but we're taking a value approach to a growth area of the market. And we've produced some pretty astounding investment results over the last five years, or four and a half years since we launched, not just the magnitude of it, but in terms of how we've performed.

Because when you run a value strategy, you expect your portfolio to under-grow the market. That's why the companies are trading at a discount. They have poor growth prospects, relative to other companies.

But what you expect, or hope for, at least, is that the multiples expand by more than enough to offset that under-growth. So you buy a company at 10 times earnings, the market ends up realising things weren't quite as bad as initially feared, and the multiple rerates for 12 times earnings. And that 20% rerating is more than enough to offset, let's say, 15% growth. You get some alpha. That's what a value manager is trying to accomplish.

We’ve been running a value strategy for years, so we're able to find companies that are trading at a discount to the market, and across a wide variety of industries: biofuel, solar, wind, batteries and storage, energy efficiency efforts, agriculture, water. We're able to find companies that we think are exposed to long term prospects associated with fighting climate change, yet we're able to find them at a discount to the market.

In the last few years, since we launched our strategy, we've had this weird profile, where if you look at the returns of our strategy, and you decompose them into the components of returns. So, earnings growth, multiple expansion or contraction, and dividend yield, or earnings growth has been far faster than the broad equity market, despite the fact that we've been buying and owning cheap companies the entire time.

Right now, despite some companies being expensive, many other companies are very cheap, and our portfolio was trading at a large discount, 30% to 40% discount to the broad equity market, despite once again, what we would expect to be better growth prospects. That's pretty exciting, from an investment perspective.

There are several tough to abate sectors, that seem as though they're likely to produce significant emissions for the foreseeable future. For example, steelmaking, cement, and shipping. Have you seen any technological developments that might assist with carbon abatement in these sectors?

Actually, our largest position is in a company called GrafTech. And what GrafTech does is, they produce ultra-high-power electrodes for electric arc furnace steel manufacturers. Electric arc furnace steel making, the full life cycle of it, is a more than 90% reduction in carbon dioxide emissions relative to traditional blast furnace steel making.

GrafTech is not a steel maker; they produce the ultra-high-powered electrodes that you need for this EAF, electric arc furnace process. And most, if not, all of the growth in steelmaking in the decades to come is expected to be in electric arc furnace steelmaking.

Going back to your value question, that's a company that trades at six and a half, seven times earnings. So it's not a super expensive company, yet it has exposure to long term secular growth.

Cement, there are some new approaches to cement, that might even be developing cement that absorbs carbon dioxide. But I would say none of those are mature or proven technologies, at cost and at scale. Because all of these problems come down to cost.

You could resolve climate change in a heartbeat if it was free. The problem is, it's expensive.

Then in the middle, would be shipping and aviation, which are other challenges with no clear solutions. You're not going to load up a plane with 8,000 pounds of lithium ion battery. So you're not going to have electric planes the way we have electric cars, but you are going to see solutions.

One of the solutions that's getting a lot of attention right now is sustainable aviation fuel, which could probably be a replacement or a substitute for jet fuel. But right now it’s being blended in with jet fuel. It is a biofuel with an 80-90% reduction in carbon emissions associated with its production, relative to traditional jet fuel.

Similarly, renewable diesel is a replacement for diesel gasoline. It is a molecular substitute, so you don't need to know that you're putting renewable diesel into your diesel vehicle or your diesel ship. You just put diesel in, off it goes. The vehicle doesn't know the difference.

The nice thing about biofuel solutions is that you don't have the same capital expenditure or infrastructure associated with it, relative to other renewables. So when you're talking about solar and wind, there's huge upfront costs, but for biofuels, you don't need a new infrastructure.

It's not like an electric vehicle charging infrastructure that we need, or a hydrogen fuel cell vehicle fueling infrastructure that we need. It can use the existing infrastructure that we have in place, and make an impact now, rather than 10, 20 years from now. So those are some solutions that we see in some of those difficult to tackle areas.

Could you maybe break down the different kind of areas of significance that the strategy invests in, and just explain the importance of each one for us? Which areas offer the best risk to reward now?

At a high level, in our strategy, we're looking for companies that are going to benefit from efforts to combat climate change. We've bucketed those in two groups: mitigation and adaptation. Companies involved in helping to mitigate climate change, companies helping the world to adapt to climate change. Because like it or not, it's here, and no matter what happens, we're going to be dealing with it for decades to come.

On the mitigation side, we're looking at clean energy efforts. So solar, wind, clean power generation, biofuels, geothermal, anything of that nature. Batteries and storage are within scope, so batteries for electric vehicles, storage for utility scale energy storage, those are likely to be different solutions because they're different problems with their own unique challenges that need to be met.

Electric grid companies are within scope, because trillions of dollars are going to need to flow into overhauling our grids worldwide, if we want to incorporate a high percentage of intermittent renewables. We need a more sophisticated, more interconnected, more modern grid than the grids that we've built up over the last 150 years. And we want to invest in the companies that are going to be involved in overhauling our global electric grids.

Energy efficiency efforts might not initially sound as exciting as electric vehicles or renewables, but if you can reduce your energy consumption by 20, 30, 40, even 50%, and accomplish the same unit of work, that's brilliant, in terms of fighting climate change. You're just reducing the energy needed in the world, and that has probably a bigger impact than adding a few percent to your renewables, or a few percent to your electric vehicle fleet.

So we look at energy efficient building materials, electrical components, appliances, lighting, mass transportation, electric vehicles themselves, which are very energy efficient, relative to internal combustion engine vehicles. Those are all within scope. And then, importantly, technologies and materials that are being put into any of those efforts.

On the adaptation side of things, food and water are big challenges in a world impacted by climate change. So companies focused on keeping agricultural productivity as high as possible, in the face of climate change. Companies focused on providing access to fresh water, whether that's through efficient use of water resources, recycling of water resources, purification, treatment, desalination, anything of that nature, would be within scope as well.

Right now, we see exciting opportunities in solar and biofuels, and they're slightly different stories.

In the solar sector, a lot of those companies we thought looked pretty expensive, if you were to go back to the early part of this year. Solar's had a pretty rough run since then though. A lot of the names have fallen back considerably, and we now see individual companies that we think trade at a significant discount to fair value. We see some exciting opportunities in solar, but we see other companies that look quite expensive.

Biofuels, when we look across the board, we see very attractive opportunities. It's a huge area of growth. It's complicated; it's not well understood by most investors.

It's a tiny little narrow niche of the market, yet we believe has tremendous and growing public policy support behind it, because of the impact that it can have on the world right now. So there are a lot of opportunities in biofuels to generate substantive returns.

Do 'green resources', like lithium, nickel, and copper form part of your strategy?

They do, and they form an important part of our strategy. I think it's critical to look at the materials that are going to underlie clean energy efforts.

It's brilliant to want to get off of fossil fuels, and transition with the clean energy economy, but it doesn't absolve you of the need for natural resources. You just need a different set of natural resources, so you no longer are going to revolve your economy around oil, coal, natural gas.

Now it's going to revolve around copper, nickel, lithium, cobalt, vanadium, silver, and just a different set of materials. To ignore those materials would be ignoring a huge part of the story, and a huge part of the value proposition in this sector, if you want to consider climate change a sector.

So yes, we invest in all of the materials that you mentioned, and other materials as well. And quite frankly, it can be a part of the market that trails behind, when other parts of the market get frothy.

So when solar went through the roof last year, there were still opportunities in nickel, copper and lithium, because their future prospects aren't really priced in to their stock prices. What's priced into their stock prices is largely the current price for those materials. So they can be left behind at times. When the hype in hydrogen, or the hype in solar goes crazy, you can still find good value in some of these companies that are a little less popular to green investors.

Are there any particular commodities that you'd call out as one being that you think offers particularly attractive risk to reward? And what's your preferred way of getting exposure to those commodities?

Copper is the safest way to invest, if you're thinking about risk and reward. Copper is a rare, precious mineral. It is not plentiful in nature. There have been virtually no copper discoveries in the last few decades of any substance. It's very difficult to find more. Ore grades are falling. So you have an extremely constrained supply side.

Then you look at the demand side, and we have countries like China, India, Indonesia – much bigger than any country that's ever tried to go through the stage of economic development that they're all trying to go through right now – where they're building out their infrastructure, their buildings, their cities, et cetera. So, that creates tremendous amounts of baseline demand growth, just from the industrialisation, urbanisation and development of the emerging markets.

Then you look at clean energy, and almost everything in clean energy revolves around copper. Coal and natural gas power plants use a fraction of the copper that a renewables project would use. Wind and solar use 4 to 12 times as much copper as the comparably sized coal or natural gas power plant.

Electric vehicles use three to four times as much copper as an internal combustion engine vehicle. If we want to overhaul our electric grids, that revolves around copper. If you want energy efficient electrical components and appliances, guess what? Copper, copper, copper.

If you want to electrify the world, and you want to clean up and green up electricity generation, it's copper everywhere you look.

There is no substitute for copper. You can find other metals that are more conductive, but you're talking about things like gold. I don't know many people who want to wire their houses and their electric vehicles with gold.

So you really need copper. We need as much of it as we can get. But some of the environmentally sensitive investors who don't want to provide capital to extractive industries, in my opinion, are missing the plot. Whether you like mining or don't like mining, we either get this copper out of the ground, and we have a fighting chance of averting disastrous climate change, or the world boils. Those are really the choices that we have, based on the technologies that exist in the world today.

The best way of getting access is, in our opinion, via the equity markets. When you invest in commodity futures, you end up dealing with the roll yield. Without getting too technical, the roll yield has been negative for about 15 years now. So commodities have dramatically outperformed the commodity futures.

The equities, on the other hand, over the long term, have performed much better than the underlying commodity prices. Because you're getting a risk premium on top of the underlying commodity movement. You wouldn't buy a company if you didn't expect a return on that investment.

Over the long term, you've gotten that from investing in mining companies. Despite the commodities themselves having been flat-ish, in real terms, over the very long term.

Could you tell us about a company that's involved in decarbonisation, that you think offers a solid investment proposition today? Could you explain both the investment case for the company, but also the impact that they're making on carbon emissions?

I've mentioned biofuels a few times already, but let me go back to that, and I'll actually give you a few companies that are interesting to look at.

Once again, there are different kinds of biofuels. There's biodiesel, which gets blended with diesel, traditional diesel, ultra-low sulphur diesel. Then you have renewable diesel, which is a substitute for ultra-low sulphur diesel, and you have sustainable aviation fuel.

Some of the companies who are involved in that are companies like Renewable Energy Group, which is located in the US. They're unique, because they're very flexible.

Biofuels come down to feedstock. How are you going to produce your biofuel? And you get very different improvement in carbon emissions profiles, based on whether you're doing something like using soybean oil as your feedstock, or whether you're using used cooking oils and greases or animal fats, or things like waste products. Waste products are better.

Renewable Energy Group is very flexible, in terms of what kind of feedstock that they use. When all the restaurants shut down, because of COVID, they were able to switch to soybean oil. As the restaurants have started to open back up, they're switching away from soybean oil. So they're unique, in terms of their flexibility to switch among feedstocks.

Darling Ingredients has an animal feed unit, and they use a lot of waste products - animal fats and things of that nature - that they can then process into usable biofuel. They kind of have captive feedstock. They don't need to go procure their feedstock. It's coming from another business unit within the company. That's an interesting company to look at, and they have a lot of new production coming online in the years to come.

Neste would be a third company in biofuels that's of interest, because they're working on next generation feedstock. So trying to figure out if can they use used plastics as feedstock, which would be brilliant.

Can they use algae as feedstock, where you'd have almost an infinite amount of potential feedstock, and other things of that nature? They're a big early mover in sustainable aviation fuel.

So those are three companies that are very attractive, in terms of their long term growth prospects. In particular, the two former companies are quite attractive, in our opinion, from a valuation perspective. Neste looks a little bit closer to fair value to us.

I'll also mention renewable natural gas, which is an emerging, relatively new biofuel. It's where you're capturing the methane from, let's say, a dairy farm, or a municipal waste facility.

Methane is horrific in terms of climate change, much more damaging than carbon dioxide from a global warming perspective. They capture that methane and process it into a usable, renewable, natural gas product that can then be monetised.

We see companies like Ameresco, Clean Energy Fuels, as two examples of companies that we think have a lot of upside, and quite frankly, are misunderstood by the market.

An exceptional opportunity awaits

Beyond the prospects for strong returns, GMO believes a climate opportunities strategy can provide diversification, inflation protection, and an opportunity to make an active and impactful investment towards the transition to a cleaner world. Get access to the biggest transformational change in investing here, or visit the fund profile below.

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GMO Climate Change Trust
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Patrick was one of Livewire’s first employees, joining in 2015 after nearly a decade working in insurance, superannuation, and retail banking. He is passionate about investing, with a particular interest in Australian small-caps.


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