by François Perrin, Portfolio Manager at East Capital.
The election of Donald Trump as US President is raising a number of questions for the future of US environmental policy. Will the US drop out of the Paris agreement on climate change? Are oil, unconventional gas and coal on the verge of a new boom? Will the “Investment Tax Credit” (ITC) and the “Clean Power Plan” supporting non-fossil energy sources survive the Trump administration?
Before the flood
We will most likely not have answers to these questions until after a couple of months. Recently, we met with the management of Vestas Wind Power, the world’s largest wind turbine company, who told us that if the ITC was part of a much larger tax credit scheme approved by a Republican Congress - and in that sense more difficult to dismantle - the forthcoming administration could more easily abandon the Clean Power Plan. The potential lifting of trade barriers would also create more volatile business conditions. Global environmental players will therefore not be immune to required adaptation of their business models, and sub-par global industry growth may be feared in the years to come for US and European players.
And this is the Trump environmental paradox. A turnaround by the US policy makers on environmental industries would structurally weaken the US and European players through the next cycle. Chinese environmental leaders are set to benefit the most from this paradox.
Setting up the scene
Of all the challenges facing China, there is one that nobody can undermine and that is making the headlines both within the country and abroad: pollution.
Three decades of massive industrialisation and rapid investment-led economic growth have led to dramatic consequences for the environment and the day-to-day life of Chinese people. And this is not a hoax… Wechat, the largest Chinese social messaging application, with 850 million monthly active users, offers an unbiased testimony on the concerns of the population during each and every pollution peak. Since 2000, the Chinese government has progressively ramped up policy support and large investments in environmental protection. The “war against pollution” is expected to reach RMB 2.5 trillion (more than the whole GDP of Denmark) per year by 2020, or 2.7% of China’s GDP, versus less than 1% in 2000.
Go back to the end of the nineties; less than 80 listed companies, either on China onshore or offshore markets, were offering exposure to environmental protection industries, defined as generating at least 20% of their turnover in environmental technologies, infrastructure or services. Chinese onshore and offshore markets have welcomed on average 14 initial public offerings of environmental companies per year over the last 15 years, bringing the total today to 350 equities offering exposure to this structural investment trend (see graph 1).
Graph 1: Number of IPO in China environmental universe (China onshore & China offshore) since 2000Source: East Capital, October 2016
With environmental protection industries promoted at the strategic emerging industries level in 2011 by the Chinese government, and leveraging on a growing number of companies active in the space, it is therefore easily understandable why under the 12th Five Year Plan (2010-2015), China became the largest cleantech market in the world, with almost 50% of worldwide investments.
This trend will not stop. Our recent discussions with the Shenzhen Stock Exchange management confirmed that more than 100 environmental companies are in the pipeline for a listing in the years to come.
Environmental allocation and risk/return profile optimisation
For various reasons, the opportunities offered by Chinese environmental companies have so far been largely ignored by international investors. These reasons include: difficulties in gaining access to the companies, lack of research coverage, inability to invest in China A-share market, and so on. Since 2010 and the launch of the 12th Five Year Plan, environmental portfolios would have however benefited from an exposure to China (see graph 2).
Graph 2: Annualised risk and return profiles of Top 100 Environmental companies, equally weighted in USD, Dec 2009 - Sep 2016
Sources: East Capital, UBS Quant Research, October 2016
Over the last 7 years, the top 100 China A+H environmental companies have largely outperformed their top 100 global environmental peers. The Top 100 China A+H environmental universe offers a much better risk and return profile than the global universe. The additional volatility inherent to the Chinese markets is largely compensated by the additional returns generated.
China Environmental strategy: 30% exposure in global allocation?
China’s environmental companies’ market capitalisation currently represents one third of the global environmental universe market capitalisation (see graph 3).
Graph 3: Total market cap - Top 100 environmental companies (USD)
Sources: East Capital, UBS Quant Research, October 2016
The total market cap of the largest 100 Chinese environmental companies has increased from USD 310bn at the end of 2009, to USD 580bn at the end of 3Q16.
In terms of allocation from a global environmental portfolio, at least 30% allocation to China A+H should be required to match economic and financial realities of environmental protection industries today. Besides, China environmental universe today offers one of the most attractive growth profiles among worldwide markets (cf. table 1).
Table 1: Aggregate financial statistics
||China environmental universe
||Global environmental universe
||MSCI AC World Index
|Price / book
|Hist. earnings growth
|For. earnings growth
|Return on equity
|Debt / equity ratio
Sources: Sources: East Capital, UBS PAS. November 2016. Global environmental universe based on top 100 environmental protection companies listed in developed markets (equally-weighted index).
On each and every aggregate statistic, the East Capital China Environmental universe offers a stronger profile.
Chinese environmental stocks are focusing on domestic opportunities
Chinese environmental stocks are primarily focusing on environmental opportunities in China. These are domestic-driven companies with extremely limited exposure to foreign markets so far, with the exception of the solar module producers. Whether or not President Trump will cancel climate change deals, the Clean Power Plan or ITC scheme will not change the current level of air pollution in Beijing and the growing discontent of the Chinese population.
China will continue to invest. Under the coming 13th Five Year Plan covering 2016-2020, the government environmental efforts will be focusing on water and waste management. These areas will account for RMB 4trn (USD 580bn), almost half of the overall environmental investment plan. They are by definition domestic and local issues, far from Washington politics. Unlike the potential “USD 1trn over a 10-year period” US infrastructure plan, the Chinese investments are already in the execution phase.
The best illustration lies in the recent targeted fiscal stimulus launched by the government in the form of “public-private partnership” projects. For the first nine months of 2016, more than RMB 1.5trn worth of PPP projects have been launched, with 15% of the investment focusing on water and waste management (water supply, water treatment, waste treatment, soil remediation, sewage, etc.). Under the 13th Five Year Plan, the total budget allocated to PPP is to reach RMB 12.5trn, twice the hypothetical US infrastructure plan.
As highlighted above, two out of the seven 2025 strategic emerging industries are environment-related industries: clean energy and electric vehicles. The government is therefore allocating consistent and substantial financial resources to meet these goals. They will ensure that within each and every clean technology, the leading domestic players will occupy a strategic and dominant position at a global level in their next growth phase. Any weaknesses in terms of competition coming from the US will foster the dominance of Chinese companies in these technologies. BYD is already producing more electric vehicle batteries and electric vehicles than Tesla.
From a timing perspective, the onshore Chinese market is expected to remain a sweet spot in the coming weeks. Supporting macroeconomic numbers, fiscal stimulus in the form of PPP, and a relatively accommodative monetary policy should ensure stability during the forthcoming political transition.
We have observed recently an increase in securities accounts’ activity and margin financing, and they have reached their highest levels since January this year. The Shanghai Composite Index is gaining momentum, as well as trading. All of these factors indicate a recovery of A-share market sentiment.
Chinese companies’ 3Q 2016 numbers have been above expectations. Q3 earnings of the vast majority of A-share listed companies exceeded market consensus. Non-financials’ net profit increased by 19% in Q3, and financials rose by 3.5%. Given that 4Q 2015 was a quarter of weak earnings, FY16 earnings may exceed market consensus.
Historically, the A-share market has a low correlation with overseas market trends (the correlation coefficient between the CSI 300 and the S&P 500/FTSE 100 is only 13%/15% in the past year). The endogenous situation has a stronger influence on the A-share market performance, while how much effect overseas sentiment will have on the A-share market depends on the correlation between the overseas events and China's economy and policies. As it is too early to tell what changes could happen in US economic policies and policies towards China, the near-term impact on the A-share market will be neutral.
In the medium to long term, the impact of Trump's victory on China's economy is likely to be felt through three major channels: the short-term Fed policy reaction and USD movement; a potential fiscal stimulus package in the US that could boost global demand; and the new administration's tariff and trade policies on China. It is still difficult to ascertain these possible changes and their impact on the A-share market.
It is worth noting that Chinese environmental companies are not exposed to Renminbi fluctuations. Following the foreign exchange volatility episode recorded at the beginning of the year, foreign debt, if any, has been converted back into Renminbi through the year and the sector’s import dependency is close to nil.
Time to invest
With the Shenzhen Hong Kong Stock Connect launch around the corner, there will be a strong focus on China's new economy related investment opportunities. The environmental space stands out in that context (see also our article from August 2016, Shenzhen Hong Kong Stock Connect - Welcome aboard China Inc.).
The Trump environmental paradox should therefore invite a revision of the existing environmental asset allocation. To match the economic reality of environmental technology markets today and tomorrow, a 30% allocation toward the China environmental space has to be considered. Trading at a price to earnings ratio of 14x for an estimated earnings per share growth at 19% (price earning to growth ratio at 0.7) and a return on equity at 17.5%, such China Environmental strategy would be positioned to seize these opportunities and to contribute to an optimisation of global portfolios.
This article was first published on eastcapital.com.