Impax Environmental Markets (IEM) says its NAV total return for 2023 was 4.5% and, as its discount widened, the return to shareholders was -3.7%. [There is no good benchmark for the portfolio, but we would use the MSCI All Countries World Index, which returned 15.3% in a year where the market’s focus was on very large cap AI stories – it is instructive that the bulk of the trust’s underperformance of this index came from not holding the ‘magnificent 7’ stocks.] The dividend was upped to 4.6p from 4.0p. During the year, the company bought back 23.1m shares, or 7.3% of the issued share capital at the start of the year.
The fee structure has changed with a new tier of fees on assets above £1.4bn of 0.45% (previously 0.65%).
The statement acknowledges that the trust “has recently experienced a period of weaker performance as a result of sharply rising interest rates and economic uncertainty” but goes on to say that “the underlying earnings of IEM’s portfolio companies remain robust with excellent prospects for growth. As the shift to a more sustainable economy accelerates, IEM should benefit from many positive trends, including requirements for countries to improve energy security, the drive by thousands of companies to achieve ‘net zero’ targets, and regulations such as the US Inflation Reduction Act, which support US domestic manufacturing in emerging industries.”
The chairman notes that interest rates have been rising and says “higher interest rates have a two-fold effect. First, they increase the discount rate applied to future earnings. This lowers the premium afforded to ‘growth’ companies relative to slower-growing companies already producing substantial cash earnings. Second, these small and growing businesses often borrow to help fund that growth. As interest rates rise, so too does their cost of debt. While IEM looks to avoid stocks with excessive debt burdens, markets have reacted to higher rates indiscriminately, selling first and asking questions later. These headwinds overwhelm the tailwind of strong earnings growth in the short term. However, the sharp pullback in valuations seen across these areas more than corrects for some of the premiums reached in preceding years. Moreover, inflation has fallen substantially around the world, and markets are pricing in the likelihood of interest rates plateauing and may soon begin to fall.”
[QD comment: While yesterday’s disappointing inflation figures in the US may have delayed interest rate cuts by a few months, we agree with the chairman’s assessment. Impax Environmental Markets is essentially a portfolio of growth stocks operating in secular growth markets. The worst of the de-rating that these businesses suffered should be behind us and the trust’s long-term prospects look brighter.]
Extracts from the manager’s report
Crucially, the bulk of portfolio underperformance was driven by stocks not held in the portfolio. IEM has no exposure to the Magnificent Seven, accounting for a performance headwind of 7.7%. These companies benefitted from a combination of market enthusiasm for AI, as well as their ability to generate strong margins and defensive growth despite high interest rates. While the company could hold Tesla on account of its EV and renewables exposure, the investment managers view its governance practices as inadequate. The remaining stocks fail to meet the investment process requirement of having at least 50% of revenues from environmental markets.
Within the portfolio, companies operating in the solar energy sector delivered some of the strongest negative returns. As discussed above, higher interest rates pushed out payback periods for customers financing the capital expenditure of a new system, just as fossil fuel prices came down from their 2022 highs. At the same time, new legislation in California has served to weaken US demand, while in Europe massive Chinese over-supply has left almost no pricing power to boost margins. Consequently, SolarEdge Technologies and Xinyi Solar have made some of the largest negative contributions to performance.
Investing in the solar sector requires a contrarian approach. Investor time horizons are typically short-term, with an almost total focus on growth. Across the industry, near-term visibility on underlying demand remains uncertain. Having added to positions mid-way through the year, this uncertainty compounded poor performance. Given the sector’s longer-term drivers and the superior profitability of these positions, the investment managers continue to hold both names, but are monitoring progress on headwinds before increasing exposure further.
The portfolio’s IPP [independent power producers] holdings also delivered some of the weakest absolute performance for the year. The sector saw rising project costs, perceived lower future returns, and at the margin, the increasing yield on offer from bonds, all weigh on investor sentiment. Within the portfolio the share prices of companies like Northland Power, Terna Energy, and EDP Renovaveis fell to levels which not only discounted the value of pipeline projects, but even existing operational assets.
Such moves reflect an intensely top-down market focused on headline-driven sentiment, rather than recognising portfolio holdings’ stated strategies and still resilient spreads above their cost of capital. Northland Power, for example, expects to initiate few new projects in the coming years and will instead focus on operating and selling down its assets with a view to boosting cash returns. The tail end of 2023 saw the share prices of both IPP and solar names rally. Yet these gains were driven entirely by interest rate expectations, with financial fundamentals a potential further catalyst to the upside.
Natural ingredients companies represent the third significant group of stocks to weaken performance. As identified in the interim report, DSM-Firmenich continued to suffer from low vitamin volumes and pricing across animal and human nutrition. China’s weaker than expected reopening has led to a flood of cheap vitamin production without the corresponding demand. Croda, conversely, has been hit by weaker personal care markets while Corbion faced lower demand for polylactic acid for bioplastics, with a focus in the industry on lower-cost alternatives.
As 2023 progressed, conversations with investee companies’ management repeatedly saw executives point to worsening demand transparency from end clients as a result of the COVID-19 pandemic. Additions to these holdings earlier in the year thus proved too soon, despite the robust fundamentals of each company. Nonetheless, there are now signs that this temporary destocking dynamic has largely played out.
By contrast absolute returns for the year have been negative, pockets of the portfolio have demonstrated the long‑term resilience that one would expect from a Company with diverse exposure to environmental markets. The two biggest areas of positivity were the Digital Infrastructure sector and companies with exposure to US construction.
In Digital Infrastructure, the portfolio benefited from strong performance in industrial software holdings PTC and Altair. The two US-listed companies produce computer-assisted design (CAD) and simulation software, respectively. Given their central role in modern manufacturing, both names have benefited from solid growth in recurring subscription revenues, as well as continued penetration across industrial markets.
Monolithic Power Systems, a producer of power management solutions, also boosted performance. The company delivered robust earnings growth, with meaningful tailwinds from its exposure to AI, where it is chief supplier to Nvidia – the leading producer of graphical processing units used in AI systems.
US 30-year mortgage rates briefly hit 8% in 2023.1 Despite this, US construction proved one of the strongest performance areas for the portfolio, confounding many commentators’ expectations at the start of the year. In the US, mortgages are applied to the property (rather than the owner) and cannot be transferred. Thus, while higher rates did cause demand to drop, supply also collapsed as homeowners choose to move on to more affordable arrangements. With new home construction still suppressed post pandemic, an easing of building supply chains made for ideal trading conditions.
Across IEM there is c.20% aggregate exposure to construction as at 31 December 2023. This exposure is diversified by region, category (residential, commercial and infrastructure) as well as type (new build vs refurbishment). While residential construction’s surprising strength drew the bulk of market commentary, municipal and commercial end markets also proved robust. Companies which performed strongly include Pentair and Zurn Elkay Water Solutions, with the former’s acquisition of Manitowoc Ice providing additional diversification in the form of exposure to the food sector. Other strong performers included wood plastic composite decking company Azek and HVAC manufacturer Lennox, which benefit from refurbishing as well as new build activity.
IEM : Impax Environmental Markets lags market dominated by Magnificent Seven