Three Years of Green in Clean Tech

Three years have passed since the Distributed Energy Financial Group, LLC (DEFG) launched its benchmark stock index, the Distributed Energy Stock Index, or DESI, to track the progress of the clean and alternative energy technology (clean tech) sector. DESI is comprised of 40 publicly traded companies from major North American exchanges. It is organized into six segments that represent the spectrum of companies in the clean tech sector.

The DESI has performed very well over the past three years, recording an overall gain of 52 percent or an annualized return of 15 percent. The DESI has outperformed other benchmark indices (e.g., S&P 500, Russell 2000, etc.) by wide margins over this period. In addition, the DESI has also done well in comparison to other clean/ alternative energy indices.

Why has the DESI has outperformed other indices and the stock market as a whole? What does the DESI’s performance tell us in regard to:

• The DESI (and by extension, the clean tech sector) compared to the overall stock market?
• The DESI compared to other clean/ alternative energy indices that are publicly traded as exchange traded funds (ETFs)?

My analysis is by no means definitive; however, I offer some observations that may be helpful to investors and others analyzing the clean tech’s sector performance. The DESI is not traded and there are no assets tied to the index.

DESI vs. Overall Stock Market

Over the past three years, the DESI outperformed other major benchmark indices by a wide margin. The DESI’s gain of 52 percent compares against the 7.5 percent gain by the S&P 500.

In addition, the DESI has outperformed the Russell 2000, an index of 2,000 small cap stocks, many of which are technology focused. The Russell 2000 is probably a better comparison in that the DESI companies are also mostly pure play, small cap stocks.

As you can see above, the DESI has generally followed the Russell 2000 in regard to swings up and down. But crucially, the upside has been bigger, and the downside not as sharp. The DESI not only outperformed the Russell 2000, but a growing gap has opened up over the past few years. Why is that?

The most obvious answer is that clean tech remains hot – and the broader market, well, not so hot. Most market analysts have concluded that the drivers behind clean tech – aging infrastructure, rising energy prices, environmental concerns and regulations, technological advances and integration, consumer desire to better manage energy costs, etc. – are strong enough to sustain growth over the following years.

Probably the most important variable is rising energy prices, particularly oil, but all energy prices and fuel inputs. The economics of clean tech is near parity for many clean technologies compared to traditional sources. Plus, the rising price of oil has provided a huge psychological boost to clean tech as an alternative – and the source of future earnings. Clean tech has become a hedge – both physically and financially – against these rising prices.

The DESI vs. Other Clean Tech Indices

A comparison of the DESI’s performance against other clean tech indices is more complex. Rather than looking at broad macro drivers, which all the clean tech indices are impacted by, the analysis must turn to the structure, rules and composition of the individual indices themselves.

The Wilder Hill Clean Energy Index (PBW) is one of the oldest and biggest exchange-traded funds (ETFs) focused on clean tech. It is therefore representative of many of the clean tech and/ or climate change indices currently in the market. When comparing the Wilder Hill Clean Energy Index with the DESI, one can see that the two indices both outperformed the Russell 2000, a broader benchmark index, based on the market drivers discussed above.

However, there is also significant deviation between WilderHill and the DESI over the last three years. What may explain the performance gaps between these two indices, and by extension, other clean tech indices?

One must look at how the indices are structured to properly understand the differences between them. The key attributes to analyze are:

Composition, Structure and Definition: What are the constituent companies in the index? How were they chosen? In other words, what composite value(s) is the index trying to capture? How is “clean” defined? How is the index structured and/ or segmented in terms of sub-categories? The type, number and categorization of companies have a direct impact on the index’s performance.

The DESI is composed of 40 constituent companies organized into six segments: prime movers, renewable energy, alternative fuels, power quality and storage, demand management and enabling technologies. “Clean tech” is not the latest “hot tip” for one stock or technology. Our energy future will require many new technologies applied through the economy by a variety of service providers. Clean tech will affect every sector of the economy. DEFG believes that it is necessary to understand all these segments in order to understand the clean tech sector.

The DESI is differentiated from other clean tech indices by a focus on capturing both the proprietary advantage of a given offering, e.g., carbon reduction or energy efficiency, along with the integrated, bundled value proposition in a distributed system from an end user perspective, e.g., overall cost savings and/ or improved performance. Thus, the DESI represents a coherent narrative, but differentiated segments and growth trajectories to spread risk. You can see the difference between indices in the sharpness of the spikes and troughs of WilderHill, which is more focused on renewable/ climate change, compared to the DESI.

Pure vs. Diversified: Along with the general focus, how “pure” is the index, meaning is the index focused on mainly companies that derive the bulk of their revenue from a clean tech offering?

The DESI is primarily made up of pure play companies. Since the DESI is intended to be a benchmark index of the clean tech sector, we wanted to mitigate against the noise generated by unrelated or tangential parts of large, diversified companies. The DESI does include those parts of diversified companies that can be: a) isolated, b) represent at least 10 percent of the company’s overall revenue, and c) clearly fall under clean tech. Other clean tech indices have more diversified companies in their index and may or may not isolate the clean tech part of those companies for tracking purposes depending on the index rules.

Weighting: What are the rules governing the relative weights of one company (the percent that that company represents in the index) versus another?

Most clean tech indices, and indices in general, weight the companies in their index using market capitalization. Therefore, a company that has a larger market cap will have a relatively greater weight in the index. In an emerging sector like clean tech, a market cap approach can distort reality as speculation drives up the stock price (and therefore the market cap and weight in the index). The spikes and troughs of some indexes are the result of market cap weighting.

The DESI, however, moved from a market cap weighing to a “fundamentals based” weighting a year ago. Fundamentals based weighting keys off annual revenue rather than market cap to determine the weights of the companies. The fundamentals approach to weighting captures what is truly important – growth – in an emerging sector. In other words, the analyst or investor gets more of what they want, e.g., a look at relative growth rates and future earnings potential, and is more forward looking.

Geographic Coverage: Is the index focused on a particular region(s) or is it global? How do you account for differences in regard to reporting requirements between the regions if global? Does the index only include companies on major stock exchanges?

The DESI rules only allow for companies to be included that are traded on one of the major U.S. stock exchanges including ADRs of foreign companies. The reporting requirements in the U.S. are stricter and more reliable, and allow for comparable analysis.

Conclusion

Over the past three years, the clean sector has outperformed the overall market. This good news for clean tech was driven by macro drivers and trends that are favorable to the sector. The expectation is that those drivers will be present and intensify on a going forward basis. The clean tech as a whole seems to be on the road to sustainable and improving performance into the future.

But when comparing the performance prospects of the individual clean tech indices, it is necessary to analyze the rules and structure which govern the respective indices and underlie their respective performance potential. The deviations between the performance of the indices will continue in the future, and could be quite profound. An index’s rules around weighting, for example, are very important.

Finally, investors must keep in mind that each index has its own fee structure which will impact real gains or losses on top of the index’s performance.