Animal Spirits Podcast - Talk Your Book: Investing in the Carbon Transformation

Episode Date: May 16, 2022

On today's Talk Your Book, we spoke with Roger Mortimer from KraneShares about the coming global transformation in carbon investing.   Find complete shownotes on our blogs...‍ Ben Carlson’s A Wealth of Common Sense‍ Michael Batnick’s The Irrelevant Investor‍ Like us on Facebook‍ And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation.‍ Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits is brought to you by Crane Shares. Go to Crane Shares.com to learn about the Crane Shares Global Carbon Transformation ETF. It's ticker KGHG. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holtz Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritt Holt's wealth management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Rithold's wealth management may maintain positions in the securities discussed in

this podcast. Welcome to Animal Spirits with Michael and Ben. Michael, we've had a few people come on the podcast over the years talking about the possibility of a commodities super cycle. I think one of the more unintended consequence way that this could happen is the movement away from fossil fuels just because if everyone's going to be driving an electric vehicle in the years ahead, getting from where we are now to there seems like it's going to take a long time for the buildout of not only the cars and the battery technology, but also the plug-in system for chargers and all that stuff. And if people see that's where we're going and then we just stop investing in oil and gas technology as much as we did in the past, doesn't that just

drive the price of oil up until we get to that point. So the transition period makes it even worse. I was about to say something, I have, like, no opinion. I don't know. I was to say, like, they're not going to stop producing oil and gas. There's so much money that I don't know. I could be missing something here, but it seems to me that going from this place where we're going to reduce emissions could actually make the price of oil even worse than

it is now. I hear what you're saying. I don't know. All I want to know is when do they make an electric minivan. I'm waiting for my electric Ford Explorer. That's when I'm going to make the move. Another thing is that's like another wealth inequality thing. If you can afford an electric vehicle, since they seem to be much higher priced in most instances, doesn't that mean that in the future, the people who can't afford one are going to be the ones complaining about gas?

And we have like a class warfare over cars. What is it? I think 10% of cars are electric in the United States. Is that about right? I thought it was 10% of sales, not 10% of total. Oh, I'm sorry. I'm sorry. 10% would be a high number.

You're right. You're right. It might be more like 2%. Oh, so we got a long way to go. 100% of all Teslas have a license plate that is unique to them. What do you call it like a personalized license plate? If you have a Tesla, you have to have a vanity plate. I think it's a rule.

Not everyone, but 70% of people with vanity plates are questionable people, should we say? I think that's pretty fair. Don't you think, you've heard people on the show. I think today Roger was one of them. I don't want to put words in his mouth, but that this is like the next big investment opportunity. Like the next trillion dollar company will be one that is in climate change. And I think that makes a lot of sense. Might or might not happen, but thoughts?

It does make sense. It is interesting between, like, how much of that is going to be government pushing stuff forward or pulling people kicking and screaming versus someone that just comes along and makes like an unbelievable technology that forces us to do it. What's the Churchill quote about, we always make the right decision, but only after exhausting all their options first? That's what I said about Americans. I will say...

That seems like us with climate change. This is a top three. I don't mind going out of my comfort zone. This is a top three conversation where I felt I knew absolutely nothing. So happy that Roger came on to help explain to us a little bit about the opportunities ahead. Here is our conversation with Roger Mortimer. We are joined today by Roger Mortimer. He is a portfolio manager at Crane Shares.

Roger, welcome to the show. Thanks very much. Today we're talking about your global carbon transformation ETF, KGHG. And I have to be honest, Michael and I don't know a lot about this space. So you're going to be schooling us a little bit here today. We're seeing this sort of energy resurgence this year. So maybe you can just tell us where this theme fits in with what's going on in the energy markets today. Here's the way to think about it.

Energy is fundamental to the global economy. A country like Germany is a $5 trillion economy that imports about $100 billion worth of energy. It's 2% of its GDP, but you can't run the economy without it. You have to have a stable energy supply. Energy, of course, is one of the sources. of CO2 emissions in the world. And the way to think about the planet that we live on today is the way that we are currently operating 80% of all of the energy that we use is generated by fossil fuels.

And so an analogy for life on Earth is we are sitting in the car in the garage with the engine running in the garage door shut. Not good. And that is unsustainable. And so we have a series of climate objectives that have the objective of reducing global climate emissions. And so the way to think about the energy sector is we use more and more of it all the time, but we also have to completely change the way that we generate energy to reduce emissions. And that's going to create a tremendous structural opportunity. Roger, you mentioned that 80% of energy that we

use today as fossil fuels. I'm curious, what was that 20 years ago? Was it closer to 100%? Have we made a dent in it at all? Yes, we have. The way to think about it, Michael, is oil and gas and electricity are kind of different things. So we tend to use oil and gas, for things where you have to get away from the plug in the wall when we use electricity for everything that is static. So transportation is primarily an oil and gas-based fuel. A lot of power generation is generated with fossil fuels. But what's going to happen over time is that electrification is going to become a much bigger theme. We're going to try to run everything on electricity and generate that electricity with renewable. So just to show you, I'm not embarrassed to say that

I'm not handy around the house. I barely even know what my house runs on. I guess it's natural gas or oil. It's one of those two, right? Why can't I just plug my house into a wall? Why get my house on electricity? Well, I think increasingly you'll find that it will. You could put some solar panels on the roof of your house, and you could have some batteries in the garage. Storage is a very important part of trying to live your life on renewables

because it's only sunny and windy at certain times, but that might not match when you need electricity. So I think what you'll see is that over time, your house, as an example of many things, will become more independent of the world around it and kind of become this self-contained unit that can draw sun from the roof, perhaps, stored in the garage, and you could probably run your car on that, and you can run a lot of things in your house on that, too. My feeling is the transition period is going to be really difficult to get us from point A

to point B on a lot of this stuff, and obviously it's not going to just all happen all at once, but what companies does it make sense to first invest in for this kind of stuff, and how does it change the commodities markets and all this stuff that we've been dealing with in the past. Like, how different does this all look? And how do we get from here to there? Here's the way to think about it, Ben, and it's pretty interesting. I've been a global investor for a long time. And the industries that have the greatest opportunity here are industries that investors have tended to pay no attention to whatsoever. They tend to be pretty cheap. We have existed in a market for a long time now, at least 10 years, where investors have had this

overwhelming preference for a certain type of company, a high growth company, and they're willing to pay a high price for it. But now we find ourselves in a situation where the constructor of everything is rising, and that's going to leave investors with less money in their pockets to buy Peloton subscriptions and Netflix subscriptions and the sorts of things that we've tended to value quite highly. And at the same time, we've got a group of industries that are behind the curve in terms of what they're delivering today, and they need to spend a lot of money to catch up. And then in addition, they're going to try to completely retool themselves. And so I think the way that I would express it is the best growth opportunities for the next

decade may come from the places that investors least expect them to and stocks that are not pricing that at all. And that's what this investable universe looks like. What is the opportunity here? I guess who's solving this? Because you would think that climate change, like it's such a buzzword and there would be such gigantic monetary rewards for people that can make us more energy efficient. It feels like just, from the outside looking in that it's happening in a glacial pace? Is that because it's a gigantic technology question? Is it like physics?

Like, what are the challenges? I don't think it is any of those things, really, Michael. There are no technological barriers. I think sometimes what happens is we all tend not to do things until we absolutely have to. We planet Earth have now found ourselves in a difficult situation where it's pretty clear that climate change is having adverse impact, and its impact is accelerating. And also, we've underinvested in energy infrastructure for a long period of time.

And that's left us with shortages all over the place. And we now need to invest heavily to catch up. You mentioned that a lot of these stocks that are in your universe are overlooked, unloved, that sort of thing. Michael and I were looking before we got on the phone here at some of the holdings that you guys have. And these are not household name stocks. A lot of them I've frankly never been heard of. So, like, what is this universe? how did you drill down into it, and how do you determine which stocks go into this portfolio?

So we're focused on global carbon transformation. We are basically interested in investing in the problem, because the problem is where the opportunity is. If you buy a wind generator today, you're going to pay a very high valuation versus buying a fossil fuel burning company. Investors have shunned those companies and driven up their cost of capital, and everybody wants to pay, what I would argue is a premium. price for the clean thing and a discount price for the dirty thing. So we're interested in investing

in those dirty companies to want to transform themselves into clean companies, and we're playing for that valuation arbitrage. So the way to think about our investable universe is look around the world at who's part of the problem and identify the companies within those industries that are most aggressively moving to where the world is going to be. And so we're talking about power generation. We're talking about heavy industries like steel, like cement. We're talking about heavy transportation applications, not necessarily your BMWI-3. We're talking about container ships, aviation, big applications that can't be solved with batteries, for example. Roger, you spoke about like cost of capital investors favoring like ESG type stuff. I just was looking at this yesterday.

There's six stocks in the S&P 500 that are up 100% year over year. They're all energy companies. ESG flows and that sort of stuff, how do you think that actually impacts the underlying economics of these companies? A lot of people just say, well, these are shares that are trade on the secondary market. You're not actually giving money to these companies. What do you say to that? How do you think all those dynamics are playing out? Well, we think about this investable universe in two ways. We think about the financial opportunity, first and foremost. I think this will prove to be one of the most effective places you can put your capital over the next decade. And what's interesting is it has also lined up with a social goal, that solving climate issues will prove

to be financially rewarding and socially rewarding, and those two factors have not lined up before. One of the byproducts of being a dirty company transitioning to a clean company is your ESG scoring will improve, and that will help with evaluation also. If you look at analysis around ESG, if all of the money flows go to ESG, then ESG itself becomes relatively undifferentiated. There's academic research around the idea of improvement in scoring. And one of the true alpha generators in ESG is buying rate of change. You buy a low scoring company that's ESG scoring is improving, and that should assist in bolstering the valuation. So we're kind of interested in buying these, what you might use the phrase, old economy,

companies that are not valued very highly have tended not to grow very fast, but for a couple of different reasons are now going to grow much, much faster than they did before. And they're also going to start to look quite different to the way they did previously. And investors are going to value them differently. The companies in this portfolio tend to be older. I would just intuitively think that these are younger companies that are like more scrappy upstart. But is that completely wrong? I think you pay a lot for the scrappy upstart. It's the guys who are in this business who actually have the best opportunities. Ben mentioned that these names are not necessarily household names. I'd like to come back to the logic for investing globally in this strategy. But here's an

example. RWE is a German utility. Germany, as I mentioned, is a very large economy that is highly dependent on energy imports. It's particularly dependent on Russia. Germany cannot run its country without imported energy. And that's a structurally very problematic place for it to be. So for both strategic reasons that are in necessity for Germany's ability to run its own economy, and for climate reasons, it signed a series of climate pledges. Germany is going to add a huge amount of renewable capacity over the next 10 years. It's essentially going to replace the imported fossil fuel energy with homegrown windmills and solar panels. RWE is a German utility. Nobody likes it. Big coal-fired generator in Western Europe. It's going to triple its capacity over the next

eight years, and it's all renewable. They're going to spend $30 billion on renewable, and they have an activist shareholder in there also who is pushing them to divest the coal. So this company's going to grow at about three times the European average for utilities. Today, it looks like a coal-fired generator in a sleepy place, but it's going to grow rapidly, 12 percent annually for most of the next decade, and it's going to come out the other side looking like a green company, and of course it treats it a massive discount to anything that looks like it. How are you uncovering these companies? How much as qualitative versus quantitative, is it more of a rules-based approach or are you having to sort of dig through the weeds on this stuff? There's no specific formula or quantitative screen that

you could apply. You really have to do fundamental research on each of these underlying industries where the problem is. And I'd say broadly speaking, Ben, we're looking for four things. We are looking for management intent. We're looking for adjacency, which I'll explain. We're looking for capital commitment and we're looking for shareholders holding their feet to the fire. So management intent's relatively easy to observe. Carbon transformation has got to be at the core of the company's strategy, and you can see that in the way they present themselves to the street and their annual reports and their capital market stays. And we want to be invested with those companies that are committed to being the leaders. The second concept is this concept of adjacency. And the way to think

about that is, does this company have skills or assets that they could use to target these new business opportunities? Do they have a leg up? Are they in the right place? Are they in the right businesses, do they have the right sorts of skills? Let me give an example, and this is kind of the poster child that we use in our presentation deck. There's a Danish power generator called Erstead. Erstead used to have both a different name and be in a different business. And then this was an offshore oil producer in Denmark that was called Dong Energy, the Danish oil and natural gas company, which obviously there's potential for confusion around the net. And so these guys have maritime assets and skills. They know how to run offshore infrastructure. They manage ships and all

sorts of big offshore assets. And they're already running the supply chains of running these derricks offshore. And what they realized was the skills and assets that they had lent themselves to get into the offshore wind business. And what they started to do is they started to invest a larger and larger share of their capital in building offshore wind fields. And then they decided, decided to sell the legacy business. And so this company went from being a Danish offshore or a gas operator or the bad name that nobody really wanted to go anywhere near, to a company that has been voted three times in a row, the world's most sustainable energy company, and the valuation tripled. Here's an example of ugly duckling becomes swan, and this is the

playbook. You've mentioned a couple of European companies so far. Is that where most of this is happening in Europe? Yeah, it's a really important question, Ben. You have to go to where the regulation is most aggressive. The companies that will have the opportunity are the ones in the place where they are being pressured to change the fastest. You want to be invested in a company that exists in a jurisdiction where the regulation is forcing them to change because those guys are going to get into these businesses to scale them faster than everybody else, and then they're going to turn around and export that to other markets as they open up. So at the moment, the most progressive regulatory game is in Europe. And you would want to

to have a global strategy trying to invest in these sorts of companies because you really have to go to where the regulatory pressure is the greatest. You mentioned valuation. Are we going to see the next trillion-dollar valuation come out of one of these clean energy companies, or am I nuts? I would say yes. I think investing around climate is going to be the dominant investment theme of the next 25 years. And so investors may not perceive that today, but scientific consensus around climate change is very strong. CO2 emissions are accumulating in the upper atmosphere and they are getting worse and that will impact our quality of life. And we're seeing that in terms of extreme weather. And so what's going to happen over time, Michael, is that

climate regulation is going to get more and more aggressive and the cost of not complying is going to get higher and higher and this activity is going to accelerate. And people are going to start to see, hey, this is where all the investment is going to be and this is where I think I should allocate some capital. So where is this actually going? Like, I guess, I don't know anything about this stuff, but it seems like wind was like the big thing, but nobody wants those giant wind farms anywhere near where they live. So what is it going to be? Is solar the big thing?

What is it exactly that's going to transform the grid? Maybe the grid is the wrong word, but the energy consumption. The reality, unfortunately, is that it is everything. These markets are so huge that you have to pull every possible lever that you can. So what is everything exactly? The elephant in the climate room would be oil and gas. We are not going to stop using oil and gas. The climate issue is not that we consume oil and gas, is that we create CO2 emissions when we consume oil and gas.

And so the conventional oil and gas industry is going to adapt to other types of opportunities that look like what they already know about, things like hydrogen, which is a gaseous fuel that you could make with renewable energy, behaves a lot like natural gas. They will also be invested heavily in carbon capture type technologies. And so what you're going to see is that the energy mix is going to shift from overwhelmingly fossil fuels to something that is much more of a patchwork. And depending on what you have, where you are, you will use that. Some places are windy, some places are sunny, some places have hydro. Some political environments will encourage the use of nuclear power. Others won't. And all of these things will get used.

And each technology will gravitate towards where its opportunity is. is the best. I paid $4.61 for a gallon of gas yesterday. What's going on? What can I do about this? You got an incredible deal. Here in California, we pay six bucks. I don't understand how that's possible. Honestly, how do people afford to fill up a tank for $6? How? You're underscoring exactly where the opportunity is for this fund. The fact that gas costs $6 leaves me with less money to spend on other things I used to like to buy, but I have to buy the gas. Because I've got to get to work. And so as the energy industry has underinvested and the economy is recovered from COVID, we're now in this situation where we have very stretched capacity and you need a

significant period of heavy investment. And so the losers are anything that are consumer discretionary, but the beneficiaries are the oil companies who are collecting your six bucks a gallon until that problem is solved. And that's going to take multiple years. You would also think that a beneficiary or like the electric cars and the battery makers. I don't see any of those. At least I can't tell in the fund. Are those specifically out? Or what's the thinking there? I think what I would say is that that is a very niche part of the story. We're invested across broad industrial and power generation markets. And when you look at where emissions are caused, transportation is part of it. But personal passenger transportation is not causing global warming. Global warming is caused by power generation

It's caused by industry. It's caused by big, heavy-using industries. And so electric cars and electrification of vehicles, that will continue to be a trend. But all of these other things need to happen also. How does this impact the commodities, Marcus? Because obviously there's different commodities we need to make some of this stuff happen. But also, if we're going to have underinvestment in fossil fuels, doesn't that in the transition period potentially just make the price of oil keep going up until all this stuff comes

online in a much bigger way? Yeah, that's absolutely going to happen. The price of these key materials, including oil, including copper, some of these other areas, where you've had substantial underinvestment for years, it's going to stay high until new capacity comes on. And that's going to take a long time. And so one way to think about it is these super major oil companies, which people tend not to like very much, are not particularly expensive, but they're going to be generating very high levels of cash flow throughout a period when everybody else is suffering. And from our perspective, if you can find

one or more of those companies that is allocating that cash flow to the transition, they've got this huge windfall that enables them to do it more quickly. Are any of those big name companies doing that, Exxons or Chevron, or any of those sort of bigger, well-known companies, are not yet? Again, the focus has been in Europe where the regulators are forcing them to do it much more aggressively. We do have exposure to energy majors, but the two examples I would give you are Total, which is a French company, and Reliance, which is an Indian company, both exist in places where there's much more pressure on them to do this. And so they are moving much more aggressively than most North American energy companies are. Roger, what's the difference between what you guys are doing and some of the other clean energy products that are on the market? There are two types of funds that are in this universe today. There are a group of funds that invest in, and the quotation would be companies that may be better positioned for the energy transition. And there are some very large funds that do that. And if you look at what those funds own, they basically own the top of the S&P. They own these cloud software type companies that are better suited for the energy transition because they don't create a lot of emissions. They're not really saying a whole lot. They're ending up with a fund that is highly

correlated to the S&P, and you're not investing in the problem. You're investing in companies that don't have the problem, which is not actually addressing the issue here. There are a second group of companies that tend to own the solutions providers, the innovators. They own what invariably are smaller and much more highly valued companies that are rifle shot solution companies. If you own a portfolio of those, you're going to pay a much higher valuation to own them, and you are operating on the assumption that somewhere within that portfolio, somebody's going to solve a huge problem, then you're going to get re-rated substantially. We are investing in management change. We're investing in perception change. We're buying companies that people don't like

today that are transforming themselves into something that is going to look a lot more appealing to investors. They're going to grow faster and they're going to look greener and they're going to be worth a lot more. And that is management-led transformational activity. And you have to be an active fund. Being a passive fund is far less effective because there's a lot of change in this environment all the time. If some of these companies are successful in the way that you think they could be, what does that mean for people in 5, 10, 15, 20 years? What do we notice that's completely different and changed about our lives if some of these companies are successful? I think, Michael, I would say you'll notice if they're not successful. We are in a challenging

place on planet Earth where climate change is accelerating in terms of its impact. And what is reasonable to expect is going to happen is that the impact is going to become more apparent to people. A lot of that will be in the form of weather impact. And regulatory pressure is going to grow. As the regulations get tougher and tougher, the status quo becomes less and less acceptable. The old cliche about the recession is when your neighbor loses his job, it's a recession. When you lose your job, it's a recession. depression. And the climate analogy is when you see somebody's house burned down on the news

because of a forest fire, that's of passing interest to you. But when your whole neighborhood goes up in flames, you call your local politician. And that's starting to happen in more and more places. And what's really notable about climate change is the events that we have here in California, for example, which are heat and fires and drought. You can find those in multiple countries around the world. These problems are starting to pop up everywhere. And so they create political pressure. And that causes the regulations to change. And that forces companies to act. What percentage of the fund is in cryptocurrency mining rigs? That is zero. Zero. We're not. I'm really teasing. Roger, what do we get people to, or investors to start taking this seriously? Is it management telling a better story? How does

change happen? Well, I'll tell you what we would like to demonstrate, Michael, is I'd like to be able to show you that investing in the problem and in the management teams that are most committed to change may prove to be one of the most effective things you can do with your capital over the next 10 years. And as people see that, as people see these orstedts transform and their valuations expand, then more capital will flow to these areas and the change will happen faster. I think it's just this really unusual situation where the barrier is not technology. The barrier is simply management will and shareholder pressure. And you have three things happening now.

You have government pushing with regulation. You have technology costs falling as it scales. And you have investors recognizing that this is actually the right thing to do and they're encouraging these companies to be in this way. And you think that the politicians in the United States, when do they start catching up to what's going on in Europe? When does that happen? I don't have a specific view on.

politics in this country, but I would suggest that no country is immune from the climate impact, and as the climate impact is apparent, you'll have the same pressures here as elsewhere. Governments see three benefits in pushing climate regulation. Let's use a European country, for example. They've signed net zero climate agreements, which are bound in law, so they're obligated to do this to meet climate treaties. But they see a tremendous energy security argument. If you're importing energy, the United States does not, but if you're an energy importer and you could grow that yourself, you've removed your dependency on someone else that's very attractive. And they see the opportunity to grow faster. So there's an economic development argument, a strategic argument, and then there's this climate pledge argument, and those have to line up.

And I think what you'll see happen in the United States is the economic opportunity will appear. you're starting to see that in places like Texas where you have a lot of the infrastructure there already and you have a lot of curtailed wind power. People will start producing hydrogen for use in industry and clean industrial applications. You just need a couple of examples that show the commercial potential and then the capital will follow. When you're talking to investors and they're asking you, or maybe they're not, like where does this fit into the portfolio? What would you say to them? Michael, this is like absolutely core. This is the center of your portfolio because this area is one where the growth is effectively regulated.

The governments are imposing laws that are making this stuff happen. What investors are discovering in the last month in the market is that when input costs and interest rates rise, the cost of everything goes up and you have less money for everything else. Your discretionary spending power falls, and that impacts everything in your portfolio. So wouldn't you be interested in investing in something where you knew there was going to be growth? And here the growth is driven by climate change, by regulation. It's not correlated to interest rates. It's not correlated to the Fed.

This is structural long-term growth. And that, I would argue, it's going to be pretty hard to find. And investors will start to notice that it lives here and that you can access it in a portfolio that, in the case of our portfolio, to trades at less than one-time sales and has a running yield of more than 3%. It's a pretty compelling security portfolio. Roger, where do you want us to send people to if they want to learn more about the fund? Well, crane shares.com is our website. The ticker of this fund is KGHG.

It's called the Crane Shares Global Carbon Transformation ETF. And we have a climate suite that also includes KRBN, the ability to invest in carbon allowances, which are an interesting subject in itself. I know that you've had my colleague, Luke Oliver. But I think the message we'd like investors to consider is that climate change is not going away. And this is going to appear on the front page of the news with increasing frequency. And there is tremendous investment opportunity that comes with the imperative to change and address these needs. All right, Roger. Thank you so much for your time today. We appreciate

you coming on. Thanks to Roger. Thanks again to crane shares. Remember craneshares.com to learn more and send us an email animal spiritspod at gmail.com. Thank you.