The Tangential Path to Alpha

062718

Renewables evolution within the Energy complex represents boom-to-bust then boom again scenario sequencing consistent with subindustry core emergence.  Patterned development over the past ten years is indicative of hard forged self-reliance evidenced by direct corporate ownership of wind farms and distributed solar generation located atop major retail stores, both far from government sponsorship of select alternative energy companies at above market rates.  Today, climate change skeptics face the certainty of value-based cultural movements.

 

Survey of US Department of Energy and International Energy Agency publications in this context detail electric generation capacity parameters (Oil&Gas, Coal, Nuclear, Renewables) and power trend growth rates effecting companies populating each Energy producing segment and classification.  Current period demand-side Energy equation power consumption dynamics converge to shape investment opportunities among supply-side Energy equation power capacity providers and requisite ecosystems across economic sectors and within industry verticals.  Corporate-sponsored Green programs place Apple, Google, Target, Walmart and similar ethos companies at the forefront of US Renewables policy alongside federal tax incentives, state mandates, municipalities and utility companies.  Here at the intersection of Renewables, Infrastructure and Environmental, Social and Governance programs lies the tangential path to Alpha.

 

On a Beta-relative basis, populist trends and momentum strategies in tandem long offered positive realizations yet while macro and sector bets via active management or ETF allocations are relatively straightforward, thematic- and niche-Beta strategies leave Alpha-driving issues such as constituency breadth and corporate profile maskings unreconciled.  Product development and newly crafted thematic indexes frequently compound errors by misaligning comparables, increasing susceptibility to performance drags relative to benchmark asset class indexes.  Counter-thesis positioning and comparable assignment inaccuracies (e.g. derivatives exposure against long-only benchmarks, government comps for corporate bonds) further hamper attempts for transparency and cloud opportunity costs.  Series development of independent benchmark portfolio overlays enhance performance attribution and tests the veracity of fund company marketing campaigns.

 

Index applications addressing limitations in allocated Beta strategies for integrated Alpha efforts necessitate a realignment of teamed analytical data sets.  Quantitative exercises to isolate Value in Growth companies (and Growth in Value) begin by deconstructing relevant Large-Cap companies into modular corporate business segment operations (BSOs), aligning revenue drivers with each other and those from Small- and Mid-Cap competitive peers.  Replacing common sector/industry/subindustry index designations with descriptive BSOs is a deliberate first step Beta-capture to an eventual Alpha-screened second cluster.  BSOs universally reflect directly the financial impacts of planned product cycle/subcycle positioning and avoid a broad array of component members recurrent in passive indexes, structured thematic portfolios and active index-plus strategies.

 

Benchmark proxy ETF composite reporting, typically grouped into five generic industries or nondescript third party categorizations, is often inconsistent with middle-down allocated Beta strategies on a relative basis or in standard nine-grid style/size box format.  Due diligence at this point creates an opportunity to reconstruct benchmark proxy ETF attributes from the bottom-up, realizing the value-add of BSOs placement into segment/classification industry verticals.  BSOs improve situational awareness by pairing forward-looking valuation analytics (i.e. variance of constituency portfolio weights to market capitalization per segment/classification) with competitive market information (functional peers, acquisition candidates) at defined points of inflection.

 

Renewables, Infrastructure and ESG benchmark proxy ETF audits reveal several useful though perhaps counterintuitive facts: 1) Renewables ETFs include Diversified Industrial and Technology companies, 2) Infrastructure ETFs include Coal and Nuclear power generating utility companies and 3) ESG ETFs include Oil&Gas companies.  These seeming contradictions are not unpredictable given ESG fund ratings criterion balancing equal considerations of corporate stewardship and a net carbon posture, after all Earth naturally provides resources for human evolution.

 

In transition from Energy policy whitepapers to investment strategies, classical portfolio configurations [(Alpha)+(Alpha+Beta)+(Beta+(Beta))] are advantaged by evaluation of BSOs (Alpha-Beta) portfolio position weight variances per segment/classification in efforts to isolate differentiated growth rates and, importantly, slope among representative companies (Alpha).  The Energy equation and potential at Alpha’s intersection are replicated below utilizing benchmark proxy ETFs performance results in comparison to major index ETFs, capitalization-based Growth and Value standards plus fundamentally weighted Smart Beta.  Proprietary research suggests BSOs liaise between portfolio themes and the total returns demonstrated by component members ranged performance:

In our example, Renewables BSOs populate the Energy equation’s supply-side based on an economic representation of public-private partnerships, mandated programs and corporate investment.  Forward-looking research embedded in actively managed Renewables benchmark proxies PBW/PZD incorporate projected changes in the levelized cost of energy, Energy equation weights, macro price drivers and emerging technologies among other catalysts of valuation and diminishes the usefulness of past-positive (historic) data in static benchmarks.  PBW 12-month constituency performance dispersion (PBW: +620.2%, -73.2% versus PZD: +145.9%, -16.4%) illustrates the benefit of Small- and Mid-Cap biases in Growth-orientated themes (PBW: Small-Cap 46.2%, Mid-Cap 33.1%, Large-Cap 20.7% v. PZD: Small-Cap 7.0%, Mid-Cap 31.6%, Large-Cap 61.4%; composite data as of 033118).

 

Contrasting persistent Large-Cap dominance of industry verticals, BSOs Negative Inversion differentials are empirical to Small- and Mid-Cap companies and serve as the building blocks of layered Alpha screens.  PBW Top 5 component member period and niche-cycle Alpha outperformers (Solar, LED) are framed by applying BSOs nomenclature (Solar—Components x 2, Solar—Systems, Solar—Wafers, LED—Components) to existing Morningstar designations (Semiconductor Equipment & Materials x 2, Solar x 2, Semiconductors).  PZD Top 5 component members included two of the Top 5 from PBW, one discretionary omission (N/A) and one of two from the same two BSOs segment/classification as carbon fiber suppliers (Wind—Components/Composites, Auto—Components/Composites) based on capitalization (Small-Cap over Large-Cap in an upcycle scenario) iteratively from Morningstar assignments (Diversified Industrials, Aerospace & Defense).

 

In the Energy complex, protocoled obliques focus attention on areas of profit/loss isolating Value in Growth companies (Renewables) and Growth in Value (Oil&Gas, Coal) and asserts its implications on a fundamental operating basis.  Ascribed singular and multi-dimensional BSOs ordinal tierings (primary/secondary/tertiary) distinguish between Beta trends and Alpha drivers by producing cyclical/subcyclical/countercyclical directional valuation markers, the long and short of the matter.  Perhaps inadvertently, factor tilts and Smart Beta adherents lend to the premise of BSOs in more granular form and the prospects of qualitative assessments (Alpha) outperforming big data applications (Beta).  Far from zero sum, capital market inefficiencies and mean reversions lend opportunity in research . . . as stated ‘correlation is not causation'.

<U/O> Universal Orbit  © 2019