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Cleantech, Optimism Squared and the Family Reunion Investment Test

Last November, Merrill Lynch released "The Sixth Revolution: The Coming of Cleantech," a thematic report from strategist Steven Milunovich that heralded cleantech as a new investment theme and forecast a coming age of plenty. A few days later venture capital icon Vinod Khosla warned a Palo Alto audience “500 million people on earth enjoy a lifestyle that 9 billion people will want in 2050.” The differences between these two informed viewpoints are more than a little stark, but they highlight a frightening truth about cleantech: for the first time in human history the fundamental drivers of a technological revolution are constraints rather than opportunities.

It is remarkably different this time!

Last weekend, I re-read the Milunovich report and spent several hours pondering the fundamental forces that drove the technological revolutions identified in the following table.


Technological Revolution
Historical Era
FIRST
The "British Industrial Revolution"
From 1771
SECOND
The Age of Steam and Railways
From 1829
THIRD
The Age of Steel, Electricity and Heavy Engineering
From 1875
FOURTH
The Age of Oil, the Automobile and Mass Production
From 1908
FIFTH
The Age of Information and Telecommunications
From 1971
SIXTH
The Age of Cleantech and Biotech
From 2003

I'm not an avid historian, but I recall that the popular reactions to the first five technological revolutions ranged from violent resistance to innovations that threatened job security (e.g. Luddites in England and saboteurs in France) to polite disdain or outright derision of innovations that were not seen as threats (e.g. Fulton's Folly). I still cringe when I remember college boy conversations where I taunted classmates with questions like "You may be able to buy a home computer in ten years but why would anybody ever want one?" The point is we didn't understand how important the innovations were until we viewed them in 20/20 hindsight. This dynamic gave important technologies time to evolve naturally, establish their value and then change the world in ways we couldn't have imagined. The process invariably took decades.

Where the first five revolutions were driven by the individual desire to do something better, faster and cheaper, it seems that cleantech is driven by a different dynamic. We collectively know that water, food, energy and commodities are not resources we can waste with impunity. We collectively understand that 6.2 billion people know how the rest of us live and each of the have-nots wants a fair share of the dream. We collectively fear a tipping point where unrestrained consumption of fossil fuels will irreparably damage our planet. We collectively worry that the world we pass to our children will face catastrophic conflict and horrific environmental consequences because of decisions that were made in a different era by our grandparents, our parents and us. So instead of viewing cleantech developments with a healthy dose of skepticism and requiring inventors to prove their worth, we collectively grasp at the latest research results and grossly overestimate their real value. A great example of this phenomenon are widely circulated stories about an MIT research project that would make it possible to recharge a GM Volt in less than five minutes by plugging it into the nearest available 125,000 watt power source.

Our problems are grave and almost everyone recognizes the desperate need for relevant scale solutions to persistent shortages of water, food, energy and commodities. But instead of acting like adults, accepting personal responsibility and doing the little things like home weatherization that could help alleviate the problems, we demand profound changes without considering whether the changes are enduring solutions or simple band-aids. We then compound the foolishness with the insane delusion that technological development is instantaneous and success is certain.

My favorite story of unbridled optimism is about a straight-laced father who thinks his son is overly optimistic and decides to teach the boy a lesson by telling him that a load of garden manure is his birthday gift. The manure is delivered and dumped in the driveway and the father puts a big red bow on top of the pile. When the son gets home from school, he promptly dives head-first into the manure pile and starts digging. When the surprised father asks what's going on, the boy replies, "There has to be a pony in here somewhere!"

It's a crazy world and an infantile time, but once the tantrum phase passes, we'll do what adults have always done. We'll get up in the morning, we'll go to work and we'll solve our problems. The first casualty will be unbridled optimism. The second will be waste in all its pernicious forms. Ultimately, rational cost-benefit analysis will prevail and we'll begin to find enduring solutions to critical problems.

Warren Buffet advocates investing in companies you understand, companies that that sell products and services you know, trust and use. Unfortunately, that methodology is almost impossible in cleantech because most of the players are new, few can point to a long and successful operating history and the principal disclosures investors rely on are forward-looking statements from people that are trying to promote an agenda or build a company; people who are by nature optimists. Any time you put an optimist's forward-looking perspective into the hands of an optimistic reader, the only possible result is optimism squared and that's a very dangerous equation for investors.

Unlike many financial bloggers, I know my opinions and outlook are far from mainstream. To compensate for that deficit, I've developed a simple technique I call the "family reunion test" to evaluate cleantech investments. It all boils down to a simple question: "How many of the people who attended our last family reunion are likely to buy this product or service at today's price?" If I conclude that most of my extended family members would be likely buyers, then it's probably a good investment. If I find myself all alone in the likely buyer class, then it's probably a good investment to avoid. Rigorously applied, the family reunion test is an amazingly accurate forecasting tool.

The battery industry is in a state of turmoil because none of the technologies we've relied on in the past are able to satisfy the extreme demands of a cleantech future. At $250 a kWh, lead-acid batteries are cheap and reliable, but they have weight, power and cycle life limitations that make them sub-optimal for plug-in vehicles. Li-ion batteries have exceptional weight, power and cycle life performance, but at $1,000 a kWh they're just too expensive for most cleantech applications. The net result is a race to the middle as lead-acid battery manufacturers work feverishly to improve performance while Li-ion battery developers work feverishly to reduce costs.

In the swamps of Degoba, Yoda told Luke Skywalker "Do or do not ... there is no try." The same wisdom holds in the battery industry. Don't talk about your plans ... talk about your accomplishments! In the meantime, investors would do well to remember that optimistic forecasts from interested parties are every bit as meaningful as the trash talk, hype and drama that precede every WWE championship.

Over the last several months I've delved into several arcane technical aspects of the battery industry. While the detail is useful for technophiles, it can be mind-numbing detail for the average reader. As penance for my past sins, I've prepared the following table that provides a simple summary overview of the differences between lead-acid battery manufacturers and Li-ion battery developers.


Lead-acid batteries
$250 per kWh of useful capacity
Li-ion batteries
$1,000 per kWh of useful capacity
Manufacturing
infrastructure
Efficient factories already exist and capacity can be rapidly and cheaply expanded.
Substantially all existing capacity is located in Asia and billions will need to be spent on new factories that will take years to build and equip.
Distribution
infrastructure
Efficient sales, distribution and customer support networks already exist. Billions will need to be spent on sales, distribution and customer support networks.
Recycling
infrastructure
Nationwide recycling capacity already exists, over 98% of lead-acid batteries are currently recycled and the recovered materials can be used to make new batteries.
Recycling techniques are in the R&D stage, there are no large-scale recycling facilities and the recovered materials are not pure enough to use in new batteries.
Technological
challenge
Improve energy density, power and cycle life; goals that appear reasonable in light of several recent advances I've discussed in prior articles.
Slash manufacturing costs by at least 50% in the short-term; a goal that is patently unreasonable for an industry that has historically achieved savings of less than 5% per year.
Raw material
availability
All essential raw materials are available in adequate quantities from domestic sources.
Essential raw materials are imported and there are important unanswered questions about future availability and price.
Financial
stability
The principal U.S. manufacturers are well financed and able to attract additional capital when necessary.
The principal U.S. developers are effectively bankrupt and cannot expand (survive?) without loans and grants from the government.
Market
valuations
Experienced manufacturers are trading for a small fraction of per share sales.
Developers with limited manufacturing history are trading at several times forecasted sales.

We are in the early stages of a technological revolution that is unlike anything the mind of man remembers. Instead of being opportunity driven, cleantech will be constraint driven. Instead of giving important technologies adequate time to evolve naturally, establish their value and then change the world, we're trying to avoid technical Darwinism, pick a winner based on theory, conjecture and public relations, and then force decades of technical progress into a couple of years. Experience tells me that the most likely outcome is catastrophic failure.

Ultimately, it boils down to your personal goals. If you want a long-term investment that will grow over time and derive immense benefit from the coming cleantech revolution, then the low-profile lead-acid battery manufacturers including Exide (XIDE) Enersys (ENS) and C&D Technologies (CHP) are probably the best choices for your portfolio. If you want a low-cost speculation on an advanced lead-carbon technology in the final development stages, then Axion Power International (AXPW.OB) may be a good choice. If you're more interested in fast paced trading in volatile markets then the high-profile Li-ion battery developers like Ener1 (HEV), Valence Technology (VLNC) and Altair Nanotechnologies (ALTI) may be best for you. In any event you should do your own research and understand what you're investing in before you place an order. My favorite place for reliable current information is the SEC's Edgar Website, which contains detailed disclosure from all of the companies I've mentioned.

I don't believe that Li-ion technology is doomed to fail. In fact I believe it has tremendous potential in a variety of markets where size and weight are mission critical constraints. However I can say without reservation that the challenges facing lead-acid manufacturers pale in comparison to the challenges facing Li-ion developers even if they get all the government support they could possibly want. To paraphrase a December 2008 note in the Wall Street Journal, Li-ion developers may well secure a place in a new electric-car industry. But at current prices, investors are being asked not just to dream, but to take success for granted.

Disclosure: Author holds a large long position in Axion Power International (AXPW.OB) and small long positions in Active Power (ACPW), Exide (XIDE), Enersys (ENS) and ZBB Energy (ZBB).

John L. Petersen, Esq. is a U.S. lawyer based in Switzerland who works as a partner in the law firm of Fefer Petersen & Cie and represents North American, European and Asian clients, principally in the energy and alternative energy sectors. His international practice is limited to corporate securities and small company finance, where he focuses on guiding small growth-oriented companies through the corporate finance process, beginning with seed stage private placements, continuing through growth stage private financing and concluding with a reverse merger or public offering. Mr. Petersen is a 1979 graduate of the Notre Dame Law School and a 1976 graduate of Arizona State University. He was admitted to the Texas Bar Association in 1980 and licensed to practice as a CPA in 1981. From January 2004 through January 2008, he was securities counsel for and a director of Axion Power International, Inc. a small public company involved in advanced lead-acid battery research and development.



was posted on AltEnergyStocks.com.


       

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Comments

John:

The cleantech 'irrational exuberance' you describe ("we're trying to avoid technical Darwinism, pick a winner based on theory, conjecture and public relations") seems akin to what investors went through with tech in the 1990s, which was decidedly driven more by opportunity than by constraint.

It seems to me as though this propensity to get collectively (and often irrationally) excited about emerging investment themes speaks more to human nature in general than to cleantech in particular. Stock market (and other) bubbles throughout history have been driven by the same basic phenomenon and have followed the same basic path from bubble to crash.

Typically, myths emerge about the potential of something (e.g. gold in the Klondike, tulips in the Netherlands, shipping in Louisiana or the internet in the US) to deliver returns well in excess of the normal returns people earn on their labour and capital when they simply "get up in the morning, go to work and solve their problems". These myths are then spread through over-simplified and embellished narratives and their growth becomes exponential. Complexity and nuance don't sell: just ask Karl Rove.

As the myths spread further and wider, information going against them - however factual and accurate - gets lost in the fray and discounted increasingly heavily versus information confirming the prevailing wisdom. This is not unique to investing and it afflicts the smartest among us: human beings have a propensity to weigh information confirming what they believe to be the 'truth' more heavily than information contradicting their worldview, and humans feel inherently more at peace following the heard than going against it.

With that in mind, I tend to apply the family reunion test (call it the bar test, the golfing with friends test, etc.) in the opposite way you do. When family members (or friends) told me that ethanol (2006) or solar (2007) sounded like interesting investment ideas, I knew it was time to get out!

Conversely, when I tried explaining why investing in the electric grid made sense and I saw people yawning and rolling their eyes, I knew I was on to something.

This approach is more in line with the Buffett way than with the Khosla way. The latter finds himself having to defend the soundness of his thesis while the former quietly waits for his "boring" investments to deliver. At the end of the day, numbers speak for themselves on who's got the right approach.

Charles,

I agree that it's time to bail out of an investment when your golf buddies love it. The family reunion test goes to buyers of the product rather than buyers of the stock.

I'm spending an inordinate amount of time thinking right now about the opportunity driven-constraint driven dichotomy and am sure I'll have more to say on the subject as my thoughts crystalize.

I agree we need a test to check ourselves for too much enthusiasm for cleantech, but the family reunion test only applied to consumer products. Even with batteries, the ones you talk about will not be consumer products, but components of such products. The factors you emphaize in your research speak to industry acceptance, not consumer acceptance.

Since most clean energy does not come in the form of consumer products (rooftop solar may be sold to consumers, but most PV goes into commercial or utility scale installations)it's more important to understand the features which will make a product sucessful in a commercial market. Often, that comes down to price, reliability, government incentives, and the ability to fit it into commercial processes. For this, I don't have a test beyond extensive and deep research, just like what you've done on batteries.

I think you do yourself a disservice to by equating your research with a half hour's polling at the family reunion.

"Ultimately, rational cost-benefit analysis will prevail and we'll begin to find enduring solutions to critical problems."

No doubt, but since we don't know--or acknowledge--many costs (CO2 pollution?) one can argue that irrational cost benefit analysis will prevail.

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