Episode #278: Lucas White, GMO, “Since Inception Of The Strategy…We’ve Been Buying Companies At A Significant Discount, Yet Our Portfolio Has Had Earnings Growth That Far Exceeded The Broad Equity Market”

Episode #278: Lucas White, GMO, “Since Inception Of The Strategy…We’ve Been Buying Companies At A Significant Discount, Yet Our Portfolio Has Had Earnings Growth That Far Exceeded The Broad Equity Market”


Guest: Lucas White is the portfolio manager for the Resources and Climate Change Strategies. He is a member of GMO’s Focused Equity team and a partner of the firm. Previously at GMO, he was engaged in portfolio management for the Global Equity team, including responsibilities for the Quality, Tactical Opportunities, and U.S. Growth Strategies. Prior to joining GMO in 2006, he worked at Standish Mellon Asset Management and MFS. Mr. White earned his B.A. in Economics and Psychology from Duke University. He is a CFA charterholder.

Date Recorded: 11/18/2020     |     Run-Time: 57:37

Summary: In today’s episode we’re talking all about resources and climate change as an investment strategy. Lucas sets the stage with why he believes the resource sector offers a huge opportunity and currently trades at an 80% discount to the broad equity market. Then we dive into GMO’s climate change strategy. Lucas explains what led them to focus on climate change and clean energy and officially launch a strategy in 2017. We talk about the allocation to different areas, including copper, food and water.

As we wind down, Lucas explains how a traditional value shop like GMO applies their value lens to this growth area.

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Links from the Episode:

  • 0:40 – Intro
  • 1:30 – Welcome to our guest, Lucas White
  • 4:05 – Timeline for joining GMO
  • 7:55 – The natural diversification of natural resource investing
  • 12:59 – How resources stack against the broader market
  • 13:08 – An Investment Only a Mother Could Love (White and Grantham)
  • 16:44 – Global Asset Allocation: A Survey of the World’s Top Asset Allocation Strategies (Faber)
  • 17:49 – What is causing the resource markets to perk up
  • 22:41 – Lucas’ preference in investing in equities over the resource itself
  • 28:58 – How GMO applies climate change to their strategy
  • 37:30 – How does their strategy span the globe vs just being a domestic initiative
  • 37:58 – Their approach to old school vs new school companies in terms of their climate footprint
  • 40:50 – Changes in climate change that people are not paying attention to: biofuels
  • 47:14 – Applying a valuation lens to this space
  • 50:46 – How institutions allocate to this strategy
  • 53:38 – Most memorable investment
  • 56:34 – Connect with Lucas – gmo.com


Transcript of Episode 278:

Welcome Message: Welcome to The Meb Faber Show, where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.

Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.

Meb: What’s up, friends? Another awesome show today. Our guest is the portfolio manager for GMO’s resources and climate change strategies and a member of GMO’s focus equity team. In today’s episode, we’re talking all about resources and climate change as an investing strategy. Our guest sets the stage on why he believes the resource sector offers a huge opportunity and currently trades in an 80% discount to the broad equity market. Then we dive into GMO’s climate change strategy, we hear what led them to focus on climate change and clean energy and officially launch a strategy in 2017. We talk about the allocation to different areas, including copper, food, and water. As we wind down, our guest explains how a traditional value shop like GMO applies their value lens to this growth area. Please enjoy this episode with GMO’s, Lucas White. Lucas, welcome to the show.

Lucas: Thanks for having me. I appreciate it.

Meb: Where do we find you today?

Lucas: I’m in the Boston area.

Meb: Former Dookie, what did you study there? Right down the road. I was a Cavalier, grew up going to watch the Tim Duncan Randolph Childress, Ronnie Rogers, wake teams battle it out with Duke in Winston-Salem. What was your focus back in those undergrad days?

Lucas: Well, I did spend a lot of time watching the basketball team, that’s for sure. Back then, we had a bunch of exciting players. When I was there as a freshman, we had Grant Hill and Bobby Hurley. It doesn’t get much more exciting than that, just miss the Laettner years. So college basketball is certainly a lot of fun down there. And I studied economics and psychology, were my majors at the time.

Meb: Totally unrelated, I just spent the most amount of money I think I’ve ever spent on my life on shoes and it happened to be a pair of sneakers. And before anyone gets too excited listening, it was like 250 bucks but it was also an investment experience because I wanted to see how the sneaker apps worked. So StockX for the listeners that have used it, there’s a whole economy around buying and selling and investing, if you can even call it investing, speculating and sneakers, but Nike had put out a Virginia championship edition, beautiful orange and blue which is perfect for me because it goes double duty as a Broncos fan although I’m not wearing those much this year. So now, I’m a proud owner still because UVA was able to say they’d be champions for two years in a row now during Coronavirus, only good benefit of Coronavirus, and then I also now own a $250 pair of shoes that I’ve worn once. They’re too pretty to wear.

Lucas: I hadn’t heard that claim that they had set claim to the championship for the tournament that wasn’t played.

Meb: Still champs. I’ll take what I can get. My defining moments in my college as undergrad was UVA was atrocious and at every other ACC school, you can probably relate to this, anytime the ACC tournament came around, you had to like camp out to get tickets or lottery, I don’t even know, depending on the school. In Virginia, a student could just walk up and go grab some. So every year, we would go get tickets, drive down to Greensboro, Charlotte, I can’t remember where it was, sell them on Craigslist, and you could get a pretty penny selling it to some Duke fans like yourself, invariably get to go to the plan game because UVA was terrible. So as usually, UVA Duke, we’d get beat by 40 and then drive home but it was worth it back in those days. 500 bucks? Man, that was a good deal.

Lucas: Yeah, it was quite a run.

Meb: We got a lot of exciting stuff to talk about today. There are a couple of topics we haven’t explored that much on the pod. We’ve talked about natural resources a bit, not as much about climate change and the investment thesis. You joined GMO right before the financial crisis. Has this been a focus from you from the beginning? Walk us through the timeline. 2006, right?

Lucas: Yeah, I joined GMO in 2006 and actually, initially, I was focused on broader mandate. So we have a quality strategy where we’re investing in big mega-cap blue-chip companies that have some sort of sustainable competitive advantage that allows them to be excessively profitable for years or decades at a time. So this would be Google, Coke and Pepsi, Procter & Gamble, Unilever, companies like that. And we had a long short variant of that, and then I was involved in running our growth and value strategies, U.S. growth and U.S. intrinsic value. And then around 2010-2011, Jeremy Grantham was wrapping up about a five or six-year research project he’d been engaged in. He’s the founder of our firm. And he was doing a lot of research into the resources markets and developed a thesis around resource scarcity that was pretty exciting.

His thesis was that commodity prices would rise in the decades to come because we know kind of definitionally, there’s a finite supply of natural resources but more importantly, there’s a finite supply of the cheap stuff, the easy to access, easy to process stuff. You used to plunk a pipe in the ground in Texas or Saudi Arabia or wherever, oil would gush out. Well, that’s not what happens anymore. We’re doing shale where we’re blasting apart rock thousands of feet beneath the earth’s surface, we’re doing ultra-deep-water, we’re doing Arctic stuff, we’re going to all ends of the earth to try to squeeze some of this stuff out. And I got tapped on the shoulder to work with Jeremy and others at GMO to figure out whether it made sense to launch a resources strategy to capitalize on that theme of kind of limited supply and growing demand for natural resources.

And when we’re doing that research, I was thinking a lot about the risks to the resources sector. If you’re a long-term investor in the resources sector, what do you need to worry about? And I could find a lot of risks that you could diversify away and a lot of risks that were short to medium term in nature but the one risk that really stood out that was a long-term risk was stranded asset risk of the fossil fuel companies. If climate change is as big of a disaster as it appears to be, can you be comfortable investing in a coal miner? Can you be comfortable investing in shale, which has terrible environmental implications if you count the methane emissions that happened during the production process?

And so I actually first thought about the idea of having a climate change strategy back then in 2011 when we were getting ready to launch our resources strategy as kind of a hedge on the resources side of things but then as kind of time went on, I saw kind of a transformation in terms of the competitiveness of wind and solar and electric vehicles and all these clean energy technologies. And it went from kind of pie in the sky, totally uneconomic, totally uncompetitive around 2010 to by 2015, you could see the light at the end of the tunnel, where clean energy solutions were just going to be cheaper than fossil fuel-based solutions. And once they’re more economic and more competitive and cheaper, why wouldn’t you do something that doesn’t pollute and why wouldn’t you do something that’s clean and quiet and hassle-free and all those great things? So that’s kind of like the evolution. I started off kind of more broad and then once I got into the resources sector, that kind of led to the work in alternative energy and electric vehicles and kind of led to the evolution of our climate change strategy.

Meb: And that might be a good roadmap for how to kind of point out this conversation. We can dig deep in a lot of different parts of this. I think I’ve read all your papers in the last day or two and some of them are really fascinating. One of the first, when you talk about natural resources, people love to bucket out all the different sectors or industries of stocks, natural resources seemed to be a bit unique. You guys touched on a couple areas in particular that make them, A, a unique diversifier and then, B, there are somewhat of the kind of tactical exposure based on value and other ideas. Maybe walk us through what the natural resources, why is that interesting area to focus on in the first place versus just say picking value stocks in the S&P or MSCI Global?

Lucas: Oh, wow, the resources sector is extremely interesting to me and, in my opinion, neglected, unloved, ignored, because it is a nasty place to invest. It’s probably the scariest sector of the market to invest in. I mean, consumer staples seem pretty safe. You know, like most of the sectors are warm and fuzzy and then you get to the resources sector, you don’t know if oil is going to be at $150 a barrel or $10 a barrel or somewhere in between. It’s just there are these wild commodity price swings, there’s volatility, cyclicality, all of those things lead to wild sentiment swings where people get all hyped up about lithium and then a couple years later, lithium prices are in the tank. And all of these things create opportunities for long-term investors. So one thing that’s exciting about the resources sectors, we think it’s just a really inefficiently priced part of the market with a lot of room to add value.

On top of that, you get brilliant diversification especially as a long term holder when you invest in resource companies over the short term in a given day, week, month. Equities move with equities but as you look out over longer periods of time, resource companies are really pretty uncorrelated with the broad equity market. And when you think of hedge funds, hedge funds are an entire industry built on generating uncorrelated returns ideally. A lot of times, they sneak some beta and they’re trying to generate uncorrelated returns but there, you’re typically expecting a lower return from your hedge fund exposure. You’re paying high fees for that low return and you’re taking on some illiquidity relative to at least daily price mutual funds or, you know, even intraday pricing you can get on ETFs or whatever.

Well, with resource companies, you don’t have to give up return. In fact, resource companies have outperformed over the last 100 years pretty substantively. Both energy companies and metals companies have outperformed the broad equity market by a fair margin. And so you’re not giving up returns but you’re still getting that diversification, that low correlation, or even negative correlation of returns. And then more recently, people have been starting to get worried about inflation again with all the money printing and fiscal stimulus and the economy operating at below full capacity, so limited supply of goods and services. So if you have a lot of money floating around and chasing a limited supply of goods and services, you can at least imagine inflation being on the horizon. And resource companies have historically provided very strong returns in inflationary periods.

So not just keeping up with inflation like you hope to get out of tips or whatever but actually growing your purchasing power by about 6% per year during inflationary periods, which I don’t know, we’ve been in high inflationary periods in about a quarter of the last 100 years so it’s not an insignificant period of time. So you just have all these great things about the resources sector. Strong returns, once again, they’ve outperformed the broad equity market and ability to add a lot of alpha and value because it’s a neglected area of the market and yet, you get diversification and inflation protection. And for all of those things, which are all great sounding things, you’d think you might have to pay up for the privilege but you can actually get these companies that are pretty substantive discount, on average, about a 20%-25% discount to the broad equity market.

But right now, and this sounds outlandish, to just say it but I have charts to prove it, these companies are trading at about an 80% discount to the broad equity market meaning energy and metals companies, which is a pretty remarkable state of affairs. And I would guess, I’ve mentioned this a bunch of times, I haven’t had any takers but I’ve challenged people, name another time where there’s been an asset class that was trading at an 80% discount to the broad equity market, yet we were more or less certain it would exist in its current form or something similar to it 10 years, 15 years into the future. I don’t think it’s ever happened. You had kind of the Asian flu in the late ’90s but back then, there was massive currency devaluation, those Asian economies were in tatters, there were real questions about whether those countries and those economies would exist in their current form.

But we know, at least pragmatic people know that energy and metals are going to be around 10 years from now. We might want to get off of fossil fuels and I’m on board with getting off of fossil fuels but our whole energy, global energy infrastructure relies on fossil fuels. They’re going to be here 10, 15, 20 years, even 30 or 40 years into the future. So it’s kind of an interesting opportunity. And the reason that’s an interesting opportunity is because people hate the resources sector.

Meb: So you guys got a couple money charts in here and my favorite, and I didn’t know this, so I love it when I get surprised by something, and this was your older, it’s a great piece called “An Investment Only a Mother Could Love.” And you touched on this already but I just want to highlight it because, to me, it’s so important. It looks at various sectors versus the S&P for the past 50 plus years, 1 month, 1 year, 3 years, 5 years, 10 years. And like you mentioned, they’re all somewhere, I don’t know, 0.6, 0.7, 0.8, almost 0.9 correlated to the S&P and energy and metals are as well at periods of a month and then it starts to decline a year. And starting at about three years, it’s close to 0, 5 years, and at 10 years, it’s hard negative.

And to me, this was a really unique insight to where I don’t think there’s any other sector of the S&P that is close to zero. I mean, and all the other sectors are still at 0.6, 0.7, 0.8. And then once you laid out the thesis as to why, A, with inflation, B, with rising resources being a drag on the economy, it makes sense. But to me, that’s a fundamentally fascinating takeaway. Anything more you can say about that? And then the tailwind, of course, is the valuations. Energy specifically I think at one point was almost 30% of the S&P and now, it’s at like 2% or close. It’s somewhere so low. Anyway, any more general thoughts because I love these charts.

Lucas: Yeah, it’s like 2% to 3%. It’s remarkable. Yeah, that side that you’re referring to, which is looking at those correlations over different periods of time, Jeremy Grantham has told me multiple times, it’s one of the great 10 or 20 charts he’s seen in his career. It’s totally unexpected. We certainly can’t claim to have known it till we dug into it and we wouldn’t have expected it ex-ante but the data is what it is and it makes sense. There are whole decades in the last 50 years where the broad equity market was down in real terms. People don’t really realize that but in the ’70s and from 2000 to 2010, the broad equity market, the S&P 500 was down in real terms, pretty substantially and yet, energy companies were up over 100% real over the same period of time and we just happen to have been in kind of the opposite kind of a situation over the last decade where we’ve been in a period of falling commodity prices and the broader economy has been doing quite well.

But once again, that all makes sense. When commodity prices go through the roof, that’s a drag on the broad economy. And when commodity prices fall through the floor, that’s effectively a tax cut for the rest of the economy. So it kind of makes sense that there’s this back and forth and flow between the two but I think it’s underappreciated by investors and not well-known.

Meb: When the index is looking at, say, energy and metals, when you say metals, is that base metals? Is that precious metals? Is it both?

Lucas: What we used in that particular chart, because we’re more focused on industrial metals, is we’re looking at iron ore, copper, aluminum, zinc, and lead, I think are the five kind of big commodities that you can kind of actually find. When you go that far back, you go to the 1920s to do a study, you’re all of a sudden looking at these things called SIC code standard industry classification codes I think that companies have to use to file with the SEC or whatever it is to pay their taxes. With the federal government, I can’t remember the exact origins. But we were able to kind of see those individual different kinds of mining companies and kind of batch together a group of them to study going that far back.

Meb: Yeah. You may be starting to see a little light of day on the base metals. They’ve been picking up a little bit in 2020 but it’s funny, you know, we over a decade ago wrote a book. And this is more meant for sort of like sentiment, anecdotal evidence on how people think about asset classes but we did a kind of fun study. We said, “Look, how do asset classes, big ones, and then sectors and industries perform after they’ve had multiple down years in a row?” And at the asset class level, it’s pretty rare to see something like X U.S. stocks to be down three years in a row. And for industries, obviously, because they’re smaller, it was like five or six but we had done a fun kind of asking for coal in your stocking into the year, what’s like kind of like these worst assets. And it’s just been a laundry list of coal stocks, uranium stocks for the last few years. There’s been anything I think agriculture-related to where they’ve just got…the beatings just continue.

And then similarly, if you look at the French pharma data going back to the ’20s and try to identify markets when they’re down 60%, 80%, 90%, assuming they’ll, as you mentioned, continue to exist, future returns have tended to be pretty strong. So at least there’s some potential opportunity. Any sort of catalysts for these sort of investments? They’re always obvious in retrospect but any general ideas in what may cause them to start to perk up?

Lucas: Well, first of all, you don’t need catalysts, right? Like when you look at the kinds of dividend yields and free cash flow yields that you see in the energy and metals space, they’re extremely high when the broad equity market is extremely low. So even if these companies go flat, you don’t need the valuations to mean revert. They could continue to trade at an 80% discount. You’ll just generate strong real returns year after year after year after year. Now, that’s a longer-term kind of thing. Whereas if there is a valuation rerating or some sort of mean reversion and valuation, you’ll get like a quick run like quick, very strong returns. I can’t guarantee either way. As a long-term investor, I shouldn’t care about what path it takes all that much. I guess you’d always rather have a quicker win because then, you could redeploy the capital and you have more capital to redeploy. But in the absence of that, you certainly can just hold on and now yield the market for long periods of time.

One interesting catalyst potentially, though, is the demand for clean energy materials. People are so focused. When they think of a natural resources strategy, they think oil. Natural resources is synonymous with oil for most investors but there happened to be some other commodities out there, right? There are agricultural commodities, there are metals, and there are other types of fossil fuels. And when you look at transitioning to clean energy, which I’m a believer that the world is going to transition to clean energy, you’re not just magically creating clean energy. It’s brilliant to want to move off of fossil fuels but moving off of fossil fuels, you’re just moving the burden to a different set of materials. So rather than using coal, oil, natural gas, now you’re going to be using lithium, nickel, cobalt, vanadium, copper, silver, like all these other materials.

And so the demand for metals, especially those clean energy metals, is likely to go up dramatically over the next decade and these could be really tight markets. Just to give you a sense for how tight these markets could get, Tesla had their battery day a few weeks ago and they projected that by 2030, they would need a certain amount of battery capacity. And if you look at the amount of nickel that that implies, it implies that Tesla alone would be consuming about 80% of current nickel consumption or nickel supply. Just Tesla. So forget about all the other electric vehicle manufacturers and everybody’s coming out with electric vehicles. It’s not going to be just Tesla, even a year or two from now, BMW, Mercedes, Volvo, Volkswagen, Ford, even GM, are all working hard on coming out with their electric vehicle lines.

So if Tesla is consuming 80% of current nickel demand, you have all these other electric vehicle manufacturers and then guess what, nickel is used in steel making and has all these other industrial uses as well that aren’t even accounted for in that. So you could be talking about a huge increase in nickel demand just using that same data point for Tesla. Tesla is expecting to consume seven times current global lithium consumption or lithium supply as soon as 2030. 2030 is not like 100 years from now. This is like a decade from now. You’re talking about a massive increase in demand for these clean energy materials and copper might be the most exciting of them all, to me, at least because copper is used not just in the electric vehicle batteries as lithium and nickel are but copper is really at the heart of almost everything.

If you’re trying to electrify the world, copper is absolutely critical. It’s going to be at the core of that. If you need to overhaul our electric grid to enable a larger percentage of renewables, well, the grid uses a lot of copper. If you wanted to electrify our vehicle fleet, put out electric vehicles, electric vehicles use three to four times as much copper as a gas-powered car. When you look at renewable projects, wind and solar projects use 5 to 12 times as much copper as the comparably sized coal or natural gas power plant, energy-efficient electrical components. I mean, the list goes on and on. But copper is really at the heart… If oil was at the heart of our fossil fuel-based economy, copper is likely to be at the heart of our kind of clean energy economy going forward.

And guess what, copper is a precious, rare mineral, very little of it, very little discoveries in the last few years or last few decades, I should say, and falling whole grains which are going to put pressure on the cost as well. So there are a lot of really exciting opportunities but people…once again, people think of natural resources as being this beaten-down value area with secular headwinds because they’re just focused on fossil fuels. But if you think a little bit further about it, there are huge growth prospects for natural resource companies. You’re just looking at different companies probably.

Meb: Yeah. And you guys have been pretty consistent in talking about this to where you talk about commodity prices, futures prices, and then lastly, actually investing through the equities. Can you just mention real quickly why you guys, to my knowledge, prefer investing in the actual securities versus the commodities themselves? And as you mentioned, by the way, quietly, if you’re looking at some of the base metals futures, ETFs, from being down around 20% I think earlier in the year, they’re actually up 10% year to date, so quietly picking up some momentum over the past few months. Why do you guys prefer the stocks?

Lucas: Yeah. So we’ve done a fair amount of research into this because when we were first looking to express a view on investing in commodities, we didn’t have a preset agenda. We didn’t have a strategy in place. We were pretty flexible about thinking, should we be expressing this view via commodity futures, direct investment, swaps, the public equities, private equity, how would we want to do it. And we landed on the public equities and the biggest factor by far is the existence of the equity risk premium. When you invest in the companies, you wouldn’t invest with the companies unless you expected to get a return on that capital in the form of dividends and growth and all those good things. So when you look once again, over the very long term, looking back about 100 years, energy and metals companies have given somewhere between 7% to 8% real returns per annum, which once again, that’s more than the broad equity market which is closer to, I’m not sure, 5.5% to 6% real per annum over the same period of time.

So that equity risk premium is brilliant, and then you look at the commodities themselves, they’ve been flat over the same period of time in real terms. So oil prices actually have been down about 50 basis points per year for the last 100 years. If you look at the industrial metals, iron, copper, aluminum, etc., they’re on average more or less flat in real terms over the last 100 years. Yet even with flat commodity prices, the commodity producers have put up substantial real returns, which is kind of…makes it a no brainer to me relative to direct investment. When you invest in the commodities, you have only one way to win, supply and demand has to be conducive to rising commodity prices. And if commodity prices are flat, if supply and demand isn’t conducive to rising commodity prices, you have kind of a dead asset there and you’re not generating any return.

Well, the energy and metals companies can thrive with flat commodity prices. In fact, they would like to lock them in, right? It would make a lot easier to run your commodity producer if you knew exactly what price you were dealing with. It would be brilliant for the industry and obviously, there would be risk dramatically in terms of how risky they were perceived to be by the market. So the equities, we think much better than direct investment and the commodities themselves and then you look at the futures, and the futures have actually underperformed the commodities that they track. And this really, it’s kind of an interesting story, to me at least, of the financial services industry changing what it’s studying. So if you go back 15-16 years ago, Goldman Sachs, Dow Jones, UBS, … a professor at Yale University, and others were trying to sell this idea that commodity futures were a new underappreciated asset class that, maybe not a new asset class but they were an underappreciated asset class that gave you some of the great things that we’ve talked about. Gave you diversification, gave you inflation protection, and gave you a risk premium.

And at GMO, we agreed. They give you diversification, they give you inflation protection. What we took issue with was the characterization of the historical positive returns for investing in commodity futures as a risk premium. It’s not a risk premium, it is an artifact of what the raw yield is and the history of futures as the futures markets were typically used by commodity producers to hedge their production. If you’re a corn farmer, you want to be able to pay your employees, you want to be able to afford fertilizer and some new machinery and equipment. In order to run your farm, you’re willing to lock in a lower price for your product to have the certainty that you can actually harvest your product. And so you accept the lower price out into the future in order to get that certainty to be able to execute your business model.

Well, once Goldman Sachs and these other characters were able to popularize this notion that commodity futures were a brilliant addition to your asset allocation, all of a sudden, the futures curves go from downward sloping, because they’re mostly used by hedgers, to being upward sloping because a lot of money flowed into these passive, long-only commodity indices, commodity futures indices. And now that they’re upward sloping, every time you go to roll your futures contracts further out on the curve, you’re selling at a lower price and buying further out on the curve at a higher price. The curve is upward sloping. So you’re losing a little bit of money every time you go to roll your future out. And generally speaking in our industry, selling low and buying high isn’t a great strategy.

So it hasn’t worked out well for the commodity futures investors. The Bloomberg Commodity Index, which is a continuation or the Bloomberg bought the Dow Jones UBS Commodity Index, but that Commodity Index, which is a futures-based implementation of an underlying Commodity Index, is about flat over the last 20 years whereas this theoretical basket of commodities that those futures are tracking the Bloomberg spot Commodity Index is up 200%. So the futures have underperformed the underlying commodity basket by almost 200% over the last 20 years. So it’s an interesting space.

Meb: Well, I mean, you’ll probably remember in 2006, when you were the vintage joining GMO, I remember going to every conference, every conference, and this was the theme is that every institution was allocating to these big commodity allocation sleeves, and fast forward 10-15 years, they are now seeing that many of them puke them up. I know. But that at the point was oil was 100-150. And then fast forward to 2020, the futures at one point trade negative, so you got to be very careful. And you mentioned kind of knowing with your own understanding contango or backwardation, all those sorts of things because if you don’t, it’s pretty easy to get upside down. But, man, those consultants and people selling those did a great job. That’s for sure.

So let’s talk about climate change a little bit. Is this a sort of evolution of your beliefs in the natural resource sector? How did you apply it? Was it something where you just simply started excluding names out of that strategy? Is that a totally different basket of funds or stocks or whatnot and how do you guys approach it?

Lucas: Once again, it really evolved out of our natural resources strategy. If you think climate change is a huge risk for the world, which I think at GMO we certainly do and you’re sitting there in 2010, and you’re looking at launching a natural resources strategy and the resources sector is 65%, 70% energy and that energy is fossil fuel-based energy, you have to think about how you’re going to manage that climate change risk. We did three things in managing that climate change risk. One, we have a dramatically lower exposure to energy than what the calculated sector is or what our competitors are. So our competitors tend to be…running global natural resource strategies tend to be, let’s say, 80% to 90% energy over most periods of time, if not almost all periods of time. And we tend to be more like 35%, 45% energy, so a much lower allocation to energy. And we’re running a much more diversified natural resources strategy than a lot of other players in our industry.

Another thing we’ve done is, since the inception of the strategy, we’ve always excluded the companies that produce the resources that have the highest stranded asset risk. So it’s fine to think fossil fuels overall have stranded asset risk. I buy that argument. But, geez, coal has a lot more stranded asset risk than natural gas. Shale has a lot of stranded asset risk. Oil stands up in Canada and Venezuela and other places have a lot of stranded asset risk. So heavy oil. So we’ve always excluded the companies that have the worst emissions profile associated with the commodities that they’re producing because they have the highest stranded asset risk and they’re likely to get hit first and hardest by any sort of carbon regulation, carbon pricing, carbon tax, or even just the world kind of moving aggressively to cleaner energy.

And now finally, getting to the point now that I’m mentioning clean energy, the third thing that we did to manage that risk in our resources strategy is we’ve always targeted some of our energy exposure to be to clean energy. So I mentioned 35%, 45% energy, but we might have 15% of that energy allocation to biofuels, to solar, to wind, to clean power generation. And it was really that investing that we were doing in our resources strategy that evolved into the climate change strategy. So we had this small allocation, not infinitesimal, but a relatively small part of our natural resources strategy invested in clean energy, because when you’re running a resource or strategy, you can invest some in clean energy, but people aren’t expecting you to have 50% of the portfolio in solar and wind and biofuels. They’re expecting some fossil fuels and metals and Ag and whatnot.

So we kind of wanted to have a fully fleshed-out strategy that was focused on what companies will benefit in a world where we take climate change more seriously, and where we have to move aggressively to fend it off. And that’s really what the genesis of the strategy was in 2015. It was, once again, we weren’t doing it to capitalize on, I don’t know, investment interest in ESP or sustainability or whatnot. If you go back five short years ago, there really wasn’t a lot of interest in many of those things, at least in the United States. Europe is a bit further ahead. We really just saw it as an investment opportunity. There’s going to be transformational change in the utility industry in terms of electricity generation and using renewables instead of coal and natural gas. When you look at the vehicle industry, there’s going to be transformational change as we move to electric vehicles and maybe even hydrogen fuel cell vehicles for long-haul trucking.

There are going to be these transformational changes. And that leads to the potential for decades of secular growth, not 10 or 20 or 30 years, but we could be talking about many decades of secular growth in these various industries. And to us, that was what was exciting was this long-term secular growth driven by the underlying competitiveness and economics associated with clean energy solutions. And that’s really what got us fired up and got us going. And it took us a while to define our universe because there’s no gigs industry or gig sector for the climate change sector. We really had to go through over 1,000 companies name by name, with a team of fundamental analysts and dig in and say, “Is this company a good play on climate change? Not a good play? Is it got some exposure to clean energy but a lot of exposure to coal as well?” Which sounds hard to believe, but you do find these companies. So we had to kind of go through and patch together a universe, which took us a while, but we ended up launching our strategy in 2017.

Meb: And you mentioned energy is like a third or a little more of the pie. What’s the other two-thirds or rest of the portfolio?

Lucas: For our climate change strategy or our resources strategy?

Meb: Okay, either both. Maybe I was commingling the two.

Lucas: Yeah. So our resources strategy is approximately 35% metals. And once again, we have a focus on clean energy, metals within that metal exposure. And then we have substantive allocations to Ag and water as well. And then when you’re talking about our climate change strategy, we have significant allocations to electric grid companies that are involved in overhauling our electric grid to allow a higher percentage of renewables into the generation mix. We have a significant allocation to copper. Once again, copper is kind of at the heart of clean energy. We have a substantial allocation to energy efficiency efforts, which it’s brilliant to have electric vehicles, it’s brilliant to have clean power generation in the form of renewables and Hydro and whatever else. But if you can just reduce your energy impact on the world and use 20%, 30%, 40% less energy and accomplish the same unit of work, that’s going to have a much bigger impact in the short term than adding a few electric vehicles to our vehicle fleet or adding a few percent renewables to our generation mix.

And so we look at energy-efficient building materials, electrical components and appliances, energy-efficient lighting, although we actually don’t invest in energy-efficient lighting for different reasons, we look at the industry dynamics, and it’s hard to find a company that has kind of a sustainable competitive advantage there. But we at least consider it for inclusion. And if we found the right company, we would. And other similar things, mass transportation, electric vehicles themselves reduce energy impact because they’re more efficient use of energy. So there are all these different business models. And then I also mentioned earlier, clean energy. So obviously, we’re going to look at batteries and storage, wind, solar, geothermal, biofuels, and clean power generation. All of those businesses I just talked about are really focused on helping to mitigate climate change. On the adaptation side of things, we also invest in companies that are going to help the world adapt to climate change.

But the two big things there are food and water. Agricultural productivity is incredibly challenged in a world impacted by climate change. And I can go talk to farmers and have them say, “Oh, God, farming used to be so easy, and now it’s starting to get hard,” right? It’s always been a difficult game. Now you’re giving them droughts, floods, extreme temperature events, which are deaths for crops, extreme downpours, which washed away their soil nutrients. We’re kind of taking a difficult game and making it much more difficult. So companies focused on agricultural productivity, precision, Ag efforts, irrigation, fertilizers, and drought-resistant seeds. Anything like that would be within scope. And a similar story on water, where water patterns and distribution is impacted by climate change pretty considerably. So company is focused on providing access to fresh water, recycling, water, water efficiency efforts, purification, treatment, desalination, anything like that in the water sector. Water is obviously an incredibly valuable natural resource. And unfortunately, it is finite in supply. And so companies that are helping us manage that extremely valuable natural resource will be in demand for decades to come.

Meb: I was smiling as you were talking about Tesla earlier and storage and batteries and their domination of a certain supply by 2030. Because if market cap is any indication, that might be an accurate number. They may be 80% of the world’s supply taking it out if their market cap continues to be bigger than all the others combined. Is this a U.S. story? Is this a story where the companies are being developed all over the world? What’s it look like?

Lucas: Our climate change strategy since inception has typically been about two-thirds to three-quarters outside the U.S. So it’s very much a global story in terms of, obviously, the markets where you’re selling your products or building your projects or whatnot, but also in terms of where the countries are domiciled. So it’s very much a global story and a global opportunity set.

Meb: You mentioned some of the challenges with companies that are somewhat complicated. And it sounds like there’s like thousands of names in your universe, I assume, certainly all over the world. But what do you do when you have a company that, say, to make it simple, half of the business is old school climate problematic but let’s say they’re also one of the biggest investors in new technologies in this space? And I think you have a few of these names out there where it’s this weird sort of barbell mix of yin and yang of the old and the new. Is that an automatic one strike, you’re out, you guys kind of say, “Okay, well, maybe it’s a little squishy in that?” How do you approach it?

Lucas: No, I think you can probably tell already by the conversation we’ve had I’m pretty pragmatic in general, and certainly when it comes to investing. And we aren’t going to be dogmatic about things like that. When we’re looking for companies that are fits into our climate change universe, we generally want companies that have 50% or more of their business tied up in climate change-related activities. Now, I’m not going to sit there and be rigid about that if there’s a company that’s 40% or 30% climate change-related activities but that’s a fast-growing part of their business relative to their legacy business or they’re in the process of divesting some legacy business, we can obviously bend in the direction of being a bit more inclusive. We can also bend in the direction of being a little bit more strenuous.

If a company is 70% or 60% wind turbine manufacturing but 30% laundromats or whatever something that’s irrelevant, we don’t necessarily need to reach for winds. There are lots of pure play winds manufacturers. There’s no reason to get a company that’s giving you watered downwind exposure. If you’re looking to get lithium ion battery manufacturing exposure, you are probably going to get some watered down exposure. You’re going to be looking at some of the big battery manufacturers like Panasonic, LG Chem and whatnot in there. It’s not going to be 50% of the revenue yet. But if you look forward in the future, it’s going to be a much bigger part of the business. So we try to be reasonable. At the end of the day, I want to feel like we did our job at running the climate change strategy. If the world plays out the way we think it’s going to, which is we think the world is going to mobilize to address climate change, we think that there’s going to be a massive amount of growth in these industries.

And if all of these things happen and we don’t benefit, because we invested in GE as a play on wind and the wind unit is 5% or 6% of their business, even though they’re one of the biggest wind turbine manufacturers in the world, well, I’ll feel like we kind of failed, we didn’t do what we set out to do. So that’s the ultimate test for us is kind of, is this a business that will succeed and do well if climate change efforts take off the way they think they’re going to?

Meb: We could spend a lot of time on these various silos, and so many of them are fascinating. You mentioned copper is one that’s particularly interesting. Are there any other themes within this sort of climate change approach that you think are particularly interesting over the next handful of years or decade? Whether it’s tactical meaning right now, or just generational sort of change that’s happening that people don’t appreciate?

Lucas: Yeah, I think biofuels are an interesting area of the market. Biofuels have been around for a while. Haven’t ever garnered much attention and you probably hear them talked about, I don’t know, 100 as much as you hear about wind and solar or Tesla or batteries and storage or whatever. But biofuels are really interesting. There’s kind of biodiesel, which has been around for a couple decades or more. Typically, biodiesel is blended in with traditional diesel and some sort of mix. You know, let’s say 20%. Biodiesel, 80% traditional diesel would be a normal kind of blend to have. And that biodiesel is much cleaner than traditional diesel. You’re talking about maybe 85% to 90% reduction in carbon emissions for that piece of it. But it’s only 20% of the whole. So, yes, 20% of your fuel is much cleaner but 80% is still diesel.

But the next generation, which is starting to ramp up right now the next generation biodiesel is something called renewable diesel. And renewable diesel is a molecular substitute for diesel fuel. In other words, you could just go to a gas station, no new infrastructure, don’t need to know what you’re pumping, you’re just pumping renewable diesel into your diesel tank, rather than traditional diesel. And once again, depending on the feedstock you use, you could be talking about an 85%, 90% reduction, something on that order of magnitude in terms of carbon emissions. So much, much cleaner.

And then one of the sticking points for climate change historically has been what to do about aviation. Like we have our solution for electricity generation or at least the ideas are out there and business models are executing. Wind, solar, needs to improve our utility scale storage. And we have a solution for electricity generation. We have ideas for how we’re going to do transportation, right? Like we have electric vehicles for our passenger vehicle fleet. We’re looking at hydrogen fuel cell trucks and other technologies for long haul trucking. But there are solutions on the horizon. And then you get the aviation, it’s been like one of these question marks, how are we going to resolve this? How are we going to address this huge emission industry?

And there’s something called sustainable aviation fuel, which is starting to get more and more attention and has great long-term growth prospects. And once again, it will probably initially be blended in with traditionally aviation fuel or jet fuel because there just isn’t enough of it to kind of run a fleet on its own but it is an interesting area for the future. And when you look at the biofuel producers, you don’t see expensive valuations. You don’t see companies with a lot of hype or sentiment kind of driving them. You see companies that are pretty reasonable valuations, yet have really good long term growth prospects, and I would argue have a tremendous amount of optionality on top of that. Just stuff you can’t model. But there’s something like 24 states right now that are working on low carbon fuel standards. And those low carbon fuel standards are really supportive of biofuel mandates and biofuel production. And the companies are raking in tremendous amounts of money right now because of some of the low carbon fuel standards that are already in place in states like California where you are.

Meb: And is that still a corn-based story?

Lucas: No. Corn was more about ethanol. So the inputs into biofuels and this is biodiesel and renewable diesel, sustainable aviation fuel. There are different feedstocks. They call the inputs feedstock. And the traditional feedstocks that some of the companies we look at use are used cooking oils, used cooking greases, so they contract out with restaurant chains and other food distributors and get their used goods and then are able to get value out of them. Animal fats would be another source of feedstock, but then, yes, you can use soybean oil and things like that as feedstock into these biodiesel and renewable diesel processes. And when you use soybeans as the feedstock, it is not as energy efficient. So maybe you get a 50% reduction in carbon emissions, but you don’t get that full 85%, 90% that you get when you’re just using basically waste as the feedstock.

I’m glad you brought that up, though, because that’s another exciting potential angle on these biofuels is that they’re working, you know, companies like NASD, the big R&D budgets do lots of refining things but they’re heavily involved in biofuels these days. And they have these big R&D budgets. And they’re looking at other feedstocks. Can they use algae? Can they use carbon dioxide as a feedstock? Can they use municipal waste? They have all these potential ways of getting feedstock that would obviously be brilliant for the world. One of the best and most exciting would be they’re looking into whether they could use plastics as the feedstock. And obviously, if you could take recycled plastics and rather than burn the plastics, as we’ve done in some parts of the world, you could actually use that as the feedstock into producing sustainable biofuels. That would be brilliant for the world. Those are kind of not on the near-term horizon, but the R&D is being done. If you look at the long-term prospects, that could be a really exciting area, as well. And once again, you’re not paying, in my opinion or the opinion of me and my team, you’re not paying exorbitant amounts for the privilege of investing in these companies, you can find them at very reasonable sober valuation levels.

Meb: There’s nothing more optimistic than watching kind of enterprising capitalists and startup scientists and investors come up with pretty amazing solutions. I remember when I first moved to L.A., I had an old Land Cruiser, terribly, terribly emission, unfriendly. It was 1967. No catalytic converter. It was grandfathered in. But there was a place that would do these conversions. And they say, “Look, the good news is you can use this oil. The bad news is like you’re going to smell like French fries all day, driving around Los Angeles.” And I said, “That’s probably going to bounce out with a decent weight loss because then I just won’t want French fries anymore. So maybe it’s a win-win.” A couple more quick questions, we got to let you go. You guys are famous for a value approach. And I think one of the challenges with some of these themes and fads and you guys have written about this, particularly in reference to I believe it was solar, maybe it was wind, I can’t remember, to where the valuations can have these massive booms and busts when sometimes everyone is excited and the PEs are all 100 are infinite and other times when they’re depressed. How do you guys apply or do you apply a valuation lens to this universe as well?

Lucas: It’s interesting these GMOs a value shop, I tend to be a value manager. But this is a growth area. Some people think that that sounds like we’re at odds with each other. But it turns out that actually, if you look at how value approaches have worked in growth universes, historically, they’ve worked very well because you’re buying the companies that are exposed to the growth trends, but you’re not paying the outrageous multiples that inevitably you end up paying when you get into the really high, really overexcited areas of the market. And so, value within a growth universe, maybe counterintuitive, lease is an exciting way to invest. And there have been great growth opportunities that you could get a discount, or at least a discount to the other growth companies.

What makes this a little bit unique and interesting to us is that we’re running a climate change strategy. It trades at a significant discount and has since its inception, a significant discount to the broad equity market. So at various points of time 20%, 30%, 40% discount to the broad market, depending on how you measure it. Yet, we don’t have this expectation that the portfolio is going to undergo the market. Typically when you buy companies at a big discount, you expect to undergo the market that’s why they’re trading at a discount in the first place. The market is not crazy; the market is going to apply a discount to low growth or negative growth companies. What you’re hoping for is a value investor is that as the market realizes the prospects weren’t quite so bad for the company, there’s a rerating.

So the company does…you buy a portfolio of companies that does under grow by 15%, let’s say, but the multiples expand, your portfolio goes from 10 times earnings to 12 times earnings. And that 20% rerating is more than enough to offset the undergrowth, and you get a bit of alpha. That’s what a value manager is really trying to do. Well, we’ve been saying, since we launched this strategy, that it’s less clear. We know we’re buying companies that are at a discount to the market, but it’s less clear that we’re not going to grow with or maybe even outgrow the market because we’re investing in a long term secular growth area. And since inception of the strategy, we’ve actually done that. We’ve been buying companies at a significant discount, yet our portfolio has had earnings growth that far exceeded the broad equity market. And we’ve been doing that for almost four years now. And that’s a super cool story.

And if I can do that five years from now, I want to come back on and let’s talk about it. Because that would be kind of a crowning achievement of my career, you’re doing something you shouldn’t be able to do and just should not be able to buy companies at a big discount in outgrow the market for a long period of time. And hopefully, we can keep it up. But that’s kind of what we’ve set out to do. How do we find strong investments at really reasonable valuation levels where there’s some sort of short term headwind or cloud over that company, but they’re exposed to this long term secular growth theme that we’re excited about and think is almost guaranteed to take place?

Meb: We don’t have to wait five years, it can be a year. They can rerate over the next year and all of a sudden have massive expansion. I’d love that and hopefully in person instead of continuing to be in Zoom. How do most institutions think about this as an allocation? Do they put it as a sub out for like a Lego for their natural resource just exposure? Do they put it in an entirely new alt anything satellite bucket? Are they doing as an inflation? How do most people think about and how should people listening think about putting something like this to work and frame their entire portfolio?

Lucas: Everybody has their own framework for how they think about positioning their portfolios or their assets. And I don’t think there’s a right or wrong way. But we have certainly seen a fair amount of diversity in how people try to fit it into their broader asset allocation Plan. We’ve certainly seen and my favorite framing of it is just fit it into your global equity bucket. Like that’s how I think about it for my personal account or my retirement account is I just think that I’m going to generate better performance or stronger performance investing in the climate change strategy than I would if I invested in equity. You don’t really need much more justification than that to fit it into your plan. But the most common framing to your point has been as part of a real assets allocation. People have replaced some of their energy.

Once again, when people talk about resources, they’re usually talking about energy. And so they’ve replaced some of their energy or resources, whatever you want to call it, some of the resources positioning with the climate change strategy, as a way to kind of look to the future and focused on where the growth is going to be and where the path is leading rather than where the path is coming from. So that’s certainly the most common framing that we’ve had clients fit it in. And then there are other investors who looked at it as some people have some sort of long term somatic growth bucket or strategy that they pursue, and it could obviously fit in there. And then increasingly, their investors, institutional investors who have a specific allocation, whether it’s the ESG, impact sustainability, it goes by a number of different names, but some sort of environmentally friendly or sustainable bucket. And obviously, for some investors, it’s slotted in naturally there.

I would say, the one thing that we’ve had a few people talk about it or way that it’s been talked about, but I don’t know that we’ve had any extra allocate to it for this reason but it seems reasonable to me, and it’s kind of a cool way of thinking about it is climate change is a big risk to the really the world, right, but also to our economy and to our markets because it’s a risk for the world. It’s a risk for the markets. And you could imagine investing in climate change or climate change strategy as a hedge on that risk. If climate change does become a headwind for the broader economy, here’s a strategy that should do quite well in that kind of a world because you can be sure as soon as climate change is kind of impacting our broader economy. We’re going to be super aggressive about rotating to cleaner energy solutions to get rid of that headwind. So that’s another way that I could imagine someone allocating to it.

Meb: What has been your most memorable investment as you look back over your career? This could be personal, it could be at work, it could be good, it could be bad. Anything seared into your brain?

Lucas: Oh, geez. I have a few of them, some good, some bad, but I’ll focus on the positive. SolarEdge which for most of I think the history of our strategy has been our biggest position for a climate change strategy and also actually a substantive position in our resources strategy. It’s a company that’s pretty unique in terms of how it’s been positioned in its industry. They are not a solar panel manufacturer. They actually produce solar inverters and optimization technology that’s paired with their inverter technology. And what the inverters do is they take the DC power that’s produced by the solar panel and convert it into the AC power that we use in our grids and our buildings and everything else. They don’t play in the panel manufacturing space, which by the way is a really nasty space to play. And they’re in the inverter side of things. And they have a patented technology. And they are able to defend those patents in various regions around the world that has led them to have higher market share.

So the old kind of typical inverters that were used on and still are used on probably more than 90% of global solar panels are these dumb things called string inverters. And they’re kind of like the old Christmas tree lights, where if one light goes out, the entire strand goes out. And so these string inverters would lead to this situation where if one solar panel went down or there was a cloud over one solar panel or a shade from a chimney or whatever, the entire array would be compromised. And solar edge technology addressed that. So it’s just a superior product. And then when you looked at the cost of that product, they are a little bit more expensive with their technology in terms of upfront cost. But you only have to replace the inverter once over a 20-year period versus twice four standard inverters.

So in terms of full lifecycle cost, cheaper. So now you have a better product that’s cheaper. And what do you think’s going to happen? It’s growing market share, it’s grown market share dramatically in the last few years. And we were originally investing in it in the mid-teens, you know, $13, $14, $15, and the company was trading at less than 11 times earnings, even though it was in this high growth area of the market. You’re telling me they’re not going to sell more solar inverters and optimization technology 5, 10 years from now than today, but at 11 times earnings in the market that was, let’s say, 20. At the time, it was being priced for shrinking, not just not growing, it’s going to shrink, and we made a big bet on it. Now it’s in the 200. So it’s been a huge winner for us, and obviously, a big part of the success of our climate change strategy, frankly, just that one possession.

Meb: I love it. Lucas, it has been a blast. Love to keep you all day. I’ll link to the show notes, listeners, a bunch of Lucas and Jeremy’s papers on the topic of some of these incredible charts. Where’s the best place to go if people want to follow you, keep an eye on what you’re up to, inquire, how to invest big bucks and your strategies Where do they find you guys?

Lucas: I guess gmo.com. Don’t do a Google search there because GMO will lead you down some very strange paths that are unrelated to our company. But gmo.com would be a good place to start.

Meb: We have to wait till February to find out who’s got a better basketball team this year, UVA or Duke. Fingers crossed, this season happens. I think it will. But look forward to getting to watch some college hoops. Thanks so much for joining us today.

Lucas: Yeah, thanks a lot for having me. It’s great talking to you.

Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us an email at feedback@themebfabershow.com. We love to read the reviews. Please review us on iTunes and subscribe to show. Anywhere good podcast are found. My current favorite is “Breaker.” Thanks for listening, friends, and good investing.