(by Rafael Coven) - To what do we owe the spectacular performance of cleantech last year? And is more of the same coming?

Overall, 2007 was a year of volatile equity markets and lackluster market returns. The year was marked by the U.S. dollar’s plunge, falling home prices, a collapse in sub-prime lending, a slowdown in private-equity acquisitions, weakness in small-cap stocks and both growing recessionary and inflationary fears.

Yet it was far sunnier for technology stocks, and cleantech ones in particular.

The Cleantech Group’s Cleantech Index (CTIUS) soared past all major U.S. market indices, posting a 42.9% return for the year, surpassing even several narrowly focused on energy.

	Q1-Q2 2007	Q3 2007	Q4 2007	All 2007
The Cleantech Index	19.8%	5.5%	14.2%	42.9%
S&P 500 Index	7.5%	2.0%	7.7%	5.5%
Russell 3000 Index	8.7%	1.5%	8.8%	5.1%
Russell 2000 Index	7.5%	-3.4%	2.3%	-1.6%
NASDAQ Composite Index	7.1%	4.4%	11.8%	10.6%
Mean Diversified US Stock Mutual Fund	7.8%	1.0%	8.9%	n/a

There were a number of major underlying factors that caused the Index to perform so well in Q4 and the year in a fairly gloomy market.

Macro-level factors

1. Strong global demand, especially from Asia’s burgeoning economies, drove energy and most commodity prices significantly higher.
2. Governments, business, and institutions showed an increased (albeit insufficient) willingness to address climate change, pollution, and energy costs with policy, action, and investment.
3. The rapid sales and profitability growth of clean energy (wind, geothermal, and especially solar) companies worldwide.
4. Increased demand for energy-efficiency and demand-management products.
5. Key technological advances e.g., LED lighting, solar and microprocessor efficiency.
6. Increased market acceptance for a number of key clean technologies.
7. The prospect of a new U.S. government more inclined to address climate change, environmental and related energy issues in a significant and proactive manner and actually to enforce environmental standards and regulations.
8. A growing belief that demand for many key cleantech products is non-cyclical and thus unaffected, or even stimulated, by a slowing US economy.

Market-specific factors

1. The Index’s minimal exposure to grain-ethanol, fuel-cell, and so-called ‘clean coal’ companies, which faired poorly.
2. High-profile water shortages – particularly in the US Southeast.
3. Strong investor preference for technology and growth stocks.
4. The limited amount of quality clean energy stocks available.
5. The Index’s focus on quality companies with high-exposure cleantech.
6. The strong inflow of cleantech venture capital and successful cleantech IPOs.
7. Numerous ‘alternative’ energy and water sector index-based equity funds drove large amounts of capital into those sectors (with little regard to company quality or sub-sector exposure).

Fundamentals, exuberance and the long-term investor

While I can’t predict changes in investor preferences, I expect nearly all of the macro-level and Index strategy-specific factors to continue for the foreseeable future, which bodes well for cleantech stocks over the long haul.

Investors in 2007 may have had a dose of ‘irrational exuberance’ for certain cleantech sectors, such as solar. A most telling sign was their propensity to fall in love with a sector instead of individual companies.

In any growth industry, consolidation is inevitable, and it’s invariably the best companies that survive (or get acquired for the highest prices). Investors are only starting to distinguish between sector leaders and the ‘also-rans’ or companies that survive on hype. Increasingly, these companies will be valued for their results.

I believe diversified indices like the Cleantech Index will continue to outperform many “clean-energy” or even “water stock” indices, especially on a risk-adjusted basis, because:

1. The Index focuses on owning only the leading companies which are less vulnerable to sector shakeouts than lower-quality companies.
2. The Index heavily favors companies with real cash earnings, which tend to do better in any downturn.
3. The aforementioned ‘peer indices’ often:
   • Are composite indexes which own nearly every company in the sector with little regard to either quality or sub-sector risk.
   • Pay scant attention to quality of their component companies or the viability of certain sub-sectors.
4. The Cleantech Index is diversified across many industry sectors and generally has far less exposure to companies reliant on subsidies/protectionism to do well.

Investors in financial products based on the Cleantech Index should remember that the Index is designed to reflect the global megatrend of the growth in demand for cleantech products and services. Funds based on the Index should be viewed as long-term holdings, and the Index’s diversity makes those funds ill-suited for short-term trades, especially vis-à-vis narrower sector funds.

Of course, it’s unrealistic to expect the Index to repeat its phenomenal 2007 performance this year, but factors driving demand for cleantech products & services are even stronger this year than last.

In fact, I expect the growth in demand for cleantech products to accelerate in the years ahead. This doesn’t mean that investors’ expectations don’t, or won’t, get unrealistic at times, but it does mean that the underlying long-term fundamentals for quality cleantech businesses are excellent.

Rising and falling stars

In 2007, no star burned brighter than the sun. Solar stocks put in an absolutely stellar performance – outshining even the brilliant energy sector.

Of the solar companies above, there are, of course, good companies, and not-so good companies. The Index includes some of the best, though Energy Conversion Devices (ENER -1%), known for its thin film photovoltaics, remains burdened by its fuel cell business.

ENER will either make a profit in 2008 or be abandoned by even the most optimistic analysts. ENER does have good technology, but it remains to be seen whether new management can develop it profitably. (See Cleantech.com’s coverage of ENER and the departure of its founder here.)

Commercial acceptance and technology advances pushed LED lighting stocks up strongly. CREE (CREE) rose 59%, and Color Kinetics (CLRK) rose sharply before Philips bought it. At the Cleantech Index, we were sad to lose CLRK, because those in the know considered it to have the among the sector’s best patent portfolio.

Strong performance and limited quality competitors to invest in propelled returns in some cleantech sectors such as geothermal - Ormat (ORA +49%), wind power - Zoltek (ZOLT +118%) and American Superconductor (AMSC +179%).

Energy efficiency and power management were also hot themes, driving up not only smaller stocks such as Echelon (ELON +158%), EnerNOC (ENOC +53% since mid-May), Comverge (COMV +41% since mid-April) and Itron (ITRN +80%), but also giant players such as Siemens (SI +60%), SPX (SPW +69%) and Woodward Governor (WGOV +71%).

On the downside, Trex (-60%) and Headwaters (HW -51%) plunged with demand for residential building materials; Maxwell Technologies (-41%) and Verenium (-54%) tumbled as profitability continued to elude both companies. Insituform (INSU -43%) fell when earnings came in below analyst estimates. Trex, Maxwell and Verenium were removed from the Index on December 30th.

New to the Cleantech Index as of December 31st are ABB and Ansys. ABB (ABB) is a global leader in energy transmission, generation hardware, power controls and process automation. It has the scale and scope to capitalize on soaring demand worldwide that few competitors can match.

Ansys (ANSS) is a leader in simulation software used by engineers and designers to test products designs for performance under a range of operating conditions. Its software is used in many industries and is critical to accelerating the development and optimizing the performance of new products, from vehicles and motors to fluid-handling systems.

Optimistic long term outlook, despite apparent similarities to 1980s

Barring a protracted global recession, it’s hard to foresee global demand, and hence prices, for most commodities falling dramatically for any sustained period of time (except for those dependent on biofuels) for any sustained period.

Not only will the Earth add 2.7 billion consumers by 2050, but rising wealth also is linked to higher per capita consumption – especially of resource-intensive goods and services. People have aspirations and many will want to eat meat instead of beans, drive instead of walk or cycle and have brick homes instead of straw.

This will, of course, drive energy demand/prices higher, hence the pursuit of energy and resource efficiency at all levels of the economy – especially if/when governments remove harmful subsidies.

Are energy prices high today? It’s all relative. Adjusted for inflation, $100/barrel oil prices are roughly equivalent to their 1980 high. However, when the increases in relative wealth are taken into account (especially in richer countries), current oil prices aren’t nearly so high.

Many things have changed regarding our energy demand since 1980, but many factors suggest it would be unwise to expect another post 1980 oil price decline:

1. The demand for all energy sources is now far, far higher.
2. There are less fossil-fuel reserves now than in 1980.
3. Many of the largest economies (particularly in Asia) are now far more dependent on fossil-fuels and fossil-fuel based chemicals than in 1980.
4. An ever-increasing proportion of the remaining reserves (especially oil & gas) are in areas that are politically unstable, environmentally sensitive and costly to reach.
5. In richer countries, rising wealth means energy expenses are now consume a much smaller share of personal incomes – despite larger homes, more cars, more electric appliances and longer commutes.
6. Nuclear power usage has declined relative to other power sources.
7. The destructive environmental impact of fossil fuel use is increasingly apparent, even to the most skeptical observer.

Rafael Coven is Managing Director of Cleantech Indices. He runs the market-leading Cleantech Index (CTIUS) of publicly-traded cleantech companies, tracked by the PowerShares Cleantech Portfolio and KSM Cleantech Index exchange-traded funds (ETFs). View the historical performance of the CTIUS Index here. Rafael has spent most of the last 21 years in cleantech as a manager, entrepreneur, equity investor, and management consultant.