In Royce Smaller-Companies Growth Fund, we look for companies with the potential to grow at an above-average rate over the long term. This search routinely leads us to industries (or sub-industries) undergoing a period of accelerated growth due to an innovation, the adoption of new best practices by industry participants, legislative or regulatory changes, or a paradigm shift that proves critical to business success.

When electricity consumption first became pervasive, electrical utilities built large, efficient coal-burning power plants that were centralized by geography, with transmission lines distributing power to the local surroundings. Just as technological advancements led mainframe computers to be replaced, first by mid-frames, then by microcomputers, a similar dynamic is currently changing the electric power industry.

Power is increasingly being generated from sources closer to consumers, in part due to the shift to renewable energy sources (solar, hydro, wind, geothermal, etc.) that are themselves being driven by regulatory and environmental mandates. A home can be powered by rooftop solar panels in tandem with a stationary battery. (The latter is necessary for renewable energy given the interruptible nature of certain green power sources.)

For several years, companies all along the supply chain have been benefiting from this massive shift. This is particularly true in California. The Golden State has mandated that all new residential construction include solar panels. In a way, this is a generational re-tooling of an entire, quite massive industry. There has been a small share loss each year from natural gas and coal powered utilities, which is catalyzing rapid growth for those companies participating in the current market share sliver of renewable power. This sliver, however, has been expanding dramatically over the last few years—with expectations of growth for many years to come.

A plethora of industries are benefiting from this shift. The pure play companies are growing fastest, with some further along their maturity curve. In addition to renewable energy adoption, the most developed examples of electrification are hybrid electric vehicles (“HEV”) and battery electric vehicles (“BEV”). Other industries that are directly benefiting from each of these adoptions include solar panel manufacturers, installers, and component makers, as well as reserve/battery manufacturers (both residential and commercial grade), lithium and other battery material miners, renewable power project developers, engineering companies, semiconductor companies, semiconductor equipment manufacturers, automobile manufacturers, automobile component manufacturers—the list goes on and on, particularly as more devices and vehicles switch to electric power and renewable power sources move closer to the users and their homes.

With its leading market share in EVs, Tesla has become a key player in an industry that has otherwise seen only modest innovation in the internal combustion engine over the past 100+ years, while fostering a significant industrial ecosystem. And although EVs accounted for only 10% of the new auto production for 2022, and only about 6% in the U.S., some forecasts suggest these vehicles will represent 30-50% of automotive production, depending on geography, by 2030.¹

An important example of vertical integration at Tesla is that the engine of their vehicles—the battery—represents 10-20% of each car’s production cost. Tesla constructed what the company calls a Gigafactory in Nevada (Tesla has since built others) that’s believed to manufacture 140 Gigawatts per hour worth of batteries each year, enough to supply approximately two million vehicles. According to Benchmark Minerals, a single Gigafactory requires the equivalent of 18% of the world’s current lithium production, along with the 24% of nickel, 14% of its manganese, and 9% of its cobalt production. Simple math suggests that if global EV passenger automobile production does in fact reach 30% by 2030, it would represent the need for 18 additional Gigafactories over the next seven years, necessitating significant investment in developing and processing the above listed materials. There is also a national need for more charging stations, electric power semiconductors, converters, electrical engine components, etc. As one industry veteran put it, “if it rolls, floats or flies…it will need battery packs in the future.” It is safe to say that lithium ion batteries are not limited to the consumer electronics and electric bicycle industries any longer.

Three portfolio positions further illustrate our interest in the related areas of electrification and EVs.

Aehr Test Systems (Nasdaq: AEHR) makes semiconductor manufacturing test equipment for the manufacture of Silicon Carbide (“SiC”) and other microchips. Known as a compound semiconductor, SiC combines elements of the traditional silicon wafer technology and a layer of ultra-pure carbon powder, which together has superior qualities, such as faster charging, longer range, etc., to traditional silicon chips for the EV battery systems. Failure rates are generally higher in SiC, which is why Aehr’s wafer-level burn-in test systems are an important step in the EV battery manufacturing process, increasing yields for manufacturers.

AMG Critical Minerals (AMG-Netherlands) is a vertically integrated miner, refiner, and processor of battery-grade lithium. Headquartered in the U.S. but listed in the Netherlands, AMG is a mini-conglomerate and something of a special situation-type of investment. In its long-life mine in Brazil, AMG will soon be able to mine hard rock lithium (spodumene), process it into concentrate on site, convert it into lithium carbonate, and convert that into lithium hydroxide to help meet high demand for battery-grade lithium in Western Europe. Over the next couple of years, management expects to add vertical production capacity (and thus capture more margin) once these processing steps are in place, expanding its already high margins. In addition to lithium, its second largest business is recycling vanadium, which will be used in stationary “flow redox” batteries in industrial applications.

Shoals Technologies Group (Nasdaq: SHLS) manufactures engineered electrical components, cable assemblies and systems for the utility-scale photovoltaic/solar farm industry. With roughly 50% market share, Shoals is the leading provider of Electrical Balance of Systems (“EBOS”) solutions, designing easier-to-install wiring systems that generally do not require high-cost labor or licensed electricians to install. Solar is cheaper than other renewable energy sources, has a faster time to production, and is more reliable. Shoals also has EV charging station and stationary storage products that should also contribute to future revenues.

Electrification is a highly visible investment area and a powerful economic driver that is still arguably in its early stages. At the intersection of EV adoption and the transition to renewable energy, we can see how these innovations are beginning to displace both internal combustion engines and coal/natural gas fired power plants over the next decade. Not only can we confidently envision significantly higher penetration rates than we have today in the U.S. but we are already seeing much higher renewable energy usage in Europe and greater EV penetration rates in China. Finally, federal governments—especially in the U.S. via the Inflation Reduction Act of 2022—continue to subsidize these powerful shifts through project funding and tax subsidies.

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