The Worst Investment in Solar

Solar stocks are hot and many investors are wondering how to get exposure to the industry. You can take a risk by buying individual stocks or you can bundle a portfolio of companies together to spread out your risk. But in this emerging market the basket may have more risk than other industries and before you go buying solar ETFs you should know why I think this is the absolute worst way to play the industry.

More bankruptcies are coming
One thing we know about the solar industry is that a lot of companies are going to go bankrupt in the next few years. There's way too much supply of polysilicon, wafers, cells, and modules, driven by subsidized Chinese suppliers. Many of these companies won't survive as new technology comes out and replaced the equipment they've spent billions of dollars on, which means they're investments you want to avoid.

We don't know exactly who these companies are because the Chinese government has funded their operations but eventually some companies will fail. I've pointed to Suntech Power (STP), LDK Solar, and Yingli Green Energy (NYSE: YGE) as three likely candidates but there are many others.

I also think there will only be a handful of major companies producing most of the solar modules a decade from now. Solar is technology-driven and the best technology will win out as it did in PCs, smartphones, and other industries.

A path to failure
If there are a lot of stocks that are terrible investments, then we certainly want to avoid them in any basket of stocks we buy. This is where the solar industry has a unique challenge compared to other industries. ETFs are usually a way to get exposure without taking risk on individual companies, but in the solar industry it's a way to ensure you get a lot of duds.

Guggenheim Solar (TAN -0.28%) is a popular solar ETF, but it has more than 4% of its assets in Trina Solar, Suntech, and Yingli Green Energy, just to name a few. Market Vectors Solar Energy ETF (NYSEMKT: KWT) is in the same boat, exposing investors to some of the worst companies in solar. Trina Solar, Yingli Green Energy, Suntech, LDK, JinkoSolar, and Renesola all account for more than 2% of assets, assuring losses when one or more goes under. Meanwhile, the fund has outsized bets on MEMC Electronic Materials, GCL Poly, and First Solar. Are these the companies you want to own in solar?

The effect of owning the solar industry laggards can be seen below. Chinese firms have been a drag on performance; if it weren't for that they may be an even bigger part of the portfolio.

Meanwhile, even after tripling in the last three months SunPower is only 6.5% of KWT and 7.3% of TAN. That's why one of the top performers has been overshadowed by lesser companies.

Buy a basket of quality
If you want exposure to solar, consider that it's harder than just buying an ETF. That's the absolute worst way to invest in the industry because you're assured to get exposure to companies that fail.

What you should do is focus on high quality companies and buy a basket that you're comfortable with. I've long said that SunPower is the best stock in solar, so start with that. Even though First Solar is going through tough times it's one of the few profitable companies in the industry, and it has the balance sheet to adjust and survive as a systems builder at least. MEMC Electronic Materials is also building systems and is a supplier to the industry and has a good shot at surviving. Finally, Power-One and GT Advanced Technologies supply inverters and equipment to make modules, supplying key parts to the industry and doing so profitably.

There are five ideas for a basket of companies with better odds of thriving than the basket an ETF can offer you. In solar, it's going to take more work to make profitable investments right now but the reward is tremendous if you do it right.