Too Late to Buy Solar?

Yesterday, I got an email asking me whether there was any way to invest in solar power and alternative energy -- and whether it was a good place for new money. After wondering what prompted that question now -- maybe $4 gas did the trick -- I realized how hard it is to make investment decisions about hot sectors.

When it comes to top-performing investments, alternative energy outshines the competition. The numbers speak for themselves:

Source: Yahoo! Finance.

Given these huge run-ups, investors face a tough judgment call: Has a solar bubble formed, or do these stocks have more room to run?

Being fashionably late
When you identify new trends before they get popular, deciding whether to invest is pretty easy. In general, it comes down to two possibilities. If you're right about the trend and its business opportunities, you'll make a lot of money. If you're wrong, you'll likely take a big loss.

After a year or two of strong returns, however, it's a different game entirely. Now, it's not enough to be right about the business, as thousands of investors who've come before you have set expectations for future profits -- expectations that are often very high. If you pick a company whose business does well, you can still lose money -- if it doesn't do well enough.

And while there's still plenty of potential for astronomical gains, lofty stock valuations mean that these stocks have a lot further to fall if things don't go exactly right.

Remember the '90s?
By now, though, the question of how to invest in hot sectors should be eerily familiar. Dell (NASDAQ:DELL), for instance, enjoyed more than 10-fold returns from 1989 to 1992. It then lost more than half its value in early 1993 -- only to rise another 10,000% by 1998.

On the other hand, eBay (NASDAQ:EBAY) gave you far less time before the bottom fell out. If you'd bought shares in 1999, after they had risen more than 1,250% in less than a year, you would have picked the exact top. You'd have had to wait four years to break even on your investment.

No easy answer
Unfortunately, while most hot sectors have dramatic ups and downs, it's nearly impossible to guess exactly when the direction will change. Even if valuations seem irrationally high, they can stay irrational for quite a while -- or prove to have been prescient once a business proves its success.

Based on past experience, however, you can look for some signals of whether a hot sector may be ready to cool off:

• Continuing innovation. Hot sectors often spawn copycat companies looking to make a quick buck. Toward the end of the Internet bubble, companies doing IPOs didn't have anything new to offer -- they were just mimicking past success stories. In contrast, advances like thin-film solar technology suggest that the solar industry is still coming up with new ideas that could give businesses a competitive advantage.
• Inflated market caps. When stocks soar, valuations can get outright ridiculous. When Internet startups became more expensive than groups of well-established older companies, many value investors saw the writing on the wall. Although solar stocks have grown quickly, most of them are still firmly in the mid-cap category, giving them room for further gains if their businesses continue to prosper.
• Macroeconomic support. Hot sectors reflect the best of the economy as a whole. The Internet bubble came during the longest expansion in U.S. history. Yet while the economic slowdown may threaten most companies, one of its causes -- high oil prices -- is supportive of solar stocks.

I have little doubt that over the long run, alternative energy will be one of the fastest-growing segments of the world economy -- and will give investors plenty of opportunities to make money. Whether the current batch of solar stocks will reap the benefits of that trend, or whether new ideas not yet even imagined will bring new companies to the forefront, is something only the future will tell.

For more on investing in hot sectors, read about:

• How you can spot tomorrow's top performers today.
• Which five biotech stocks to keep an eye on.
• What the next ultimate growth stock will be.