Beware of These Strong Buys

It's an understatement to say that investors are excited by the opportunities in green tech.

John Doerr, one of the world's most successful venture capitalists, called cleantech the "biggest economic opportunity of this century." One of the best-performing stocks of 2007 was none other than First Solar, up an incredible 795%. And recent data from the Cleantech Group (reported by CNET News) showed that VC investment in green tech increased 44% in 2007 -- from $3.6 billion to nearly $5.2 billion.

Triple back-up-the-truck, booyah, right?

Not so fast
A centerpiece of the recent Roth Capital investment conference in California was an "Investing in Green Tech" expert panel. Its goal was to reveal how to make obscene profits by investing in green tech stocks.

But it did the exact opposite.

As the panel went on, it became clear that even these experts -- people who now devote their careers to advancing green technologies -- weren't quite sure what the perfect green tech policy, incentive, initiative, or technology looked like. But who could blame them?

Wrap your head around this ...
First, there's significant government involvement in the sector that distorts market forces. That is an immediate red flag for prospective investors. Whenever the government is involved in something, there can be no certainty.

Second, green tech development cycles are becoming increasingly rapid. What seems like a great idea today could be obsolete tomorrow. For an investor in an early-stage company, your product may never get to market -- so you're staring down a significant risk of total capital loss.

Finally, though we can expect more "green" spending in an Obama administration, our country still hasn't decided what the goal of green tech is. Is it to increase efficiency and reduce demand? If that happens, energy prices will drop and consumption will just rise again. Is it to build cleaner generation and consumption technologies? Unfortunately, every alternative solution has a shortcoming. Wind, for example, tends not to blow during hot days, when demand is highest. And windmills aren't always welcome additions to a community's skyline. Other groups just want to achieve energy independence, while still others are willing to pay any price to stop global warming. These may all be noble goals, but there is no consensus.

Buyer beware
Still, investors continue to throw money at the sector and they remain optimistic about current investment opportunities. Just look at the analyst ratings for a few well-known green tech stocks:

That overwhelmingly positive analyst sentiment could entice you to enter the sector. This comment from Lisa Bicker of CleanTech San Diego, however, might send you running in the other direction: "The capital markets for these types of investments are very frothy right now, yet there are few productive investments available."

A case study
What happens when frothy markets meet a lack of productive investments? Take a look at ethanol stocks over the past two years. It was once thought that ethanol could make the U.S. both greener and more energy independent, but recent research has revealed that ethanol production could offset or, even worse, outweigh the greenhouse gas reductions caused by its use. What's more, the combination of rising corn prices, and farmers growing more corn and less of everything else, has led to higher food prices across the board.

Of course, demand for ethanol wasn't necessarily stoked by market forces. The government, the politicians who coveted the Iowa primary, and several powerful interest groups were very much involved in making ethanol a green tech priority.

All of this combined to make ethanol stocks a very bad investment when they were touted in the spring of 2006. For example, on April 5, 2006, analyst Michael Brush wrote about a few "ethanol stocks to get revved up about." Here are the performances of those picks since his article was published:

Another high-profile ethanol play, VeraSun Energy, IPO'd in June of that year with shares trading at $25 per share. It recently filed for bankruptcy.

I am not against saving the world
Energy companies pursuing green solutions are not bad or misguided companies. The world is clearly pursuing solutions for cleaner energy, even as the demand for energy around the world rises.

Still, investors can turn even the best company into a bad buy by paying the wrong price. That's a real risk in the green tech sector, where outcomes are uncertain and valuations are "frothy."

If you do it, do it right
Nonetheless, there is a wide market opportunity for green tech companies today -- and a wide market opportunity is a core trait we look for in the small companies we recommend to investors in our Motley Fool Hidden Gems service. So, while we're somewhat wary of the sector, we're also taking a long, hard look at it.

Governing that research are a few tips from those Roth conference panelists:

• Focus on green initiatives that offer customers immediate return on investment. They're most likely to be adopted.
• Pay attention to the large utilities that will make many spending choices going forward. They will be extremely interested in distributed generation, energy storage, and advanced metering technologies because peak demand for electricity is an enormous challenge.
• Watch hybrid vehicles; they have real consumer appeal, and they're one of the few ways individuals can participate tangibly in emissions reduction.
• Do not overpay.

So, while we're looking hard at green tech at Motley Fool Hidden Gems, we won't recommend any stock at the expense of a compelling valuation. When it comes to buying green tech stocks, you should do the same.

This article was first published on March 7, 2008. It has been updated.

Tim Hanson does not own shares of any company mentioned. As a vigilant steward of the environment, he walks to work, uses reusable bags at the grocery store, and pushes the limits of his wife's tolerance for cold when it comes to managing the thermostat at home. Suntech Power is a Motley Fool Rule Breakers recommendation. The Fool's disclosure policy doesn't require that he tell you all of that, but you can read about what is required here.