Beware of These Strong Buys

Though there's recently been volatility in the sector, 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." And before this market downturn hit, one of the best-performing stocks of 2007 was none other than First Solar, up an incredible 795% in a year.

Further, though the market has soured on these stocks recently, investment in the sector continues to be hot. Recent data from Cleantech Group showed that venture capital investment in green tech increased 38% in 2008 to $8.4 billion. And support of clean, renewable energy and energy independence has become one of the key strategies in the new federal budget.

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

Not so fast
Even experts -- people who now devote their careers to advancing "green" technologies -- aren't sure what the perfect green tech policy, incentive, initiative, or technology looks like. But who can blame them?

First, there's significant government involvement in the sector that distorts market forces. That should be 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. That means that what seems like a great idea today could be obsolete tomorrow. For an investor in an early-stage company, that means your product may never get to market -- so you're staring down a significant risk of total capital loss.

Finally, we still haven't decided what the goal of green tech is. Is it to increase efficiency and reduce demand? If that happens, energy prices would drop and consumption would just rise again. Is it to build cleaner generation and consumption technologies? Unfortunately, every alternative solution has a shortcoming. For wind, it's the fact that wind tends not to blow during hot days when demand is highest. Plus, windmills aren't always welcome additions to a community's skyline. Is it energy independence? Then we're relying on cash-strapped American consumers to pay more in order to achieve this somewhat abstract goal.

Buyer beware
Yet there continues to be optimism for the sector. Just look at the analyst ratings for a few well-known green tech stocks:

The question is: How productive will these companies ultimately be given the noise in the sector? And further, how well can you see their futures given that same set of circumstances?

A case study
For evidence of what happens when a once-hot green technology turns heel, take a look at what's happened to ethanol stocks over the past three years. Once thought to be a product that could make the United States both greener and more energy independent, recent research has revealed that ethanol production may actually offset or, even worse, outweigh the greenhouse gas reductions caused by ethanol 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, politicians who coveted the Iowa primary, and several powerful interest groups were very much involved in making it a green-tech priority.

All of this combined to make ethanol stocks a very bad investment back when they were being 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 is the performance of those picks since his article was published:

I am not against saving the world
This is not to say that energy companies pursuing green solutions are bad companies, or that they're misguided. The world is clearly pursuing cleaner energy solutions, 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.

If you do it, do it right
Nonetheless, there's clearly a wide market opportunity for green tech companies in today's economy -- and a wide market opportunity is one of the core traits 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 gleaned from speaking with some of those aforementioned experts in the sector:

• Focus on green initiatives that offer immediate return on investment to customers. They're most likely to be widely adopted.
• Peak demand for electricity remains an enormous challenge, which makes distributed generation, energy storage, and advanced metering technologies extremely interesting to the large utilities that will be making many of the spending choices going forward.
• Hybrid vehicles. They have clear consumer appeal, and they're one of the few ways for individuals to participate tangibly in emissions reduction.
• Don't 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.

At Hidden Gems, we focus on valuation in the small-cap space. You can check out what we're recommending today by joining Hidden Gems free for 30 days. There's no obligation to subscribe.

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

Tim Hanson does not own shares of any company mentioned. And lest you think he hates the prospect of being a good steward of the environment, know that 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. The Fool's disclosure policy doesn't require that he tell you all of that, but you can read about what is required here.