Solar companies across the board have seen huge pops in the past few weeks from a combination of market and political news.

In this week's episode of Industry Focus: Energy, Motley Fool analyst Sean O'Reilly and contributor Travis Hoium explain what's got the market so excited about the solar industry in the past few weeks, and how likely this growth is to continue. Find out which policies have changed recently and what it means for the industry, and how the biggest players are setting themselves up for a big long-term advantage. Also, learn the most exciting companies that investors might want to check out, the most important things to keep in mind before buying into the solar industry, and more.

A full transcript follows the video.

This video was recorded on June 29, 2017.

Sean O'Reilly: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, June 29, 2017 so we're talking about energy and industrials. I'm your host, Sean O'Reilly, and joining me today via phone to check in on the solar sector is one of The Motley Fool's top solar contributing investors and newly minted dad, Mr. Travis Hoium. How's it going, Travis?

Travis Hoium: It's going well. How are you doing, Sean?

O'Reilly: Very well. So, you have an 11-month-old running around the house, or lack thereof.

Hoium: 11-week.

O'Reilly: Sorry, my bad, 11-week.

Hoium: Yeah, just a little guy. Still getting used to him, but he's doing really well.

O'Reilly: Awesome. You're going to be a great dad.

Hoium: Thank you.

O'Reilly: And his entire college fund will be funded by solar investments, I'm sure.

Hoium: That would be the hope, yeah.

O'Reilly: So, Travis, I had to have you on the show today because solar stocks have had a good couple of weeks. You got First Solar (NASDAQ:FSLR) up 10%, SunPower (NASDAQ:SPWR) up 21%. Their solar yieldco, 8point3, is up 9%. Canadian Solar (NASDAQ:CSIQ) is up 20%. And that's making up for some losses. Just two weeks ago, these things were way lower. So, to start us off, what caused the sectorwide rally?

Hoium: There's a few things I think that are playing in here. The first is, the fundamentals are getting a little bit better in the industry. And the thing that has really driven stocks over the last month or so is that investors are seeing that project values are going up. One of the stocks that has gone up the most is Vivint Solar, and one of the reasons is an analyst sent a note to investors that said, "We actually think the underlying assets that Vivint Solar owns is worth a lot more than the market cap of the stock." If that's true, and you listen to comments from companies like SunPower and First Solar, who are saying that the assets that they're anticipating selling this year are going to be worth more than they were anticipating coming into the year, then the underlying assets under all of these solar companies are worth more. So that pushes values higher. We may not actually see that reflected in earnings yet. So we'll see how that plays out as the year goes on. But that should help companies overall, if the fundamental value of their assets is going up. 

The second thing that has really caught investors' attention is Trump talking about this border wall and putting solar on it. That's kind of a shiny object to look at. But it could really help policy going forward. That's the third thing, and maybe the most important thing long-term, that the policies underlying the solar industry are getting better in 2017. That's really a positive. Nevada opened up their net metering again. That was something they eliminated, pushing out all of the residential solar companies a couple years ago. Florida has opened it up; Texas is opening up. And if you layer those policy changes on top of Trump maybe looking at the solar industry a little bit more positively, that could be a long-term catalyst.

O'Reilly: For sure. So you outlined two major causes for this. The first one, that analyst note, do you know how they came up with this? That's a very Ben Graham, intrinsic value kind of thing. It's like, "We think this is actually worth this on the private market." Did that analyst call utilities and say, "What are you guys willing to bid on these things for?" How did they decide that?

Hoium: We know how companies are valuing themselves. They often disclose what they call retained value. Sunrun calls it their net present value. So they'll say, "OK, we have a 20-year contract with a customer, these are our cash flows; if we discount them to the present day it's worth X number of dollars." That, for a long time, was how particularly residential solar companies were valued. SolarCity really rose on that valuation model. And the last couple years that's kind of fallen by the wayside, because some of the assumptions they've used to build those models are really aggressive. So it's assuming only a 6% discount rate, for example, which is --

O'Reilly: How'd they pick that, right? [laughs] 

Hoium: Yeah. So, if you go to an 8% or 9% discount rate, you see your valuations go down pretty quickly. The other thing that is assuming is, a lot of these companies assume that customers are going to renew their leases after 20 years, and that's kind of a ridiculous assumption. We have no data to indicate that because the industry is just too young. I don't think it's reasonable to assume someone will renew a lease on 20-year-old solar equipment when we're going to be installing something much better in 20 years from now.

O'Reilly: I remember well before Tesla bought SolarCity, you were always writing about how you thought the discount rates were ridiculous.

Hoium: Yeah. That was really what made those projects look profitable. If you change those assumptions, suddenly all the value creation goes away. So we've kind of gone back and forth with this for the last couple years. For a while, I think things were overvalued. Early 2017 and into 2016, things maybe got a little bit undervalued. So now we're kind of recovering. And part of the stock move right now is, we're coming off of a really depressed point in the industry. There's a lot of pessimism coming into 2017. The big residential solar companies were losing market share. Some of them were actually installing less. Tesla is one of the biggest ones, that they've really shrunk their solar business. So if we're starting to turn that around in 2017, then the outlook looks a lot better going into 2018 and beyond, when we should be at a little bit more consistent growth point for the industry.

O'Reilly: How have these share prices been doing recently?

Hoium: I looked back two weeks, and that's kind of when things really started to move. That was when Trump started talking about the solar wall. SunPower and First Solar jumped 26% and 13% in just the past two weeks. They're the U.S. companies. They don't have a lot of manufacturing in the U.S., but they're two potential suppliers for the solar wall, or if there's policies that make it advantageous to be a U.S. manufacturer, they could be winners there. Canadian Solar, who you mentioned before, and Jinko Solar, who are two of the largest manufacturers in the world, up 26% and 16% in the last two weeks. And I think the two surprise companies, and this is what gives me hope that this is about more than just Trump, is that Vivint Solar is up 60% in two weeks, 80% in the last month, and Sunrun is up 28%. So those are some really big jumps in the residential solar space. If that is something that get stronger, we should see that help a company like SunPower, who also has a presence in residential solar, and that will be a real boost for the industry overall.

O'Reilly: Travis, what has been going on with the industry itself, from a fundamental basis? Because up until this point, all we've really been talking about is Trump and an analyst note that says their projects might be worth more. Are these guys getting better at what they do? Are they actually getting new contracts? What's going on, on a fundamental level?

Hoium: It's a little bit early to give a definitive answer to that. I'll tell you what I think we're seeing. The first quarter was bad. There's no way of getting around that. In 2017 overall, it'll likely be pretty bad for most of the big solar names. In particular, First Solar, who is actually taking this opportunity, it was kind of a weak point in the market, to upgrade their equipment to a product they call Series 6. It's revolutionizing their technology, the way that they build their solar systems. That's something that, we won't see the fundamental impact of that until late 2018 to 2019. SunPower is making some similar changes, big changes in a product they call P-Series and Oasis, which is their utility-scale product. Again, we'll see a little bit of impact on that this year.

O'Reilly: Which is what both those names are pivoting to, they're shifting toward making huge projects for utilities, right?

Hoium: Right. Over the last five years, they moved into building their own projects. They said, "This is crazy, that we're selling these huge projects to people like Warren Buffett and then he's making a ton of money on these. We're going to actually build them on our balance sheet, and then we'll sell them when they're completed." And that made sense for a while. But what they found was the margins that came along with developing those assets really started to deteriorate over the last couple of years. So they're actually moving to component sales, which I think makes a lot more sense long-term, but it's going to be a little bit of a bad transition for them financially in 2017. We probably won't see growth numbers until 2018 or 2019.

O'Reilly: Now for the layman that's listening, real quick, can we back up and define the difference between what they've traditionally done? It sounds like there was a limbo period where they were doing the project sales and realized, not only do you have the problems that you mentioned, but you need a bunch of money lying around on your balance sheet. Talk to me about component sales. What does that mean? What's the difference between a module and the actual solar cell?

Hoium: The module is the 2 meter-by-1 meter solar panel.

O'Reilly: So these are the things I see on roofs and at the airport and stuff, right?

Hoium: Exactly. The cell is the pieces that go into the module. So a silicon cell, that's going to be a 4-inch-by-4-inch, 5-inch-by-5-inch solar cell, and they're going to connect those together to make the module. What First Solar and SunPower are doing is, they have long made modules, but what they would then do is put those on rackings, connecting inverters, connecting entire systems to the grid. That's the project-development side. We're moving away from that. They're saying, "It doesn't make sense for us to build the whole project, but we'll complete the engineering part of it, and you can just buy our fully engineered solutions." For example, NextEra Energy bought a 125-megawatt solution from SunPower, and they basically said, "We'll provide you with racking, modules, inverters, and you can just plug it in, but you're going to be the project developer and take the project-associated risk. We'll just provide all the components." In some ways, it's similar to the way that GE does some of its electric supply components, although they do some financing on their financial arm. But that's the model that they're moving to, is, "We just want to be supplying pieces; we don't want to be taking these huge financial risks."

O'Reilly: It seems like that's where their competitive advantage lies. If you're NextEra Energy, which is not only one of the most -- I'm phrasing this poorly, but, renewable utilities in America, but they're capable of building things. What they can't do is build a solar module really well. So it seems like, by doing this, they're focusing on what they're good at.

Hoium: Right, that's the theory. I say that's the theory because --

O'Reilly: The devil is in the details? [laughs] 

Hoium: -- if you have one of these shifts, the economics change, and what seems to make sense one year maybe doesn't make sense three years down the road. I think the strategy makes sense. I'm a little bit hesitant to say with full certainty that it's going to be the correct strategy in five years from now, because the solar industry just changes so fast, we just don't know.

O'Reilly: Speaking of that, can you fill us in on, the driver of that change that you just mentioned, it seems to be efficiency. It's kind of like computers. My computer today is eight times better than the Dell I had in 1998, and it seems to be the same way with solar cells; they're getting more and more efficient. In fact, correct me if I'm wrong, they just reached parity with traditional power generation options in a lot of places. What could efficiency gains do to throw a wrench in these plans?

Hoium: There's a couple things. There's a dynamic between cost and efficiency that's really important in the solar industry. In space-constrained environments, what we would call distributed generations, so, solar panels you would put on your roof, or they might be on a Target store -- that's where efficiency really matters. Because it's very expensive to do the permitting, to get the labor up there, to wire these things. So if you can squeeze out more power in a small amount of space, efficiency is very important. In the utility side -- and this is one of the reasons that SunPower really had to go through a big strategy change over the last couple years, moving to a different module -- efficiency isn't quite as important today as cost. You would maybe pay a few extra cents per watt for a more efficient solar panel, but you're not going to pay 50% more. You're not going to pay $0.60 a watt when you could buy a competitor for $0.40 a watt just because it's more efficient. There's just not that much to be gained by saving a little bit of space on the utility side.

Now, with that said, we are getting to the point where more efficient modules are cost-effective versus their less efficient brethren. Even companies like Jinko, Canadian Solar, are moving toward what's called mono-PERC, which is the next generation of efficiency or commodity cells. So that efficiency is happening, but it's happening in different ways in different segments of the market. And that's something that's important to understand. I think efficiency is going to be a huge differentiator long-term, but there's these ebbs and flows that happen. Sometimes efficiency is going to be really important in a place like commercial solar; sometimes cost is going to be more important. So, long-term, I think you want to bet on the companies that have the efficiency advantage, because cost advantage just isn't something that's sustainable in the solar industry. But I'm hesitant to say that 2017 is going to be the year that efficiency is going to be the breakthrough. So that's what I write about a lot on fool.com and try to cover that dynamic that's going on between cost and efficiency.

O'Reilly: I was talking to a co-worker the other day, and they were asking me about one of your pieces. I was like, efficiency isn't just the name of the game, especially right now. You might have an 18% solar panel, and then someone offers you a 19% efficient solar panel, and then you'll want the 19%. But, what if the 19% efficiency solar panel costs 20% more? Then it's like, well... you know what I mean? So who are the companies that stand out, given the shake-up and the dynamics you see playing out in the next couple years?

Hoium: I'm really interested to see these U.S. players. So SunPower is clearly the efficiency leader. In the residential and commercial space, I think we should see margins go up. Those have been pretty depressed this year. 2017 is going to be a real shake-out for them financially as they push a lot of things off their balance sheet, and clean things up for 2018 and beyond. And this move to this P-Series product, I think, is what they had to do, but they have a lot to do to prove that that's going to be a huge financial win. Same with First Solar. They're spending about $1 billion to upgrade their manufacturing facilities and make a slightly more efficient and cost-effective installation system so that they can sell components competitively to their customers. But we don't yet know what those economics look like. So those are the big questions. Then you have companies like Canadian and Jinko Solar who I think are really starting to consolidate their power in the Chinese manufacturing market. China has long dominated manufacturing for the solar industry. That's starting to wane a little bit as technology becomes more important, and having scale and a blank check from a Chinese state-run bank, which is how a lot of this manufacturing was built -- that's not necessarily a sustainable competitive advantage.

So they're going to be a couple companies I'm more hesitant on from an investment perspective, because they're still making a commodity product. But we'll see how that plays out. We'll see if customers are willing to pay a little bit more to have a name like Canadian Solar, rather than a Yingli Green Energy, who is still making solar panels, but it's a company that's really in a financial hard time. So there's multiple segments of the market. Those are a few of the companies I'm watching. The second quarter will be really interesting, to see how residential solar companies do. Are big installers -- which would be like Vivint Solar and Sunrun, to a lesser extent Tesla -- going to be able to take market share back? Because they've been losing market share for two years. So that's something that I'll be watching. They've been trying to focus more on profitable customers instead of just growing. That should be good for their business long-term, but I want to see what those economics look like from the residential solar side.

O'Reilly: Awesome. Travis, I can't thank you enough for your time. We'll have you back on the show again soon to check in on all this.

Hoium: Thanks a lot, Sean!

O'Reilly: You bet. That's it for us, folks. Be sure to tune in tomorrow for the Technology show with Dylan Lewis. If you're a loyal listener and have questions or comments, we would love to hear from you, just email us at industryfocus@fool.com. As always, people on this program may have interests in the stocks they talk about and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For Travis Hoium, I'm Sean O'Reilly. Thanks for listening, and Fool on!

Sean O'Reilly has no position in any stocks mentioned. Travis Hoium owns shares of 8point3 Energy Partners, First Solar, General Electric, and SunPower. The Motley Fool owns shares of and recommends Tesla. The Motley Fool owns shares of General Electric. The Motley Fool has a disclosure policy.