The energy sector was the worst-performing sector in 2020. Now, it's the best-performing sector so far in 2021.

Chock-full of volatility and value traps -- yet ripe with opportunity and growth -- the energy sector can be feast or famine. Here are three tips to help you navigate the energy sector, avoid common mistakes, and make winning investments.

Wind turbines contrasted with an oil pumpjack

Image source: Getty Images.

1. Know what you want out of the energy sector

Before selecting individual companies, it's important to determine what you want to get out of the energy sector and how much risk you are willing to take.

For example, oil majors like Chevron (CVX 1.54%) and refining companies like Phillips 66 sport dividend yields over 5% but suffered major earnings hits in 2020. Conversely, pipeline giants like Enbridge and Kinder Morgan yield around 7% each and faced relatively minor earnings declines thanks to their business models. However, Chevron and Phillips 66 have more upside if commodity prices rise.

On the renewable front, pure-play solar energy stocks crushed the market in 2020. Although expensive, they continue to have compelling long-term growth prospects. But there are plenty of other companies, namely utilities and industrial stocks, that offer exposure to solar energy and pay dividends too.

Less talked about than solar is wind energy. The industry is fairly easy to understand, but it can be hard to find wind energy stocks. Like solar, wind energy has some fantastic growth prospects and there are hidden gems if you know where to look.

^SPX Chart

^SPX data by YCharts

2. Avoid tempting high-yielding dividend stocks

Whether you're interested in oil, gas, or renewables, chances are you've come across several high-yielding dividend stocks. The energy sector is home to some of the highest-yielding stocks on the market, but many of these dividend stocks can be terrible investments. One of the best lessons a new energy investor can commit to memory is that behind every stock is a company. Learning this lesson the easy way means understanding that a bad company paying a high-yielding dividend is worse than a good company or even an OK company that doesn't pay a dividend. The holy grail is finding great companies that pay stable and growing dividends. You can do this by focusing on companies with strong balance sheets (low debt) and growing free cash flow (FCF).

3. Focus on the balance sheet

The balance sheet is the heart and soul of a company. The downfall of most oil and gas companies is a bad balance sheet. At the extreme, it can lead to bankruptcy. To a lesser extent, poor financial health can result in high-interest expenses and an inability to invest without stressing the balance sheet further. The common theme behind the worst energy stocks of 2020 was a weak balance sheet. The common theme behind better energy companies was a strong balance sheet and an ability to invest in distressed businesses at bargain prices.

Profiles in energy

Looking at some examples of market-beating companies across the energy sector provides a good baseline for what success looks like. 

TPL Total Return Level Chart

TPL Total Return Level data by YCharts

Despite a tough few years for oil stocks, Texas Pacific Land Trust (TPL) has beaten the market over the past three years. TPL is the largest landowner in West Texas and earns revenue from oil and gas companies through commercial leases, royalties, and easements. With low expenses, a high operating profit margin, and a debt-free balance sheet, TPL has very little downside risk and plenty of upside. When business is good, it earns more FCF, which it then distributes to shareholders in the form of special dividends.  

NextEra Energy (NEE 0.45%) is the largest U.S.-based utility by market capitalization. It has a strong foundation in fossil-fuel-based power generation but is aggressively investing in both solar and wind energy. The company pays a stable and growing dividend and continues to post excellent earnings despite record-high capital spending. 

TPI Composites (TPIC -0.37%) is a pure-play wind turbine blade manufacturer with a market-leading position. It has long-term service agreements with several major original equipment manufacturers (OEMs) like General Electric, Siemens, and Vestas. Although significantly risker than TPL or NextEra Energy, the company has a high growth rate and is expanding internationally, hoping to secure contracts with OEMs it currently doesn't do business with.

SolarEdge Technologies (SEDG -2.77%) is a pure-play solar stock that has skyrocketed over the past few years. The company makes inverters and power optimizers, two critical elements in a typical solar system. SolarEdge has posted strong growth numbers thanks to lower solar power generation costs and growing investment. Solar energy is projected to be the cheapest form of energy by 2025 and comprises the majority of new capacity installations. SolarEdge is a leader in this field, but the stock's epic rise has called into question its valauiton