One of the most well-known exchange-traded funds (ETFs) for tracking the solar industry is the Invesco Solar ETF (TAN 2.46%). The ETF caught the market by storm in 2020, roaring 233% higher in a single year. But since then, the ETF has fallen 57%, and is down 39% in 2023 alone.
Let's discuss why the ETF deserved to fall, and why it now offers long-term investors an attractive balance of risk and potential reward.
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A primer on the ETF
The top three largest holdings in the fund are Enphase Energy (ENPH 3.80%), SolarEdge Technologies (SEDG 2.81%), and First Solar (FSLR 2.12%), which together make up some 30% of the fund. The ETF offers a nice blend of technology companies, utilities, parts and component manufacturers, and more. About 54% of the fund is geographically tied to the U.S. and 20% to China.
When you think of solar, you may imagine fast growth and new technologies. But in a lot of ways, solar functions like a traditional industry. It requires funding, a complex and integrated supply chain, project management, and more. In this vein, the Invesco Solar ETF does a good job of offering exposure to aspects of the solar industry that may normally be overlooked, and geographical exposure to securities that are difficult to invest in if you live in the U.S.
One of the negatives of this ETF, however, is its 0.69% expense ratio, which is steep for an ETF and may shock ETF investors who are familiar with well-known Vanguard funds (many of which feature expense ratios of less than 0.05%). But when you consider the purpose the ETF is serving and the fact that nearly half of its holdings are international, the expense becomes worth it. But it's still something you'll want to be comfortable with before buying the ETF.
A justifiable sell-off
The Invesco Solar ETF simply ran up too far, too fast. If you think 2020's gain was impressive, consider that the ETF shot up 454% in 2019 and 2020. When a stock or fund goes up that much in a short period of time, it can usually only be justified by a sustained blistering growth rate, which is difficult to expect in a cyclical industry like solar.
Downturns in the cycle can happen for a variety of reasons. But this downturn was definitely in response to rising interest rates, which acted like a double whammy on many solar companies. Higher interest rates make it more expensive to fund growth with debt, which can throw a wrench in growth plans that were made assuming lower interest rates. And customers may be less interested in investing in solar if the return on investment isn't as high as it once was with lower rates. This affects both the residential and commercial side of solar.
The current operating environment was already going to be challenging. But what made it worse from an investing standpoint is that the industry was priced to perfection going into the downturn.
Secular tailwinds
2023 has been a painful reminder that although the solar industry has growth potential, it is cyclical. And if a downturn happens at the wrong time, it can wreak havoc on equity prices.
The good news is that the solar industry has some of the strongest secular tailwinds imaginable. Utility-scale solar is now cost-competitive with fossil fuel options, such as combined-cycle natural gas-fired power plants. Strong support for electrification, environmental, social, and governance goals, and emissions reduction efforts across virtually every sector of the economy create a lot of demand for renewable energy in the years and decades to come.
The solar industry has also been impacted by geopolitical risks, such as Russia's invasion of Ukraine. The reliability of oil and gas may seem more attractive than an intermittent power source when tensions are high. But over time, solar investments make a ton of sense. And there's still been a ton of support for solar funding even in this downturn.
On Oct. 30, the White House released a statement supporting a 100% clean electricity grid by 2035. Solar energy is needed to make that happen. And there are plenty of subsidies to support the industry.
Better valuations
Given the ongoing slowdown in the solar industry, there's a good chance that valuations will not look cheap anytime soon once the upcoming quarters are factored into the trailing 12-month earnings. But the industry could begin to normalize in the second half of next year as the cycle works itself through and interest rates begin to decline.
If that happens, many stocks could begin looking cheap in the second half of 2025 or by early 2026 on a price to earnings basis alone. Throw in a return to growth, and you could have an industry that blends value and growth if equity prices stay depressed.
Of course, there is a scenario where the market perceives the industry is recovering and goes on a buying spree before the results actually improve. But either way, there's a good chance the industry will look cheap in the next year to three years, which is the exact opposite dynamic from an industry that looked way too expensive just a few years ago.
Now is the time to invest in solar
In the stock market, it's common to measure a company's or industry's success based on the stock price. But if you did that with solar, you would think the industry was unstoppable in 2019 and 2020, and falling apart today.
The truth lies somewhere in between. Market dynamics were far easier a few years ago. But nothing has changed about the long-term investment thesis for solar. However, the industry could remain challenged over the short term. And it wouldn't be surprising if equity prices remained strained in 2024.
For that reason, it's best to only approach the industry if you have at least a three- to five-year time horizon. But if you do, the industry-wide sell-off has drastically lowered the investment risk, while the long-term potential reward remains as strong as ever.
