When it comes to investing, return versus volatility is a very important metric. As an example of its significance, an investor could beat the market if he had an asset that delivered market returns with lower volatility. This phenomena could in fact be the reason why Warren Buffett is the Oracle of Omaha.
According to the Yale paper Buffett's Alpha, the secret to Warren Buffett's success is that he buys low volatility stocks that don't fall very much in bear markets but perform similarly well in bull markets and levers them up with insurance float. The strategy of using low-cost insurance floats to buy companies with wide moats, predictable cash flows, and low volatility has made Warren Buffett into the greatest investor of all time.
Unlike Warren Buffett, most investors do not own insurance companies and look to higher volatility (beta) stocks to produce better returns.
There are very few sectors that are more volatile than the solar sector. The solar sector is filled with many high beta names. Canadian Solar (NASDAQ:CSIQ) is among the leaders with a beta of 3.68. Trina Solar (NYSE:TSL) has a beta of around 3. First Solar (NASDAQ:FSLR) rounds out the pack with a relatively modest beta of 1.84.
Why solar companies are so volatile
One reason solar companies are extremely volatile is because they are almost pure growth stocks. Unlike value stocks that pay dividends and have relatively high price/book values, the majority of a growth stock's value is in its future earnings, which are very dependent on the growth rate. Many current events can alter that growth rate and change that future value drastically. As an example, the September Chinese government announcement of a 50% rebate on VAT tax from October 1, 2013 to the end of 2015 sent many solar stocks flying over 25% in the days afterwards. The VAT tax rebate meant higher profit margins and higher future growth rates.
Another reason for the volatility is that many are levered with significant debt. Any change in gross margins will impact the bottom line greatly. Trina Solar has a total debt to equity ratio of 1.49. Canadian Solar has an ever higher total debt to equity ratio of 3.85. First Solar is the least levered company in the space with a net cash balance of over $1 billion.
The last reason is that the solar sector is filled with hot money. The sector does not have a lot of institutional ownership, which tends to hold for longer periods of time. In terms of institutional ownership, First Solar leads the way at 65%. Trina Solar is not far behind at 57%, and Canadian Solar lags with institutional ownership of only 30%. High volatility attracts short-term and momentum traders that may leave at the first sign of trouble.
The bottom line
Investors should realize that the solar sector is speculative and only invest what they can afford to lose. Solar stocks are vulnerable to sentiment shifts and are liable to sell off if expected growth rates do not materialize. That being said, I believe that the long-term solar economics of falling production costs and increasing demand are extremely compelling and will reward long-term shareholders in sector leaders such as First Solar and Trina Solar.
Jay Yao has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.