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.

Furthermore, though the market has soured on these stocks recently, investment in the sector remains 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 President Obama's 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 policy, incentive, initiative, or technology looks like. But who can blame them?

First, there's significant government involvement in the sector, which 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 -- leaving you 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. Wind tends not to blow during hot days when demand is highest, and 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 optimism for the sector persists. Just look at the analyst ratings for a few well-known green tech stocks:

That overwhelmingly positive analyst sentiment could entice you to enter the sector. This comment from Lisa Bicker of CleanTech San Diego, however, might send you running in the other direction: "The capital markets for these types of investments are very frothy right now, yet there are few productive investments available."

A case study
What happens when frothy markets meet a lack of productive investments? Take a look at ethanol stocks over the past two years. It was once thought that ethanol could make the U.S. both greener and more energy-independent, but recent research has revealed that ethanol production could offset or, even worse, outweigh the greenhouse gas reductions caused by its 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, the politicians who coveted the Iowa primary, and several powerful interest groups were very much involved in making ethanol a green tech priority.

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

Another high-profile ethanol play, VeraSun Energy, had an IPO in June of that year, with shares trading at $25 per share. It recently filed for bankruptcy protection.

I am not against saving the world
Energy companies pursuing green solutions are not bad or misguided companies. The world is clearly pursuing solutions for cleaner energy, 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, where outcomes are uncertain and valuations are "frothy."

If you do it, do it right
Nonetheless, there is a wide market opportunity for green tech companies today -- and a wide market opportunity is a core trait 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 from panelists at a Roth Capital investment conference on "Investing in Green Tech":

• Focus on green initiatives that offer customers an immediate return on investment. They're most likely to be adopted.
• Pay attention to the large utilities that will make many spending choices going forward. They will be extremely interested in distributed generation, energy storage, and advanced metering technologies because peak demand for electricity is an enormous challenge.
• Watch hybrid vehicles; they have real consumer appeal, and they're one of the few ways individuals can participate tangibly in emissions reduction.
• Do not 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.

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

Tim Hanson does not own shares of any company mentioned. As a vigilant steward of the environment, he skateboards 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.