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 First Solar was up an incredible 795% in 2007.

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 the 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:

How productive will these companies ultimately be, given the noise in the sector? And how well can you see their futures, given that same set of circumstances?

A case study
For evidence of what happens when a once-hot green technology turns heel, look at what's happened to ethanol stocks over the past three years. Once considered a way to make the United States both greener and more energy-independent, recent research has revealed that ethanol production may actually offset -- or, even worse, outweigh -- the greenhouse-gas reductions caused by ethanol 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, politicians who coveted the Iowa primary, and several powerful interest groups were very much involved in making it a green-tech priority.

All of this combined to make ethanol stocks a very bad investment back when they were being touted in the spring of 2006. For example, in April 2006, analyst Michael Brush wrote about a few "ethanol stocks to get revved up about." Here is the performance of those picks since his article was published:

Another high-profile ethanol play, VeraSun Energy, launched an IPO in June of that year with shares trading in the $20s. It's since filed for bankruptcy.

I am not against saving the world
Energy companies pursuing green solutions are not bad or misguided. The world is clearly pursuing solutions for cleaner energy, even as the demand for energy 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 a panel at a recent Roth investors' conference I attended:

• Focus on green initiatives that offer customers 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 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 March 7, 2008. It has been updated.

Tim Hanson does not own shares of any company mentioned. As a vigilant steward of the environment and someone who enjoys putting himself in grave danger, he skateboards to work. First Solar is a Motley Fool Rule Breakers recommendation. The Fool's disclosure policy doesn't require that he tell you that, but you can read about what is required here.