Beware of These Strong Buys

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." One of the best-performing stocks of 2007 was none other than First Solar (NASDAQ:FSLR), up an incredible 795%.

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 very well have you considering entering the sector. Yet Lisa Bicker of CleanTech San Diego told me recently: "The capital markets for these types of investments are very frothy right now ... yet there are few productive investments available."

A case study
For evidence of what happens when frothy markets meet a lack of productive investments, take a look at what's happened to ethanol stocks over the past two years. Once thought to be a product that could 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, on April 5, 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, had its IPO in June of that year, with shares trading at $25 per share. It's now in bankruptcy protection.

I am not against saving the world
This is not to say that energy companies pursuing green solutions are bad companies, or that they're misguided. The world is clearly pursuing cleaner energy solutions, even as the demand for energy around the world rises. A company like Fuel Tech, which can help power plants reduce their emissions, will clearly benefit.

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 "frothy."

If you do it, do it right
Nonetheless, there's clearly a wide market opportunity for green tech companies in today's economy -- and a wide market opportunity is one of the core traits 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 guidelines we've honed over time:

• Focus on green initiatives that offer immediate return on investment to customers. They're most likely to be widely adopted.
• Peak demand for electricity remains an enormous challenge, which makes distributed generation, energy storage, and advanced metering technologies extremely interesting to the large utilities that will be making many of the spending choices going forward.
• Hybrid vehicles. They have clear consumer appeal, and they're one of the few ways for individuals to participate tangibly in emissions reduction.
• Don't overpay.

So while we're looking hard at green tech at Motley Fool Hidden Gems, and we have Fuel Tech on our Watch List, 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.

After all, that focus on valuation in the small-cap space has our picks more than five percentage points ahead of the market, on average. You can check out what we're recommending today and read all of our research and notes from the conferences we attend by joining Hidden Gems free for 30 days. There's no obligation to subscribe.

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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. And lest you think he hates the prospect of being a good steward of the environment, know that he skateboards to work (shout out to Sector Nine longboards), uses reusable bags at the grocery store, and pushes the limits of his wife's tolerance for cold (in winter) and heat (in summer) 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.