Why I Invested in Solar Stocks: A Look at the Industry's Bright Future

Joel Anderson  |

Buying massive index funds was (and mostly still is) my M.O. However, at the end of May this year, I changed things up pretty drastically – I took a significant amount of my investments out of my super safe, super conservative, super passive Vanguard index fund1 and bought up shares in the Guggenheim Solar ETF (TAN) .

Pretty Risky Play

This was a pretty drastic shift in strategy. I mean, just taking money out of an index fund and putting it into a single ETF is, in and of itself, a pretty substantial increase in risk. But I didn’t just do that, I picked maybe one of the riskiest, most-volatile of ETFs. And one coming off a year where it more than doubled in value, making the pullback it’s experienced since I bought it pretty obvious in retrospect (I’m off a little under 10% down from my entry point at the moment).

There’s all sorts of reasons why this was potentially a very stupid thing for me to do. But, at the same time, I’ve been following this industry for a while now and I’ve firmly come to the conclusion that, while risky, the investment also has real potential for big gains in the long run. So much so that I actually bought another (smaller) chunk of shares in early October when I thought it was hitting a low (which, much to my chagrin, it hadn’t).

I had my reasons for plunging in and I still feel good about the investment over the next 5-10 years and longer, even if it’s not looking good at the moment. So I thought I’d share them with you here.

Solar — A Pragmatist’s Nightmare?

Solar is nothing new to the investing public. In fact, TAN’s current share price of around $35 a share still puts it about $250 below its all-time high. That was back in the heady days of 2008 when TAN had only just come into existence and people were still saying things like “I mean, how bad could this ‘housing bubble’ really be?”

Since the 1970s, environmentalists have been championing the solar panel as the future of power while people in the utility industry continued to laugh at them. Clearly, solar provides some tremendous advantages. The most obvious being that, unlike virtually all traditional power plants, solar doesn’t require a fuel source. Someone owning a solar plant doesn’t need to worry about commodity costs or procuring and transporting coal, oil, or natural gas. Just the weather. And, as an added bonus, there isn’t any discernible air pollution created. Who wouldn’t love that?

Those in the utility industry, though, have long known that it was a bit more complicated than that. The necessity for consistency in generating electricity is a big one. Utility customers aren’t going to accept a situation where they call up their provider during an outage only to be told “sorry, it’s a bit too cloudy today for you to turn on the lights.” No matter what, a source of electricity that was available on demand would always be necessary, meaning solar could, at best, supplement the existing power grid. Of course, the bigger issue, though, was that solar was just way, way more expensive. Traditional coal-fired power plants were king in the United States because coal was cheap and plentiful and solar panels were expensive and inefficient in addition to being inconsistent and not producing any electricity at night.

A Different Equation for Solar Power: Not Just a Hippy-Dippy Thing Anymore

Since 2008, though, that basic equation has been changing. Rapidly. Simply put, solar panels are way more efficient and way cheaper now. The technology has caught up in a major way, making the installation of power plants using solar panels a much more reasonable way to supplement the power grid. Power plants are going up across the southwest, boosted by big tax credits and a California law calling for a third of its power to be attributed to renewable sources by 2020.

This has resulted in a building boom that has boosted First Solar (FSLR) , the most-valuable solar company in the world. Much of First Solar’s business lies with large utility-scale installations and said business has been brisk since reaching a low point in 2011.

Rapid Growth Abroad

The United States is not a good test market for utility-scale solar. The abundance of cheap fossil fuels makes America a dream location for energy produced in traditional fashion. But that situation is fairly unique. In a lot of locations, solar provides a superior option. In areas that are particularly remote, or a long way from fuel sources, solar can often become the most economical option.

South and Latin America have proven to be major areas for growth. Chile is ideally suited for solar plants and is seeing the construction of large scale plants without subsidies, Mexico’s robust commitment to developing small-scale projects is boosting installations there rapidly, and Brazil has recently made its own push to get into the action.

The Middle East and Africa also present growth markets with massive potential. For Middle Eastern countries that rely on oil exports, any crude used domestically to generate electricity is lost profit, not to mention solar-powered desalinization plants could provide fresh water to the historically dry region. I’m also told that they have a fairly sunny climate, so there could be some real potential there.

And all this is not to mention the two biggest areas for potential growth: India and China. The two most-populous countries in the world are both watching their tremendous economic growth creating a new middle class that is driving a huge spike in demand for energy. And, in both cases, these countries appear committed to making solar a huge part of the solution.

China’s plans for 2014 included 14 gigawatts of newly installed solar capacity, following up on the 11.3 GW installed in 2013. That 11.3 GW, bringing the total to 18.3 GW, represented a more-than 60% boost in a single year. And while there’s some doubt that they’ll hit that 2014 target, it would represent a more-than 75% increase in the nation’s solar capacity a mere year later. Thing is, that’s just peanuts. The long-term plan involves hitting 70 GW in total capacity by 2017.

India is also getting into the act, touting plans to hit 100 GW itself by 2022. That means the two most-populous countries in the world appear committed to making solar a key part of their plans for providing electricity to a rapidly growing middle class.

Beyond the Solar Power Plant

There are, however, two key developments for the solar industry that have proven to be major drivers for the industry that don’t involve large solar plants at all.

The first is what folks in the solar industry refer to as “distributed generation.” This is something tied to the fact that solar panels are entirely scalable. Electricity has traditionally, by necessity, required a hub-spoke system whereby a massive central power plant distributes power out to consumers from a central location. This is because it’s neither efficient nor at all safe to build your own coal fired power plant (just ask 19th century London).

Not so for solar. No matter how large your roof/yard/Winnebago, you can affix some solar panels to it and have your own source of electricity at a cost per watt not out-of-line with that produced by a massive solar plant. Throw in the potential for a battery system that stores energy during the day for use at night and we’re really cooking with gas. Or, not with gas, as it were.

Why is this important? Well, it means that solar power has a much larger customer base than just those people with at least a few hundred million dollars laying around to spend on a massive power plant. Pretty much anyone can buy a small solar array for their roof and cut their power bill significantly. That includes homes, warehouses, apartment complexes, skyscrapers, pretty much anywhere with empty space that isn’t in the shade.

China’s original 14 GW goal for 2014 included 8 GW of distributed generation projects. Wal-Mart (WMT) , whose massive box stores include acres of unused roof space across the American Southwest, has signed on with SolarCity (SCTY) to install panels on top of some 75% of its California stores. Distributed generation means the opportunity for expanding solar use in tiny bits and pieces, as well as big chunks, is possible in ways other methods for generating electricity can’t claim.

Advancements in Financing Almost as Important as Technology

Even if a business owner can be confident that buying solar panels for the roof of his warehouse will pay for itself in saved energy costs over several years, they may still balk at putting a big up-front cost onto their balance sheet. That’s doubly true for a manager for whom adding red ink to the books in the short term might result in them losing their jobs prior to the real benefits being clear.

Excessive upfront costs are a big part of why plenty of wise investments in infrastructure go unfunded. That’s why perhaps the most important development for the solar industry was not a technological but a financial one. Jigar Shah, who founded SunEdison (SUNE) in 2003, developed the process that would unlock much of the potential for the American solar industry: the purchased power agreement (PPA).

The PPA is a contract between the company installing the panels and the owner of the building they’re on. The company installing the panels maintains ownership of the equipment, and the building owner agrees to purchase the electricity generated by those panels.

The result? The owner of the rooftop gets electricity at a steep discount to the rate they would pay the utility, often without any initial cost. The companies installing the panels, meanwhile, can keep the value of the installations on their balance sheet, collect tax breaks for the depreciation of those assets, continue collecting a steady stream of income for selling the electricity, and, here’s the real kicker, receive the hefty federal tax credit paid to the entity paying to install the panels.

As an added benefit for the solar companies, the PPAs can be securitized and sold. A robust, liquid secondary market (required addendum as of 2007: when it DOESN’T create a dangerous speculative bubble) can go a long way towards solidifying a budding industry. It’s a lot easier to engage in new business when you know there’s enough liquidity to trade assets with ease. It tends to make things more predictable and makes it easier for companies to plan into the future in a way that reduces costs and improves margins.

All told, PPAs allow individual consumers to avoid assuming risk and start-up costs while giving solar companies more flexibility in managing their revenue streams and a whole heap of tax benefits. And, with the big one-time costs removed from the decision, solar companies can unlock a broad new customer base that wouldn’t have the cash to pull the trigger otherwise.

…But Not NOT a Hippy-Dippy Granola Thing

While advances in technology and financing techniques may have made the decision to go with solar a simple black-and-white financial choice for plenty of people out there, that doesn’t mean that the environmental benefits aren’t also there. Environmental benefits that will likely continue to matter more and more in coming years.

The result is that I feel confident that there’s going to continue to be legislation passed by governments around the world calling for increased use to renewable sources of energy. The California law calling for the state to derive 33% of its electricity from renewables also helped entice the legendary Warren Buffett into plopping down a big bet on the industry. His $30 billion invested in wind and solar is driven at least in part by the reality that California utilities are going to be required by law to buy power from some of the plants he’s investing in, even if it’s at a higher cost.

Domestically, the solar industry got a huge boost from tax credits, which are set to expire at the end of 2016 but could easily be extended, and federal loan guarantees, a program that’s been incredibly successful despite the effort to publicize a few misses. Solar capacity in Germany was boosted tremendously by government support there. The industry appears to be reaching the point where it can stand on its own at just the time that governments around the world are recognizing the tremendous incentives for providing more subsidies to grow the industry.

Seemingly Inevitable Long Term Growth

Since making my investment, things have not exactly gone swimmingly. So far, 2014 has proven a pretty brutal year for small-cap growth stocks, as a lot of investors waited out the inevitable correction for massive gains in 2013. Solar, an industry that already had a ton of beta with small-cap growth plays, had the biggest year of any industry in 2013, making the pullback all the more inevitable. Add to that fact that crude oil hit five-year lows on Black Friday and TAN has gotten hit pretty hard. Not that the crude oil markets and the solar industry have any real tangible connection, but it seems like they would and sometimes that’s all it takes.

But I’m looking at all of this as more short-term noise than anything. Much of this isn’t actually driven by weaknesses in the industry, just stock market dynamics that tend to clear up as an industry becomes more established. As the industry continues to prove itself to the stock markets, the less we’re going to see market dynamics defining how these companies trade.

Like I said, I see a lot happening for solar – if not this year or even next year, in the 5-10 year range. Which is how long I’m planning on holding onto TAN, really. I’m genuinely sold on the idea that the solar industry is finally coming into its own for purely business reasons and the additional environmental factors only further boost those prospects. I’m genuinely sold on roof-top solar arrays becoming the norm over the next decade or so. I’m genuinely sold on solar plants continuing to be attractive options for countries around the world expanding their grid capacity.

And hey, if I’m wrong, I’m going down with the ship on this one.

1 I own the Vanguard Total Stock Market Index Fund Investor Shares ($VTSMX). This actually makes for an intriguing dilemma every time I’m trying to disclose my holdings for an article as I’m technically long almost everything.

Stock price data is provided by IEX Cloud on a 15-minute delayed basis. Chart price data is provided by TradingView on a 15-minute delayed basis.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer.

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