We explore a once-hot sector that used to attract a great deal of attention but is now forgotten by most investors and resembles IT stocks after the burst of the dot-com bubble. But the growth in the sector is picking up and, along with it, the share prices of companies in this space. But we believe the best is yet to come.
The Trade: Buy Guggenheim Solar ETF (TAN)
Quick Trade Thesis
If you’re short on time, this is what you need to know:
Technically, solar stocks have fallen by about 90% over the last 9 years. That in itself should be reason to take a look. But most importantly, there is now strong evidence that they have formed a long-term bottom.
Solar stocks are held by a relative few investors creating a very small pool of marginal sellers ( i.e. downside will be limited hereon in).
Fundamentally, valuations, while not screaming cheap, are not demanding and certainly don’t factor in significant growth over the coming years or any increase in profitability which we believe is coming.
Profitability is likely to be considerably higher over the coming years with margins increasing with the crossover of producing electricity from solar vs. fossil fuels being within a few years.
Technological innovation and bankruptcies over the last 5 years have resulted in huge consolidations within the solar sector with only the fittest surviving. In fact, in that respect, it’s not unlike the uranium sector which we’ve spent a lot of time harping on about.
We are about to see massive growth in the solar sector but it is NOT being priced as a growth sector rather a value sector with limited growth prospects, and therein lies the opportunity.
Solar Stocks Now in Strong Hands
Was the boom in Solar energy stocks from 2005 to 2007 too much, too soon (not unlike what we saw with the explosion of all things IT in the late 1990s)?
From 2005 to 2007, solar stocks increased sixfold. Expectations ran high and, as per usual, the crowd overdid the upside. Oil rocketing past US$100 barrel in 2007/08 (and everything that went with it like natural gas and coal) acted as an accelerant, causing a rush into solar and alternative energies in general.
Infrastructure Gets Built
Booms are needed for wonderful things to be built. Take the dotcom boom. The math never worked on a ton of the projects. It took a certain level of insanity to provide the capital to go and built the modern day version of the pyramids. What is then required for that infrastructure to be utilized to the full is a subsequent catastrophic bust.
The fibre optic undersea cables that are transmitting this data to you today were not cheap. The reason I can send you this information and you can receive it at costs approaching zero is because in the inevitable bust that followed, the companies that came in and picked up the infrastructure did so for cents on the dollar. Their entire capex and opex models are completely different to the companies that actually laid that infrastructure that preceded them. This is how they could offer and build products on top of that infrastructure for costs that actually don’t make economic sense (based on the actual cost of the infrastructure at its outset).
The reason I’m telling you about the dotcom boom is because we had the same boom in alternative energy. Remember Al Gore’s “Inconvenient Truth”?
Remember the trading of carbon credits?
Remember that 2006 and 2007 saw record amounts of venture capital flowing into “alt energy”?
That capital went into infrastructure which has largely been built, and guess what? The wipeout (and jeez, it’s been a doozy) has meant that consolidation has happened… much like the Internet era referenced above.
Today, we’re sitting on wonderful fundamentals, an entire sector experiencing accelerating technology (Moore’s law doing what it does) and cost declines across the board which leads to margin expansion… and nobody is focusing on the space (as it should be after a brutal bear market).
Take a look here:
You can see the euphoria in the chart. Not dissimilar to the TMT bubble that preceded it:
Remember, the Nasdaq increased some 4 fold in the three years before it peaked out in 2000.
Looking at both graphs above there is one striking thing in common: They all came back to the point at which they started going parabolic (about 3-years prior to their eventual peaks).
Each market struggled for a long time since it peaked out. Some 7 years after “bottoming” in early 2003, the Nasdaq was virtually unchanged.
The MAC Solar Index bottomed in 2012. Now, 5 years later, it is more or less unchanged and still down about 90% from its peak.
Maybe 2009 would have marked its low if it wasn’t for the great commodity crash we saw from 2011. Commodity markets crashing made it even more cheaper to produce electricity from fossil fuels as opposed to renewable fuels so it was less competitive than it may otherwise have been.
I firmly believe that solar stocks now are in the same position as IT stocks were at the end of 2002. At the start of 2003, virtually every retail trader was out of IT stocks. You never heard of investors talking about IT, media, or telecom stocks unless they were cursing or spending an hour on the punchbag at the gym. Back then, all the “geniuses” were talking about the “tech wreck”. Once again… as it should be.
So if tech stocks were held by the vast majority in early 2000, they were owned by a narrow minority at the start of 2003. Perhaps that is why they stopped going down. IT stocks literally ran out of sellers. Fundamentals were once again sound, and we had the foundation for a new bull market. Today, we’re staring at the “FANGs” as evidence of that and, of course, today everyone is long FANGs. If you bring up alt energy in polite company you’ll be ostracized and chuckled at under muttered breath (as it should be).
My feeling is that solar stocks now are as tightly held by investors as IT stocks were at the start of 2003. This is a very bullish underlying market structure.
In addition to this, we have had a purging of many (if not all) marginal and highly-leveraged solar companies over the last 5 years. Those that have stayed the course up to now are likely to be the higher quality companies.
The same situation existed at the end of 2002 with respect to IT stocks. From 2000 to 2003 there was a wave of bankruptcies in the IT space. That shakeout left only the stocks that were well capitalized and had great business plans (as opposed to stocks with delusional dreams). Consolidation also allowed for survivors to develop scale of economies very cheaply.
As Buffett once said, only when the tide goes out can we really see who was swimming naked. More on the bankruptcy issues later.
Thank the TMT bubble for all that we have now in IT (or at least most of it). Remember back to all the dreams, forecasts and expectations that everyone had about IT in 2000?
Well, most of that has now come true in large part due to all the capital and infrastructure that was ploughed into the IT sector in the 1990s.
Perhaps 10 or so years from now we will be saying the same about the capital that was sunk into alt energy and solar (our focus) from 2005 onwards.
The Silver Lining of Two KOs
Solar was showing so much promise in 2007 (to the untrained eye) but then along came the GFC and then the great commodity bear market from 2011 to 2016. The cost of coal plummeted and so, too, did the cost of producing electricity via coal. Solar couldn’t compete because it couldn’t stand on its own two feet. The fundamentals were still largely sh*t.
Then along came fracking to top it all off. Double whammy.
You may remember that this is what caused natural gas to plummet. So you have the cost of producing electricity from conventional sources (coal and natural gas) reducing significantly over the last 6 years. Tough times if you’re trying to achieve scale in solar. Very tough!
This didn’t help the solar industry at all (at least for solar investors), which 6 years ago had a much higher cost structure. However, there is a silver lining here. You don’t get a sixpack from sitting comfortably on the sofa. It comes from working out at the gym. Change happens in the face of adversity, not when everything is going well.
The collapse in commodity prices from 2011 to 2016 caused a “revolution” in the solar industry. It pushed solar cell producers to become more efficient at producing solar panels with large amounts of capital being invested in research and development.
Ironically, I think in the years to come the “fracking revolution” will go down in history as the biggest contributor to pushing solar electricity/energy to becoming more cost effective than coal and natural gas. Wouldn’t that be something?
So we’ve subsequently seen a huge reduction in the cost of solar panels – some 80% reduction since 2008:
However, the big fall in 2010 is probably more due to the price of polysilicon falling substantially in 2009 and 2010 (polysilicon is the principal input used to produce solar panels).
Sorry for the elementary graph above and the fact that it is 3 years out of date but it is the best I could come up with.
Polysilicon ramped up from 2004 through 2008 as the German government provided enormous increases in subsidies for solar power, prompting a surge in demand. The supply of pure silicon failed to keep pace. Governments forget that markets work. In any event, its price rose from US$25 a kilogram in 2003 to as much as US$250 in 2008, abruptly halting the downward march in the price of panels.
However, as it always happens in commodity driven businesses, the best cure for high prices is high prices, and manufacturers ramped up production capacity and prices collapsed equally dramatically. Currently they sit at about US$16 per kg (they have essentially flat lined since 2014).
Polysilicon aside, the cost of solar panels and the costs of producing electricity from solar has come crashing down over the last few years as technology improves. And this trend is set to continue.
Where do we sit now on the crossover? In other words, when does electricity from solar become cheaper than electricity produced from fossil fuels?
This is the question that everyone asks but there is no one answer. It is various shades of grey.
For a start, at this stage solar doesn’t provide base load power and neither does wind… yet. When the sun goes down and/or the wind stops blowing that is when fossil fuels come into their own. So fossil fuels aren’t going away just yet. But to be sure, the competition provided in this space is dramatic and solar is now profitable without governments nicking our money and sending it to solar companies in the form of subsidies.
Furthermore, different countries have varying cost structures with respect to electricity generation. But as a massive “generalization”, if current trends continue, then the crossover will be somewhere in between 2021 and 2025.
But that is for existing power generated from coal and natural gas. The bigger issue is that if you want additional capacity (base load), it will take a long time to build a coal or natural gas (CCGT) plant and at huge expense relative to solar. Solar energy is, I believe, yet another example of decentralisation I’ve been talking about. Solar exists for the individual business or consumer in a way that coal, natural gas, and fossil fuels don’t.
Again, it is very difficult to compare apples with apples when it comes to electricity generation. It would certainly make things a lot easier if energy from solar could be stored for base load (use at night or when the sun don’t shine).
There are lots of ideas out there to store energy, of course. Tesla’s battery farms come to mind. But though the US media fawns over Tesla, the reality is there are initiatives all over the world in this space.
Producing electricity cheaply from solar sources (for immediate consumption) is one thing, but competing for “base load supremacy” is something very different.
I think we’re still ways out but should battery storage accelerate (as is almost certain), then this will have a non-linear effect on solar relative to fossil fuels. In other words, solar will be leveraged by battery storage in a way that natural gas, coal, and so on aren’t. I’ve not seen anyone make that connection though it seems both obvious and inevitable.
Even without batteries getting better solar companies are experiencing margin expansion quite simply due to costs either falling or remaining flat relative to the advances in the technology and energy produced.
Since the “good old days” (from 2008 onwards), there has been a proliferation of bankruptcies as companies that couldn’t adapt to plummeting prices for solar panels went bust.
The last high profile bankruptcy was SunEdison back in April 2016.
SunEdison was once the world’s biggest solar company with a market cap of US$10bn. Well, not anymore. It seems they became victim of their own success as so often happens. Growing too fast has its issues particularly when much of the growth is financed by debt.
Popular opinion would have it that things aren’t going to let up for the solar sector as more bankruptcies are likely for the rest of the year:
One of the most interesting things and something I routinely look for now in markets is seeing a sector rallying on bad news. This is exactly what we’re seeing in the solar space now.
I don’t doubt that there will be more bankruptcies but stock markets have a great habit of bottoming and then rising while the news flow is still toxic.
What is the significance of SunEdison’s bankruptcy? Usually, high profile bankruptcies coincide with a bottom in the business cycle for the sector. Did SunEdison’s bankruptcy signal the bottom in the solar sector?
We will never know what the ultimate bottom was until the passage of time.
However, I’m not one to sit on the fence. I will say it: The bankruptcy of SunEdison marked as close to the bottom of the business cycle as is necessary for investors such as myself to begin accumulating for the long-term value appreciation and trends that over time provide asymmetric payoffs.
Check out the graph below. April 2016 was the point at which SunEdison turned out the lights.
Contrary to popular belief, all these bankruptcies are a truly wonderful thing. Hard times weed out the inefficient producers. Those who are left (most of them, at least) have effective business plans and add value to the market place.
What is the Market Pricing?
So just what sort of a future for solar stocks is being implied/priced by the market?
The following are the fundamental metrics for the components of Guggenheim Solar ETF on a median basis: P/Book 1.6x, ROE (current) 5%, and ROE (forward) 5%.
This might seem elementary but fundamental valuations don’t seem so demanding and certainly don’t seem to factor in any increase in profitability.
After all this time with all the dramatic reduction in the pricing of solar panels, the bankruptcies, etc., the industry is still profitable. I’m quite sure that at very worst profitability will be maintained at current levels. Furthermore, profitability will likely surprise on the upside over the next 5 years as solar’s popularity takes off due to it becoming increasingly competitive with fossil fuels for non-base load energy (or should I say fossil fuels becoming increasingly uncompetitive with solar for non base load).
Pay close attention to the leader of the sector for signs of direction in the industry.
Last week, First Solar reported earnings way ahead of expectations. While that was great, it was the guidance that First Solar provided that was very telling of a turnaround in the industry.
First Solar raised its revenue guidance to the band of $3.0–$3.1 billion from $2.85–$2.95 billion. It has also lifted the gross margin guidance in the band of 17%–18% (12.5%–14.5% guided earlier).
Furthermore, the company increased the operating income guidance in the range of $170–$220 million compared with the previous guidance of $40–$80 million.
It also raised its operating cash flow guidance to $850–$950 million compared with $350–$450 million predicted earlier.
Currently, the company expects its panel shipment to lie in between 2.6−2.7 gigawatts (GW) band compared with the prior guidance of 2.4−2.6 GW.
Full-year earnings are also anticipated in the range of $2.00−$2.50 per share compared with the prior guidance of 25−75 cents.
It seems that First Solar is seeing an upturn in its business. Remember, this is all taking place while oil is dirt cheap (and thus very competitive), as is natural gas. Any increase in the costs of fossil fuels makes solar more competitive.
And look at what has been happening to its stock price – from its April lows it is up some 100%.
Granted timing this is difficult but it does highlight that when news comes out better than expected for beaten up stocks they rocket.
To “Passively” Invest or Stock Pick?
Do we try our luck at stock picking or rather just buy the solar stocks “most likely to outperform” Guggenheim Solar ETF?
While I fancy my chances of making a call that solar stocks in general will be materially higher 5 years from now, I have to be true to myself and say I have no reasonable clue as to which stocks will outperform during this period.
I’m certainly not one for “passively investing” by buying a stock index but this isn’t remotely like buying a major market index tracking ETF. In any event, I believe my “alpha” is from making sectoral calls (which sector has the greatest chance of outperforming major market indices) rather than individual stock picking.
I also believe that the industry is changing way too quickly for anyone to be able to correctly pick which stocks will outperform. Hence the reason for picking the broad solar ETF (Guggenheim Solar ETF).
However, if you want to get “clever”, then instead of trying to be a hero and picking which solar stock will outperform, why not look at stocks that are likely to rise with solar stocks? Maybe those stocks will rise way more than solar stocks?
Here is an example:
Solar stocks seem to move hand in hand with alloying base metal producers. Below, I overlayed the stock price of Eramet (French producer of manganese, alloying metals, and nickel) in USDs with the MAC Global Solar Energy Index (the index that Guggenheim Solar ETF tracks) and indexed it to 100 as of 2005 and the bottom chart is indexed to 100 as of 2011.
It seems that both time series are highly cointegrated (they move in lockstep). I don’t think that this is a “spurious” relationship.
And here is what happens when I overlay VanEck Vectors Rare Earth/Strategic Metals ETF (REMX) with Guggenheim Solar ETF (TAN) with both time series indexed to 100 in 2011. Apart from 2013, there seems a strong relationship, and, in any event, after 6 years both time series more or less equal each other.
So here is a hypothetical situation: What if base/rare earth metals (for whatever reason) were to increase materially over the next 5 years? Would we also see solar energy stocks follow suit?
So wouldn’t buying base/rare earth metal stocks not give you exposure to the solar energy sector?
That is a very interesting thought, and it does open up the question that if you are “bullish” on the solar energy sector, isn’t there a better way of playing it than a direct exposure to solar energy stocks?
Let’s keep it simple and stick with Guggenheim Solar ETF. But just remember that if you are staring down the barrel of a significant positive return on Guggenheim Solar ETF in say within the next 5 years, it is quite likely that a significant part of the move was due to bigger forces at play rather than just “the outlook for the solar industry improving”!
The Trade: Buy Guggenheim Solar ETF (TAN).
Time Frame: Be prepared to hold it for the next 5 years
Allocation: Due to this being a sectorial call, I wouldn’t be afraid to put up to 5% of one’s capital on this trade.
What About Options? Yes, this is possible but you won’t be able to do it through Guggenheim Solar ETF as the option market isn’t great (it only goes out to January 2018). What one could do is buy call options or do some sort of bullish option strategy on First Solar (FSLR), the biggest component of Guggenheim Solar ETF.
Below I have indexed First Solar (FSLR) and Guggenheim Solar ETF to 100 as of 2007 (when Guggenheim Solar ETF was first listed)
The two time series more or less track each other (as they should). They would track each other 1:1 if it wasn’t for SunEdison going bust (remember, when Guggenheim Solar ETF was first listed, SunEdison was its biggest component).
So if you take a leap of faith and want to bet on First Solar continuing to closely follow the fortunes of Guggenheim Solar ETF then you could look at options on First Solar as a proxy for Guggenheim Solar ETF.
The only issue I have with options in the US is that they only go out two years at best, which is often not long enough if you want to express a bullish view on a deep value situation. These “situations” can take a lot longer to play out than you think, and you’re quite likely to only capture a portion of the meat and do so with much greater risk.
Anyway, for those of you who like using options you can look at buying an ATM call on First Solar for January 2019 expiry (US$50 strike) which would cost about US$10. So to make a 100% return, you would have to see First Solar get to US$70 by January 2019 – a 40% move. And for a 200% return at US$80 – a 60% move.
These moves aren’t “outliers”. Yes, First Solar could certainly get there, but within 18 months? Believe me, 18 months is a shorter period of time than you might think. Just ask any veteran options trader.
My preference would be to keep it simple and stick with simply buying Guggenheim Solar ETF (TAN). You don’t have to worry about your view playing out within a certain time frame. Also, you won’t have to concern yourself about the stock(s) you picked (if you decide to stock pick) outperforming Guggenheim Solar ETF or simply being around in 5 years to celebrate the uptake of solar energy and all its technological innovation.
Founder & Editor In Chief, Capitalist Exploits Independent Investment Research
Founder & Managing Partner, Asymmetric Opportunities Fund
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