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Rare Value In Alternatives

Until now, I have said very little about alternative energy stocks. Let me make it clear; it’s not that I don’t believe in the desirability or potential of renewable energy sources. Population growth and increasing demand for energy make it essential that the World’s reliance on fossil fuels comes to an end fairly soon.

It’s just that everybody who looks rationally at evidence and science knows and understands that and, because of that, value is hard to find in the sector. The conversion to alternative energy will come one day, but that day is unlikely to be next month. The stocks of many alternative energy companies, however, are sometimes priced as if that day were coming next week. In short, value is hard to find.

Value is a tricky thing to define. Just because something is cheap, that doesn’t mean it represents value. There is an old saying among London forex traders; “You can’t eat value”. The point is that it doesn’t matter how much value you perceive in something, if you buy it and the price falls you still lose money. I understand that, but when looking for opportunities in any market, the ratio of the price to earnings (P/E), especially in comparison to other companies, is one of the few metrics that really count.

Companies in the solar energy business have baffled many on that basis for several years. Multiples in the broader market have recovered since the recession. The average forward P/E of the S&P 500 is now at 15.84, somewhere close to historical averages. Most companies in the solar business, however, trade at significantly lower multiples than that.

Investors have been burnt too many times by overestimating the immediate potential of solar power but analysts’ estimates, on which forward P/E is based, continue to assume that the boom is just around the corner. Solar power, though, is still expensive compared to fossil fuels. That, and a strategic decision by China a few years ago to expand production in the area, puts massive pressure on margins.

So, you have an industry that is attempting to wean itself off of government subsidies all over the world, has a history of not meeting expectations, and where competition is fierce. It doesn’t sound all of that attractive, does it? As I said, though, logic says that that situation will change at some point.

In that situation, the key to building a position in the industry is to look for short term value, then manage the position to leave yourself with a manageable cost basis. That’s a fancy way of saying buy the dips and take partial profits on the recovery. From that perspective, solar energy companies look like a decent buy right now.

I like two in particular to recover from recent losses.

First Solar (FSLR) is an obvious choice.

First Solar Inc

When they reported Q1 earnings earlier this month, they killed it, to use a technical traders’ term. They posted EPS of $1.10 versus a consensus forecast of $0.50. As you can see, the stock reacted positively to that, jumping over 20% on the day. Since then, though management must be wondering what else they need to do, as FSLR has retraced by the same percentage.

Some of this, of course, is due to the natural tendency of traders to over react to news, good or bad, but, just as the reaction to the upside was overdone, so is the correction.  Also, some is due to a general pessimism about the industry outweighing that great performance. Once again this doesn’t deter me. Given a choice, I will take hard evidence of profitability over vague feelings of worry every time.

FSLR’s forward P/E, at 13.66, represents a discount to the market, but if you want really cheap, then my second pick, Canadian Solar (CSIQ) is for you, with a P/E of 7.01.

In contrast to FSLR, CSIQ missed estimates when they reported last week with EPS of $0.07 versus expectations of $0.08. Interestingly, though, that release (indicated by the yellow vertical line on the chart below) marked the bottom of the stock’s recent run down.

Canadian Solar

This is a fairly simple risk/reward play as much as anything. Buying at current levels with a stop on a break of $20 would limit potential losses to around 20%, while a recovery to anything approaching a more normal P/E ratio would give a profit over 50%. If this comes, then at somewhere around $37 I will be looking to cut the position in half, giving you a net position long at around $11. Now that’s what I call value!

Both of these are somewhat risky trades. Solar power is a volatile sector, but as with all volatile markets, that works both ways. Stop losses are important to limit potential losses, but if, as I suspect, recent losses have been an overreaction to pessimism, then when the mood changes the run up will be just as fast. Both FSLR and CSIQ look cheap. Looking back 3-6 months from now, I suspect they will look like great value too.

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