David Jackson The Green Investor

Within the alternative energy sector, solar stocks have become the new darling of investors. There's good reason for optimism: The global solar energy market has averaged a stunning 25 percent-plus annual growth over the last 10 years, with worldwide growth for the last 5 years well over 35 percent. Yet solar electric energy still accounts for only 0.1 percent of primary energy production globally.

If you're looking for exposure to the solar market, which stocks should you consider?

First Among Equals

Perhaps the most prominent solar stock is First Solar (FSLR). First Solar went public in November 2006 at $20 a share, raising $400 million in a 20 million share offering. By the end of 2007, its shares were trading at $267 -- a stunning return of over 700 percent that leaves the company with a market capitalization of $18 billion. (The value of this stock, along with others mentioned in this article, has fallen dramatically in recent weeks.)

First Solar manufactures solar energy modules with a patented process that lowers solar electricity costs. It became the first to achieve the highly sought-after energy conversion rate of more than 10 percent for its thin-film solar chips, via a technology that previously generated less power per square foot than the more conventional approach of crystallized-silicon photovoltaics (PV).

Let's take a closer look at First Solar's numbers. Revenues for the third quarter were $159 million, an increase of $81.8 million over the second quarter of 2007, and an increase of $118.2 million compared to the same period the previous year. Yet with the huge run-up in the stock, FSLR's trailing 12-month price to earnings ratio remains sky-high at 182.

What will it be in 2008? Before deciding to buy any stock, investors should read the company's latest conference call transcript to understand what the company is saying about its business and what issues concern Wall Street analysts. On First Solar's most recent earnings call, CFO Jens Meyerhoff said:

"Revenue in the first half of 2008 is expected to decline sequentially over the fourth quarter of 2007 levels, due to our contractual price decline, foreign exchange rate assumptions, and the anticipated timing of incremental capacity contributions from our Malaysia plants."

High-valuation growth stocks tend to depend heavily on growing revenue momentum, and FSLR has already run into trouble in the first weeks of 2008. But the long term outlook remains quite positive: First Solar has over $6 billion in contracts locked in over the next five years.

But not everyone is bullish on First Solar. Tom Konrad, an independent investment advisor and financial analyst specializing in renewable energy, recently shorted First Solar. Konrad explains his thesis:

"First Solar's valuation seems out of line because of an inherent limitation on their profitability. Their solar panels are based on cadmium-telluride (CdTe) thin film technology, and tellurium (Te) is one of the scarcest elements in the earth's crust. In 2006, First Solar's 60mW of production consumed 4 percent of the world's annual supply of the metal. In 2008, analysts expect revenues of approximately 4 times the 2006 number, meaning they will need approximately 16 percent of new annual tellurium supplies."

Other 'Pure Play' Solar Stocks

What other pure-play solar companies should investors consider?

• SunPower Corporation (SPWR) designs and manufactures high-efficiency silicon solar cells and solar panels. Its stock price was up over 230 percent in 2007, but its P/E ratio is a towering 661.

• Suntech Power Holdings Co. Ltd. (STP), headquartered in China, is another solar stock that's shown strong growth. Lehman analysts Vishal Shah and Tim Luke published a note claiming that demand trends are tracking "well ahead" of Street expectations and are likely to impact favorably on this stock and the sector as a whole.

• JA Solar (JASO) designs and manufactures solar cells, primarily in China. In November, JA Solar lifted its 2007 full-year revenue expectation to $320-$370 million, with gross margin expected to be approximately 20 percent. You can read what the company said on its latest conference call here.

• China Sunergy (CSUN) is another stock to watch, especially after China's government announcement in late December that it would commit the country to developing forms of renewable energy. The company sells solar cell products to Chinese and overseas module manufacturers and system integrators, who assemble solar cells into solar modules and solar power systems for use in various markets.

• LDK Solar (LDK), also based in China, manufacturers multicrystalline solar wafers. In 2007, the company's stock performance hardly mirrored First Solar's, beginning trading in June last year at $27 and ending 2007 at $47. But this solar player might be undervalued. The company just released its preliminary guidance for 2008 and indicated that 2008 revenue would be between $960 million and $1 billion. Q3 2007 revenue was $158.7M.

• Solarfun (SOLF) is a manufacturer of both PV cells and PV modules in China. Investors who bought this one in January 2007 saw their investment grow threefold by year's end, with a closing price of $37.64. The company recently raised its 2007 guidance and expects revenues in the range of $280 million to $300 million, up from the company's previously forecasted sales range of $250 million to $270 million. Here's more on Solarfuns' upside.

As you can tell from the descriptions above, China is a major player in this industry, and most of the companies mentioned here maintain a strong international presence that provides investors with some global diversification. Be sure to recognize, however, that solar stocks are highly volatile -- brace yourself for sharp daily fluctuations in price.

Solar Sector ETFs

Investing in an alternative energy ETF is another option to capture the solar sector's rapid growth. ETFs effectively invest in a basket of stocks and avoid some of the volatility and risk of individual names.

Today, there are over nine alternative energy ETFs for investors to choose from, and while none of them focuses exclusively on this subsector, some have more exposure to solar energy stocks than others.

First Trust NASDAQ Clean Edge U.S. Liquid Series Index Fund (QCLN), for example, has over 8.5 percent of its holdings in First Solar, and another 15 percent in other solar energy stocks.

Market Vectors Global Alternative Energy ETF (GEX) has a 5 percent stake in Solarworld AG, a 4.3 percent holding in First Solar, and a 4.25 percent position in Suntech Power Holding Co Ltd.

Risk vs. Reward

Solar is a fast-growing market, and could prove lucrative for investors over the next few years. But high P/E ratios indicate that to a great extent, the pure-play solar stocks already reflect those expectations. Any disappointment in the companies' growth could therefore hit the stocks hard.

Moreover, pending expiration of the alternative energy U.S. tax credits at the end of 2008 is a factor that could also hit this sector hard. This shift will squeeze margins and raise overall product costs for many solar companies. And although the long-term outlook for solar is exciting, that message hasn't been lost on venture capitalists, who are pouring money into solar startups. A few years from now, many of those emerging technologies will be competing with today's publicly traded companies, potentially taking market share and driving down prices in the sector.

So if you decide to own pure-play solar stocks, be prepared for volatility, and make sure these positions account for a limited percentage of your portfolio. In a future column, I'll look at other, perhaps less risky ways to play the solar market.