The Best Way to Handle Solar's Transition

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Solar energy is in a transition.

Panels are achieving parity with grid energy in more-and-more places. The maps put out by groups like the Institute for Local Self-Reliance as recently as this year may be partly obsolete, as installed costs for panels are now far below the $3.72 per watt being quoted as the 2013 average.

Prices for Chinese polysilicon panels, roughly 50 cents per watt, on par with grid power are now expected to fall to as low as 36 cents per watt in four years. And past performance has exceeded these kinds of estimates.

In response, the two main “green energy” ETFs, the Claymore/MAC Global Solar Index (NYSEMKT: TAN) and the Market Vectors Solar ETF (KWT) have both been rising. KWT is up 22% over the last three months, TAN is up almost 36%.

In the past these have been the best way to play the sector. Are they still?

What grid parity means

Grid parity is an important concept for solar investors. It means that you can put up a solar panel and deliver power for the same price as the power grid can.

It's a tipping point. Before grid parity you need various forms of subsidies, like Feed-in Tariffs (FiTs) and Renewable Energy Credits (RECs) in order to make a deal work. The Feed-in Tariffs are direct subsidies. The RECs are used by power buyers to make their operations appear “green.”

Once you pass grid parity, these tools are no longer necessary. Government aid to the sector can be safely removed, and the sector will continue to improve. Demand feeds on itself. The only case for government aid, in fact, becomes a protectionist one – you want your nation to have a piece of the growing market? Then make sure your prices are competitive.

Another thing happens when you reach grid parity. The margins within the channel come under pressure. When prices are higher than those for grid energy, then anyone who can talk people into buying solar power is very valuable. Afterward, you can stock panels in a big store and get a crowd. This is what happened with computers in the 1970s – margins were compressed as the business moved from Value-Added Resellers to computer stores.

The whole vs. the niche

TAN and KWT invest in the whole sector. Both suffered in 2012 because they were very heavily invested in panel producers, especially those based in China. The bigger gains, meanwhile, went to those companies that could create a channel for panels. The market's recovery began with companies like First Solar (NASDAQ: FSLR), which began building utility-size projects which were sold to power companies, and to SolarCity (NASDAQ: SCTY), which were selling and financing rooftop systems to consumers.

Those companies are now near the end of that run. SolarCity is especially illustrative. The stock peaked in May at over $50 per share, but now stands below $35 per share, a 30% drop. Sales remained strong, and were 20% higher in the first quarter of 2013 than the same quarter a year ago. But net income, which seemed headed into the black, turned sharply lower – the company lost $39 million in the March quarter.

First Solar has been partly protected from that change, because they make panels, they don't just sell them. The company remained profitable in the first quarter, with sales 60% higher than in the same quarter a year ago. But solar does not have the same sales pattern as other technologies, and the 30% drop in revenue from the December quarter had to be worrying to investors.

While SolarCity has been the best place to play since the start of the year, the more recent action has told a different story. The indexes have been far stronger than the individual players, with SolarCity accelerating to the downside over the last month, and both the indexes showing strong gains over the last three. First Solar, meanwhile, has done even better than the funds, scoring a 42% gain for shareholders in the last three months.

Buying the sellers

While the funds represent good value and good protection for your money, they need to remain aware of these shifts in the market, from dominance by re-sellers to boom times for panel makers, and investing accordingly.

You will get good returns from TAN and KWT going forward. They will be less volatile than individual stocks. When you are buying the funds, you are buying their expertise, their ability to move in-and-out among individual stocks.

But over a longer time horizon, over the next five years, you may want to transition away from the funds, toward the companies that sell panels. Unfortunately, most of these are Chinese companies, like Yingli Green Energy (NYSE: YGE), up 24% so far this year. Yingli is the sector's largest player, and the winner in the vicious price wars that took out so many competitors there in the last year.

The biggest risk in a panel maker like Yingli is that technologies beyond polysilicon could emerge which threaten its market share. The same risk holds for First Solar, which makes its thin-film panels from Cadmium-Telluride, a material it says is a waste product of mining.

Now might be a good time to take a flyer on a panel maker, while keeping the bulk of your solar investment in the index funds. Be ready to move more aggressively in that direction as the market realizes the power of going beyond grid parity.

Dana Blankenhorn has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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