Solar-energy stocks got off to a strong start in 2019. Through March 28, the Invesco Solar ETF(NYSEMKT:TAN), which comprises 22 different companies across the solar industry, is up 24.5%, with a number of individual solar stocks up far more. That’s a big reversal from an ugly 2018, as major policy changes by both the U.S. and Chinese governments — the world’s two biggest solar markets — cratered expected demand for solar panels last year. In 2018, the Invesco Solar ETF lost 26% of its value, and many solar stocks fell 30% or even more.

Yet despite last year’s weakness, the future remains incredibly bright for top solar stocks. And a handful of stocks in the industry are set to benefit even more than others; investors should consider buying them for 2019 and well beyond.

What is a solar stock?

The solar industry is both dynamic and varied, and shares of very different businesses can be called solar stocks. Here are the main categories.

Solar-panel makers are the companies that manufacture solar panels and the solar cells they’re made of. While most panel makers focus on the manufacturing and sale of solar panels, some also develop and build large utility-scale projects — solar projects that generate power consumed directly by the utility grid — and then sell them to utilities or independent power producers, also called “yieldcos.”

Yieldcos operate, invest in, and develop large-scale utility and commercial solar projects. Typically affiliated with a sponsor company, which is often either a renewable-energy project developer or a utility company, yieldcos primarily make their money by selling the power produced by their solar assets on long-term contracts, generally to utilities or industrial users with very high energy-consumption needs.

Solar installers are companies that sell, install, and maintain distributed solar systems, primarily to residential and business customers.

Solar component and accessory manufacturers are generally smaller, more specialized companies that make a specialized product; they often sell that product directly to a solar-panel maker for integration with a solar panel or a panel installation. Examples include solar-power optimizers, inverters, mounting racks, and battery storage systems.

What are the risks and rewards of investing in solar?

The solar industry goes through big yearly swings in demand for new panels and equipment, primarily due to the ebb and flow of spending to build large-scale solar projects from one year to the next. But over the next several decades, a quickly expanding global population, along with the growth of electric vehicles, will require trillions of dollars in spending around the world to add new power capacity. Moreover, older nuclear and fossil-fuel power plants will need to be replaced, and cheaper and cleaner renewable-energy sources like solar are expected to get much of this investment.

Solar energy is already growing faster than fossil fuels, and as solar-panel and energy-storage technologies continue to improve and costs fall, that trend is likely to continue — and potentially accelerate — for years to come. According to a recent presentation by Brookfield Renewable Partners, one of the biggest renewable-energy producers in the world, it will take $11 trillion to replace all the current fossil-fuel and nuclear facilities around the world with renewable energy. Furthermore, this will be a multidecade trend, creating an amazing long-term opportunity for investors to build tremendous wealth.

It’s worth noting the significant risks associated with solar that investors must consider — especially in the short term. While there will be enormous long-term growth, the global solar industry has proven viciously cyclical, as investors should have learned in recent years. This is driven by multiple things, including swings in demand for utility-scale projects due to the spending cycles and capital-investment priorities of large power producers, and changes in government policy.

Utility-scale solar is the biggest segment of the market, and solar panels make up a substantial portion of the costs for these projects. In early 2018, a 30% tariff was implemented on the vast majority of foreign solar panels imported into the U.S.; a substantial amount of business was pulled into late 2017, as companies aggressively greenlighted projects before those tariffs would be enacted in order to avoid additional expenses. This led to a relatively weak 2018 for utility-scale solar.

China’s decision to slash its domestic incentives in mid-2018 further weakened an already weak market for solar-panel makers. The result of two major policy headwinds in solar’s two biggest markets left panel makers with far more manufacturing capacity — and the underlying expense to operate it — than demand for solar panels.

Needless to say, when demand falls and there’s a big oversupply, prices fall, too. That’s exactly what’s happened; according to industry analysts, solar panels were more than 25% cheaper in last year’s third quarter than they were at the end of 2017. This has taken a big bite out of many solar-panel maker stocks in 2018:

FSLR DATA BY YCHARTS.

Furthermore, even with demand improving in 2019, there’s still a global oversupply of manufacturing capacity, and it will almost certainly take multiple years of demand growth to absorb that capacity. That’s expected to keep prices low, setting solar-panel makers up for another tough year.

Put it all together, and the biggest risk with solar stocks is investing with a short-term focus: Year-over-year shifts in demand can cause very wide swings in a company’s results, and its stock price.

Cost per watt: Since different solar panels convert sunlight to energy at different rates, cost per watt is a measure that normalizes the price of panels based on a fixed unit of electricity: the watt. This measure is used in multiple ways by different solar companies. For instance, knowing how much it costs solar-panel manufacturers to make a panel on a cost-per-watt basis makes it easier for investors to compare them to competitors. Knowing solar installers’ installation costs on a per-watt basis is valuable for comparing those companies. Even as a consumer, comparing different solar options on a per-watt basis can help you determine which option delivers the most value.

Megawatt (MW): This is a unit of 1 million watts. You will also see wattage measured in kilowatts (kW) and gigawatts (GW), measuring a thousand and a billion watts, respectively. In the solar industry, companies use these measures to report panel sales or installation volumes, and to measure the capacity of manufacturing plants. Companies often use this metric instead of revenue when discussing results from a specific period, as solar-panel prices can fluctuate greatly from one year to the next.

Furthermore, yieldcos — companies that operate solar-power farms and sell the electricity — use these measures to describe how much power capacity they own and how much power they can sell. They often express results in watt-hours (Wh) sold — generally in multiples such as kWh, MWh, or GWh.

Efficiency: This term is generally used to describe how much sunlight a solar panel can convert into electricity. It’s expressed as a percentage; a panel that converts 18% of sunlight into electricity would be considered 18% efficient. Two same-size panels with different efficiency ratings will generate different amounts of electricity. This is a key reason why the cost-per-watt metric is important: It normalizes costs based on power output, so that competing systems of different efficiency can be accurately compared.

Cash available for distribution (CAFD): This measure starts with a company’s operating cash flow, then subtracts other cash items such as certain capital expenditures. The end result is leftover cash that a company could potentially distribute to investors in the form of dividends. This metric is commonly used by yieldcos to determine how well their dividend payouts are supported by their cash flow.

The terms above are a solid starting point, but here’s more you can learn about investing in solar-energy stocks.

Five top solar stocks for 2019

While solar-panel makers will likely struggle under the weight of low prices on their margins, solar installers like Vivint Solar, power-management and energy-storage equipment makers like SolarEdge and Enphase, and renewable-energy producers like Pattern Energy and TerraForm Power actually benefit from cheaper panels, for a variety of reasons we’ll explain below.

Here are five top solar stocks for 2019:

REVENUE AND MARKET CAPS AS OF APRIL 1, 2019.

TerraForm Power: A yieldco for income and dividend growth

Back in late 2016 and early 2017, TerraForm Power wasn’t a company that most investors would have wanted to go anywhere near. And for good reason, with the bankruptcy of former parent SunEdison creating substantial risk. But once Brookfield Asset Management (NYSE:BAM)acquired TerraForm Power — and sister company TerraForm Global — from SunEdison in late 2017, things quickly began to improve.

Brookfield Asset Management has a well-earned reputation for finding undervalued and underperforming assets like TerraForm Power and turning them around. Since it took over and put new leadership in place, TerraForm Power has taken several big steps forward. In 2018, the company took measures to lower its operating costs, including signing a long-term service agreement with General Electric to help streamline maintenance costs for its North American wind-turbine fleet.

A MIX OF WIND AND SOLAR WILL DRIVE THE FUTURE FOR TERRAFORM POWER. IMAGE SOURCE: GETTY IMAGES.

But it’s TerraForm Power’s growth prospects that investors should get excited about. The company closed its acquisition of Spanish renewable-energy producer Saeta in the third quarter, which played a big role in boosting its results. Power generation increased 46% to over 2,000 GWh in the third quarter alone, pushing adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) up 79%, and CAFD up 69% per share.

Management said that this one acquisition “almost doubled the cash flows of the company on an annualized basis and facilitated the overall improvement of the company’s capital structure.”

The current dividend is well-supported by current cash flow, which is set to continue growing along with demand for more solar and renewable energy all over the world. Investors can likely count on the company living up to its long-term plan to raise the payout between 5% and 9% every year. The high yield and that level of dividend growth alone could deliver market-beating returns over the long term.

Pattern Energy: A higher yield, but also higher risk

As of this writing, Pattern Energy Group owns only a small amount of solar-power assets, counting on wind for the majority of its cash generation. But CEO Mike Garland has said the company will continue to take steps to expand beyond wind. In early 2018, Pattern Energy made a substantial investment in renewable assets in Japan that included 39 MW of solar capacity.

However, since that acquisition, the company has sold off more assets than it’s acquired. From the end of its first quarter to the end of its third quarter of 2018, Pattern Energy’s total power capacity actually declined 4% to 2,861 MW.

So what gives, and why is a company that’s going backward in the growing renewable-energy market worth investing in? In short, because Garland and his team have proven to be excellent capital allocators. Pattern Energy has been able to command an average of 15 times CAFD for the selling price of the assets it’s sold, while only paying around 10 times CAFD for the assets it’s acquired.

PEGI DIVIDEND DATA BY YCHARTS.

In the short term, this has resulted in more assets sold than acquired, as management bides its time in adding new assets to the portfolio. That can be painful for investors; Pattern Energy’s weak cash flow growth caused plenty of investors to sell, and the stock price fell. Furthermore, weakening cash flow has put the dividend at risk; last year the company paid out almost all of its CAFD in dividends, giving it very little margin for error.

But management’s disciplined approach to asset allocation should pay off over the long term: Paying fair value when buying, and commanding a premium when selling, will almost certainly result in greater cash flow over time. The company recently laid out a two-year plan to grow its cash flow so that it exceeds the dividend by at least 20%.

The risk is that, because essentially all of the current cash flow goes to the dividend today, the company’s plan must go relatively smoothly to reach the 80% payout ratio management is calling for. The good news is that the plan is relatively straightforward, already has a number of components in play, and doesn’t require Pattern Energy to find an outside source of funding.

Vivint Solar: A low-cost solar installer with big growth prospects

The past couple of years haven’t exactly been great for solar-power system installers in the U.S. Residential solar installations fell over 2% in 2017; the total market (not just residential, which did better) fell slightly again in 2018, following the implementation of tariffs on the vast majority of solar panels imported into the U.S.

This caused many solar installers to shrink, but Vivint Solar took advantage of the cyclical downturn to aggressively take market share. Furthermore, the company makes money in two ways: one that generates cash flow today, and another that will deliver steady cash for many years to come.

When customers decide to go with solar power, they also must choose how to pay for it: buy the system with cash or a loan, or sign a long-term lease or power purchase agreement (PPA) with the installer. If a Vivint customer chooses the former option, the company gets paid up front for the sale. However, for customers who sign a long-term agreement, Vivint fronts the cost to buy and install the panels, agreeing to collect payments for the power produced by the system over a 20-year period.

Many solar installers can’t afford to front the money for every solar-power system they sell on a lease or PPA, so they sell off the value of those agreements, typically at a discounted rate, for their long-term value in order to capture cash today. Vivint, however, has proven quite adept at retaining a large portion of those contracts. At last count, Vivint estimated it had $968 million in net value in retained contracts, which works out to more than $8 per share in cash that those assets will generate over the next 20 years.

The beauty of Vivint’s ability to hold on to these assets can be summed up in one word: optionality. The company gains substantial financial flexibility by holding these assets, as a source of steady cash, but also as something it can sell for additional liquidity. Right now the company is steadily growing this cash-cow asset: Net retained value has increased in 10 out of the last 13 quarters, and is up 42% per share since the beginning of 2016.

With some of the lowest installation expenses of any national installer, and over $800 million in cash-producing long-term value on its books, Vivint is set up for long-term success.

Enphase and SolarEdge: Key solar suppliers with multiple ways to grow

Both Enphase and SolarEdge play important roles in the solar industry, supplying both solar-panel makers and solar-power system installers with important components and power management software. With well-established technology and large market share, these two pure plays in the solar market offer investors incredible growth potential.

Enphase is by far the smaller of the two, with annual revenue still shy of $350 million. However, it has multiple catalysts working in its favor that should help it deliver big growth in 2019 and beyond.

in mid-2018 the company signed a big deal to acquire solar-panel maker SunPower‘s (NASDAQ:SPWR) microinverter business, and to be the company’s exclusive supplier of microinverters. Enphase expects to see an extra $60 million to $70 million in annualized revenue as a result of this one deal, and forecasts that it will command gross margins of between 33% and 35% as a result. On the low end, that’s worth almost $20 million in incremental gross profit — not a bad deal for $25 million in cash and 7.5 million shares of Enphase stock. Depending on the extra operating expense Enphase takes on to support SunPower as a customer, this looks like an incredibly good deal for Enphase over the long term.

It’s also expected to push Enphase out of the red by the end of 2019, a notable improvement for a company that has yet to produce a GAAP profit since going public in 2012:

ENPH EPS DILUTED (TTM) DATA BY YCHARTS.

It should also help drive operating cash flow higher, supporting planned investments in another key growth segment for Enphase: energy storage. Later this year, the company will significantly expand its residential energy-storage systems from the current 1.2 kWh battery, and will add 3.3 kWh, 10 kWh, and 13.2 kWh systems to its lineup.

As battery costs fall and utility energy prices rise, energy storage represents a massive market opportunity for Enphase. Investors who buy shares now are getting in very close to the beginning of what could prove a transformative period for the company.

Similarly, SolarEdge is a pure-play supplier for critical components to solar-energy installers and panel makers. However, it’s far larger than Enphase, generating almost $1 billion in sales in 2018; it’s also solidly profitable, and has been every year since going public in 2015:

SEDG EPS DILUTED (TTM) DATA BY YCHARTS.

That profitability, along with its big market share in the inverter and power-optimizer business, allows Solar Edge to make strategic investments, including acquisitions, to take more share and expand into growth markets. And that’s exactly what management is doing.

Over the past year, SolarEdge has made substantial investments that should help it grow across three different, yet related, markets: uninterruptible power supply, electric-vehicle (EV) charging, and energy-storage products. As more companies and people rely on renewable energy and alternative power sources for transportation, all three of these segments will see substantial growth in demand in coming decades.

2019 is a critical year for SolarEdge to integrate all of these acquisitions into its existing business. It’s not guaranteed to go perfectly, but if management can leverage even two of these three new market opportunities, it will be incredibly well-positioned for years of profitable growth.

Invest opportunistically, but with a long-term outlook

2018 wasn’t a very good year for most solar stocks, as the dual impact of U.S. tariffs and China’s slashing of its domestic incentives yanked the rug out from under panel makers. The massive oversupply that resulted from the cut in global demand is a key reason you don’t see any solar-panel makers featured above: 2019 isn’t likely to be a good year for most panel makers, as they work through an oversupplied market and fight each other tooth and nail to win whatever business they can.

However, the companies on the other end of the solar industry, like yieldcos and solar installers, should see a benefit from low solar-panel prices, which lower their costs. This should help drive higher demand throughout 2019 than we saw last year, helping to boost Enphase and SolarEdge.

The bottom line: These five companies represent solid value at recent prices, while also having substantial long-term prospects to grow their businesses much larger. As investors learned — quite painfully — in 2018, policy changes can cause the global solar industry to turn on a dime. You should be prepared to take a long-term approach, and be willing to hold your investments in the best companies even when things aren’t going well. These five are some of the best investments in solar, both now and for the long term.

Source: fool