Solar stocks may soon face the agony of multiple contraction

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Today’s topic is “multiple expansion”.

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Multiple extension is the term Wall Street analysts use to describe the boost a stock receives when investors give that company a higher and higher valuation.

Imagine, for example, that “Acme Widgets” is a $ 10 stock that produces $ 1 per share in annual profits. At that price, Acme would trade for 10 times earnings – also known as a “price / earnings multiple (P / E) of 10.”

Now imagine that investors become so enthusiastic about Acme’s prospects that they offer its price for up to $ 20 per share, even though the company’s annual earnings have not budged by $ 1.

Under these circumstances, Acme’s multiple P / E would have gone from 10 to 20. This is a “multiple expansion”.

Each time the P / E multiple of an action increases, that action benefits from a multiple expansion. Conversely, whenever the P / E multiple of an action drops, that action suffers from an evil twin called “multiple contraction”.

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Unsurprisingly, P / E multiples tend to rise during bull market phases when investors are bullish… and contract during bear market phases when investors are pessimistic.

Most of the time, multiple expansions or contractions happen slowly and only accentuate any uptrends or downtrends that are underway at the moment.

But in extreme trading environments, these expansions or contractions can dominate the entire stock market and become the only influence that matters. We call times like these “buying panic” or “selling panic” – times when feedback takes a back seat to raw passion.

Having said that, it is easy to see that the current market conditions are more bullish than bearish. Stock market valuations are reaching historic highs. It is a phenomenon that occurs near major peaks, not near major issues.

Plus, signs of extreme optimism and moss sprouted up like mushrooms at a music festival. One of these signs is the rapid pace of multiple expansion taking place in various industries.

In today’s issue, we’ll take a look at a multi-expansion “case study”.

And we’ll talk about another sector that has not been affected by multiple expansion – and therefore still has plenty of room for growth …

A solar balloon

Daqo New Energy Corp. (NYSE:QD) is a remarkable player in the solar energy industry.

Two years ago, the stock was selling for five times profit, which is a P / E multiple of 5. Just a few weeks ago, this same stock was changing hands for 118 times profit. !

It is not a typo. Daqo’s P / E multiple fell from 5 on February 12, 2019 to 118 on February 12, 2021. As a result of this dramatic multiple expansion, the stock has climbed 1,700% during that two-year period.

For perspective, Daqo’s P / E ratio was on average less over 10 in the entire decade leading up to its recent moonlit.

What is behind Daqo’s incredible multiple expansion? In a word, exuberance.

In recent months, investors have fallen in love with “green energy” stocks of all types. This love affair prompted them to throw money at individual names like Daqo, as well as exchange-traded funds (ETFs) specializing in green energy stocks.

I certainly understand this passion.

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Over the past four years, I’ve recommended 14 distinct trades in the solar industry – and my members have made several triple-digit gains on those.

But recently I have moved away from the solar energy business. I continued to recommend indirect plays on renewable energies by investing in metal battery stocks.

In general, these stocks have much lower valuations than renewable energy stocks while offering a similar growth profile.

Evaluation matters… ultimately.

When I started recommending solar stocks in mid-2017, I almost apologized for doing so. Solar stocks had been performing so poorly for so long that a reversal of fortunes seemed unlikely to most investors.

To generalize, few investors were interested in solar stocks in 2017. But today, even fewer investors not care about them. Just four years ago, these stocks were outcasts. Today, they are the darlings of the stock market.

As the old Wall Street saying goes: “No one wants stocks below, but everyone wants them above.

True, solar energy stocks could continue to rise, but they are much more likely to fall, simply because their valuations have reached extreme levels. And in general, the stock market does not tolerate extremes for long… which brings us back to Daqo.

When evaluation starts to matter again

The stock was recently trading for over 100 times annual profits. Hardly anyone would pay such an outrageous price for a business in the non-Wall Street world.

Would you like?

For example, would you pay $ 1 million for a burger franchise that only earns $ 10,000 a year?

This is what 100 times the earnings mean.

I am not attacking the solar sector. In today’s market, many stocks sell for 100 times earnings, or 200 times, or, for companies with no earnings, ad infinitum.

The solar sector, despite all its investment virtues, is vulnerable to severe shrinkage. The sector is simply not producing the kind of robust earnings growth its high valuation anticipates.

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Yes, there are many solar companies that are growing rapidly and will continue to do so. But profit margins in the industry are noticeably slim, and competition is noticeably intense. It is not an industry that is likely to produce profit growth in line with revenue growth.

The Invesco Solar ETF (NYSEARCA:BRONZER), which reflects the MAC Global Solar Energy Index, gives us a good overview of the entire industry. At 100 times the payouts, its price is perfect.

TAN’s high valuation creates a headwind for further price gains… at least compared to similar stocks which may trade for much lower valuations.

Just as the multiple expansion has elevated the solar sector to nosebleed ratings, the multiple contraction may soon suck some air out of that flying balloon and send it back to land.

Buyer, beware!

This is why, in the latest issues of Fry’s investment report, I focused on stocks and sectors that were not affected by multiple expansion.

For example, over the past few weeks, the three 5G companies that we are following closely in the Fry’s investment report portfolio reported quarterly earnings.

Collectively, these earnings announcements indicate that 5G technology is gaining traction around the world.

And in the last issue of Investment report, I made my last 5G recommendation.

This one has a double identity. By virtue of its reputation, it is the world’s leading content delivery network (CDN) provider. But behind the scenes, it is becoming one of the world’s leading cloud cybersecurity companies.

This company’s CDN serves more than 900 cities in 135 countries, which means it carries around 30% of the world’s internet traffic. This business will certainly continue to grow, as 5G technology increases the demand for data in many applications and end uses.

You can find out more about membership Fry’s investment report here.

Greetings,

Eric Fry

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REMARK: As of the publication date, Eric Fry neither directly nor indirectly held positions in the securities mentioned in this article.

Eric Fry is a award-winning stock picker with many “10-bagger” calls – in both good AND bad markets. How? ‘Or’ What? By finding powerful global megatrends… before they take off. In fact, Eric has recommended 41 different scholarship winners over 1000% over the course of his career. Plus, he beat 650 of the world’s most famous investors (including Bill Ackman and David Einhorn) in a contest. And today he reveals his next potential 1000% winner for free, here.

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