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What constitutes a "green" company leaves some room for interpretation, as is often the case with color coding schemes. In the context of this article, I will define green companies as those companies that are engaged in environmental markets, which comprise renewable energy, energy efficiency, pollution control, waste management, and water treatment and conservation. In the aggregate, I will refer to these sectors as the Green Economy. Although stocks in this space have largely disappointed in recent years, it is the promising future that warrants a closer look by investors.

The long-term thesis for the Green Economy is intact. Global economic growth will become increasingly constrained by ecological limits, which lead to higher environmental costs and resource scarcity. At the same time, growth in the population size and standard of living in emerging and frontier markets is accelerating the demand for resources and putting ever greater strain on the planet's ecosystems.

As a result, the global economy needs to generate more output with less physical inputs, and fewer environmental externalities. This, in turn, will drive demand for products and services related to renewable energy, water and waste management, and the mitigation of environmental impact. In the recent past, however, publicly traded "green stocks" have generally been risky and disappointing. What does the next 3-5 years have in store for green investors and how should one approach this space, in light of its current challenges?

Starting with renewable energy, the sector looks promising. Solar power installations reached a record 27.7 gigawatts globally in 2011, growing by 67% compared to 2010, according to the European Photovoltaic Industry Association. The US installed nearly 2 gigawatts, according to research firm Solarbuzz, a doubling of installations compared to the previous year. Prices for solar panels fell by nearly 50% and polysilicon prices- the key material in non-thin film photovoltaic cells and a major component of the solar cost structure, dropped by nearly two thirds.

Whereas China was an irrelevant market a few years ago, it installed over 2 gigawatts in 2012 and is forecast to reach as high as 5 gigawatts in 2013, easily outpacing the US and possibly becoming the biggest market for solar globally. Yet all this growth has not been kind on solar company stock prices. As measured by the Claymore/MAC Solar Index (NYSEARCA:TAN), solar stocks declined 63% in 2011 and are down 90% since TAN's inception on April 18, 2008, despite the fact that global solar installations have grown at an annual compound growth rate of 77% over the last five years.

The wind industry tells a similar story of growth in sales and compression of stock prices. As measured by the First Trust Global Wind Energy ETF (NYSEARCA:FAN), wind energy stocks are down by 73% since inception on June 20, 2008. More broadly, as measured by the Ardour Global Index, which is comprised of companies engaged in Clean Energy, Energy Efficiency, Environmental Technologies, and the Water sector, the Green Economy is down 73% from June 1, 2008.

Some of the decline can be chalked up to headwinds that are specific to the Green Economy. Especially in the renewable energy sectors, companies have been plagued by oversupply, commoditization, inventory write-offs, and low barriers to entry for second tier manufacturers. However, other contributing factors to the decline were external to the Green Economy. One such external factor was the flight from risky assets - also known as the "risk off" trade - that drove investors to US Treasuries with negative real yields and that favored US blue chips and the US dollar at the expense of emerging market equities and global currencies.

Another external headwind is government policy, or more accurately the lack thereof. Regulatory uncertainty in the US and sunsetting renewable energy incentives in Europe have done great damage to investor confidence in the green sectors. After all, if there is one thing that the market dislikes it is uncertainty. Federal solar loan guarantees previously announced are now in question and the wind production tax credit (NASDAQ:PTC) expiring at the end of 2011 has put new projects on hold and has failed to get extended as an amendment to the payroll tax compromise and the transportation bill.

In Europe there is uncertainty around the speed at which feed-in tariffs are scaling down. Furthermore, in the US there is talk of imposing trade barriers against Chinese solar companies, which could have negative implications for the solar end market as well as US solar companies (and other exporters) that sell components and capital equipment to China. Even otherwise defensive green companies in the pollution control space have sold off, as Congress is attempting to dismantle various EPA regulations.

Despite short-term challenges, I am confident that in the long-term fundamentally sound green companies can generate positive returns for investors. After all, we still have a need to diversify the energy mix for security, environmental, and cost reasons. It is still a fact that energy efficiency saves money which is good for government, business, and consumers.

Finally, virgin resources, ecosystems, and fresh water supplies are still being depleted, and new products and technologies are required to ease the burden on these finite resources, so that global economic growth can continue. These challenges have not receded in recent years, but public attention has (temporarily) shifted elsewhere; when it returns green stocks should be well positioned for growth.

In the meantime, an investor in green stocks is wise to be selective and consider a company's balance sheet, near-term prospects, capital expenditure requirements, and cash flow. A discriminating approach rather than a thematic investment in the macro story that is the Green Economy has the better risk/reward trade-off in my view. At the same time, investors should note that today's market, with its distaste for green stocks, provides an attractive entry point into selective names, with exit potential a few years down the road when green investing returns to the cover of Fortune.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.