TAN: Short The ETF, Focus On The Few Good Individual Solar Stocks

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About: Invesco Solar Portfolio ETF (TAN), Includes: CSIQ, FSLR, RUN, SEDG, SPWR
by: Nairu Capital
Summary

The Invesco Solar ETF TAN has seen stellar performance this year and appears to be topping out.

The fund has been propped up by highly speculative inflows that have pushed the value of the companies far away from fair level.

AUM inflows are in a topping pattern and selling has already begun for investors in the Americas.

Many companies are burdened by very high debt, sub-par revenue growth, and are burning through cash faster than a Hummer with gasoline.

SolarEdge and First Solar still look like decent companies.

(Source - Pexels)

It seems that clouds are on the way yet again for solar stocks. I have been waiting quite some time to write an article on the Invesco Solar ETF (TAN). While I am a firm believer that solar energy will become an increasingly popular tool to combat climate change, I am not a believer in most of the companies working to do so. At least, not as much as most of the investors in TAN and its constituents.

The reality is that it is extremely difficult to make a profit in the solar industry, particularly when government subsidization is removed. Frankly, it seems that investors today are far too charitable when it comes to investing in firms that "are the future," but lack the earnings, revenue growth, and managerial skill to back that up. The fund has had a stellar run this year and is currently up around 60% on the year and looks unlikely to continue higher.

Unfortunately for solar investors, it seems that a new generation of buyers have pushed stock prices too high and are in for yet another round of sharp declines. Take a look at the price of TAN vs. its AUM over the years:

Chart Data by YCharts

Since the fund's inception in 2008, it has seen four major bull runs and has ended even lower after each. Today, the fund's total AUM has shot up back to the $450-$500M level that has effectively become a resistance zone for the sector. Unfortunately, history tends to repeat itself and, after looking through the fundamentals, it seems that the fund has reached a top and is headed lower.

A Few Details About The Fund

Before we dig into the nitty-gritty, let's talk about the fund broadly just so we know exactly what we're getting into. Unfortunately for the fund, it was created in April of 2008 and began its life with a roughly 85% decline until reaching a bottom in March of 2009.

The fund has 22 holdings with market caps that range from the low hundreds of millions to over $5B so it is primarily invested in small-cap companies. About 60% of its holdings are "solar technology" companies while 30% are solar utilities and the remaining bit are mixed. It is a global fund so it also comes with a bit of currency risk. The ETF's country exposure is as follows:

(Source - iShares)

Interestingly, the companies in the fund with exposure to China are the few which generate reasonable profit margins. That said, China also has very high currency risk today and they also have very high debt levels.

Speaking of which, let's dig into the fundamentals of these companies.

Poor Profitability And Very High Debt

The fund currently has a high weighted average "P/E" multiple of 34X and a "P/B" ratio of 1.5X. According to Invesco, the forward "P/E" of the fund is 18.7X, but as you will see in a moment, that predicted earnings growth looks a bit overestimated.

Usually, high growth companies have lower debt ratios as they depend on equity financing to achieve growth. Interestingly, this is not the case for the solar companies in TAN. Take a look at the fundamentals of the companies in the ETF:

Note: "Typical" denotes harmonic mean for valuation data and median for others.

(Data Source - UncleStock)

As you can see, the fundamentals of these companies have an extremely high range. Some are trading at an earnings discount like Canadian Solar (CSIQ), but most fail to generate a profit. The median net profit margin of the companies is merely 3% and most have very poor cash balances as seen in their current ratio.

The median company has a very high debt ratio of 75% and not enough cash to make ends meet. It is likely that many of these companies will experience serious financing difficulties over the next year and, if equity prices fall as I expect, I would not be surprised if a few go chapter 11. SunPower (SPWR) and Sunrun (RUN) in the United States look particularly unstable.

Even revenue growth is not strong for many of these companies. It seems that the companies' sales are either growing rapidly or falling like a knife.

There are a few companies that do not fit this bill. I was an investor in SolarEdge from (SEDG) late last year when it was extremely undervalued until a few weeks ago. I sold simply because the company was no longer cheap and it's hard to not take profits after a 100% gain. That said, the company is still likely to outperform the others. First Solar (FSLR) also looks like a likely outperformer and possibly Canadian Solar.

Despite the few good picks, these companies as a whole are probably headed much lower unless they can benefit from government subsidization or if non-alternative energy rockets in value as in 2008 and spurs a huge increase in demand for panels and cheap energy.

Technical Price Signals Indicate "Sell"

Those of you who follow my research may note that I have a very different approach to technical analysis. For me, it is all about understanding who owns what and what they believe will happen. Like playing poker with a friend whom you know will bluff whenever they get the chance, it is easy to profit when you know your counterparty on a trade.

A way to do this is by separating the price of a fund into two separate indices and analyzing their trends independently. One index measures the performance of "buying at the open and selling at the close" which indicates how much buying pressure is done from investors in the U.S timezone. The other index measures the performance of "buy at the close and sell at the open," which indicates buying pressure from overseas investors in China and Europe as their trading day is during the U.S night.

This gives us a "foreign" index and a "domestic" index. Here is the price of TAN (dark blue) vs. the "domestic performance" (neon blue) index:

(Source - Thinkorswim/self-sourced)

As you can see, the domestic index has a high degree of mean reversion and tends to track the "ebb and flow" of TAN. The index is also plummeting right now which is a sign that U.S investor sentiment is rapidly reversing.

On the other hand, here is a chart of the "foreign performance index" vs. TAN:

(Source - Thinkorswim/self-sourced)

As you can see, this index tells us the primary driver of the trend in the ETF. The overnight/foreign performance index is currently rocketing higher and looks to be blowing off. It is tough to say if this trend will end, but if TAN goes much lower, it is likely that foreign investors in the fund will have a change of heart and follow their U.S counterpart. It is worth noting that U.S selling (neon blue) tends to lead foreign selling in most assets I've analyzed.

Alarmingly, the vast majority of owners of TAN are non-institutional investors that tend to push prices away from their fair value. According to Nasdaq, 80% of the investors in TAN are non-institutional (institutional usually makes up 60-90% of a fund's investment base). This is confirmed by the fact that TAN is about the 40th most popular ETF among Robinhood investors.

It seems that the smart money wants nothing to do with the ETF and after combing through the financials of the companies, I think they're right to avoid it.

The Bottom Line

To me, TAN is an excellent short opportunity. It has undergone yet another speculative rally that has pushed the value of the companies into unreasonable territory given their balance sheet risks. The fund's price seems to be topping out and domestic selling pressure indicates that downside is likely.

In my opinion, the ETF is probably at a fair value of around $10-$15 per share or around half (or less) of its current value. I see it entirely likely for the fund to fall to such a level by year-end if equities in general fall, though admit that the fund could fall slowly if equities march higher. Still, I see very limited upside for the fund besides a few solid companies like SolarEdge. Overall, TAN appears to be a clear "sell."

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in TAN over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.