Feb 25, 2021 How We'll Profit if Solar Starts Sinking Hello, Savio. Today’s topic is “multiple expansion.” Our case study is Daqo New Energy Corp. (DQ). “Multiple expansion” is the term Wall Street analysts use to describe the boost a stock receives when investors award that stock with a higher and higher valuation. Imagine, for example, that “Acme Widgets” is a $10 stock that produces $1 per share in annual earnings. At that price, Acme would be trading for 10 times earnings – also called a “price-to-earnings (PE) multiple of 10.” Now let’s imagine that investors become so enthusiastic about Acme’s prospects that they bid its price up to $20 a share, even though the company’s annual earnings haven’t budged from $1. In this circumstance, Acme’s PE multiple would have expanded from 10 to 20. That’s “multiple expansion.” Whenever a stock’s PE multiple is rising, that stock is benefitting from multiple expansion. Conversely, whenever a stock’s PE multiple is falling, that stock is suffering from the evil twin called “multiple contraction.” Not surprisingly, PE multiples tend to expand during bull-market phases when investors are optimistic and to contract during bear-market phases when investors are pessimistic. Most of the time, multiple expansions or contractions take place fairly slowly and merely accentuate the bullish or bearish trends 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 moments like these “buying panics” or “selling panics” – moments when valuations take a backseat to raw passion. Unfortunately, most investors only recognize buying or selling panics in hindsight. The excitement, terror, and/or frenzy of extreme moments can impair our dispassionate analysis and cloud our judgement. That said, it is easy to see that current market conditions are more bullish then bearish. Stock valuations are hitting all-time highs. That’s a phenomenon that occurs near major tops, not near major problems. Furthermore, signs of extreme optimism and frothiness have been popping up like mushrooms at a music festival. One of those signs is the lightning-fast pace of multiple expansion that’s taking place in various sectors. Consider Daqo, a standout performer from the solar energy industry. Two years ago, the stock was selling for five times earnings – i.e., a PE multiple of 5. Two weeks ago, that same stock was changing hands for 118 times earnings! That’s not a typo. Daqo’s PE multiple expanded from 5 on February 12, 2019, to 118 on February 12, 2021. Because of that spectacular multiple expansion, the stock rocketed 1,700% during that two-year time frame. 
Even after the stock’s recent correction, it is still selling for 100 times earnings. That’s rich. For perspective, Daqo’s PE ratio averaged less than 10 during the entire decade that preceded its recent moon shot. What’s behind Daqo’s incredible multiple expansion? In a word, exuberance. Irrational or Not? During the last several months, investors have fallen in love with “green energy” stocks of all types. This love affair has inspired them to throw money at individual names like Daqo, and also at the exchange-traded funds (ETFs) that specialize in green energy stocks. I certainly understand that passion. As many subscribers know, I’ve recommended numerous investments in the renewable energy sector during the last three years, including six separate solar energy trades that produced triple-digit gains. And I am continuing to recommend indirect plays on renewable energy by investing in battery metal stocks. But valuation matters… eventually. When I first started recommending solar stocks in mid-2017, I almost apologized for doing so. Solar stocks had been such poor performers for such a long time that a reversal of fortunes probably seemed unlikely to most investors. Therefore, when I introduced one of my earliest solar recommendations, I acknowledged the negative sentiment surrounding the sector by recounting the story of Augustin Mouchot: One decade before Thomas Edison invented his revolutionary lightbulb, a fellow named Augustin Mouchot had developed a revolutionary invention of his own – the “solar concentrator.” This device harnessed the sun’s energy to power a steam engine. He wowed the crowds by capturing the sun’s energy to make ice. That clever trick was pretty mind-blowing stuff in 1878.
And yet, Mouchot did not become a household name. His invention did not propel him to the sort of fame and fortune that Edison achieved. While Edison stacked success upon success to amass a $200 million estate in today’s dollars, Mouchot’s invention would fade into obscurity… and produce nothing more for him than abject poverty… For most of the 149 years since Mouchot invented his solar concentrator, the solar power industry has been a graveyard for capital. To be sure, the industry has continued to progress and innovate, but it hasn’t created generations of “solar millionaires” or landed any “solar entrepreneurs” on the cover of Time magazine. Although solar power has always offered the tantalizing promise of huge rewards, it has usually delivered the disappointing reality of meager profits… or large losses. But solar’s long, disappointing history is over. A new history has begun.
To generalize, few investors cared about solar stocks in 2017. But today, even fewer investors don’t care about them. Just four year ago, these stocks were outcasts. Today, they are stock market darlings. As that old Wall Street saying goes, “No one wants stocks at the bottom; everyone wants them at the top.” To be sure, solar energy stocks might continue to zigzag higher, but they are much more likely to zigzag lower, simply because their valuations have reached extreme levels. And generally speaking, the stock market does not tolerate extremes for a long time… which brings us back around to Daqo. When Valuation Starts to Matter Again The stock is trading for more than 100 times annual earnings. Almost no one would pay such an exorbitant price for a business in the non-Wall Street world. Would you? For example, would you pay $1 million for a hamburger franchise that earned just $10,000 per year? That’s what 100 times earnings means. I’m not picking on the solar sector. In today’s market, many stocks sell for 100 times earnings, or 200 times, or infinity times… because there are no earnings. A couple weeks ago, Tesla Inc. (TSLA) stock was changing hands for 1,200 times earnings. And even now, after its recent sell-off, the stock is trading for 981 times earnings. But the solar sector, for all its investment virtues, is not producing the kind of robust profit growth that its lofty valuation anticipates. Yes, many solar companies are growing rapidly, and will continue to do so. But profit margins in the industry are notoriously thin, and competition is notoriously intense. This is not an industry that will likely produce profit growth in line with revenue growth. When searching for a way to profit on the solar industry, investors often choose the Invesco Solar ETF (TAN). At 100 times earnings, TAN is priced for perfection. Its lofty valuation creates a stiff headwind to additional share-price gains… at least relative to similar stocks that may be trading for much lower valuations. Just as multiple expansion has elevated the solar sector to nosebleed valuations, multiple contraction might soon suck some air out of this highflying balloon and return it to terra firma. Therefore, as a portfolio hedge, I recommend betting against the solar sector by buying a long-term put option on TAN. This trade is the first of several new hedge trades I plan to recommend over the coming weeks. However, my main focus continues to be identifying unique and compelling stocks and/or LEAPS call options to buy. Action to Take: Buy the Invesco Solar ETF (TAN) January 2022 $80 put option for $13 or less. The current “offer” price is $11.25. Use a “limit” order, not a “market” order. Regards, 
Eric Fry
The Speculator
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