Why We're Buying These 2 Energy Leaders

The alternative energy company Solazyme (NAS: SZYM) and traditional energy giant ExxonMobil (NYS: XOM) might appear, at first glance, to be strange bedfellows. But that's precisely why we're adding them to our real-money, 10-Baggers portfolio.

The great Peter Lynch once said, "You have to know what you own, and why you own it." With these two selections, we're aiming to balance the high-risk, high-return potential of Solazyme with the steady cash flows that ExxonMobil delivers year in and year out. We feel both of these outstanding companies have an important place in our portfolio.

Spinning plant sugars into oil
Solazyme has everything we look for in a potential multibagger. It has a transformational technology, an engaged management team, and plenty of financial potential. Alternative energy is a burgeoning field with lots of different players. There's no guarantee that Solazyme will rewrite the history of alternative energy, but we think it's worth risking a little capital on one of the more promising players.

There are many different ways to generate hydrocarbons besides pumping fossil fuels out of the ground. Some competitors use corn to generate ethanol. Kior (NAS: KIOR) has developed a process to use non-food feedstocks such wood and agricultural waste to develop fuels. Solazyme uses microalgae and sugar in a fermentation process to generate various types of oils -- and it now intends to ramp up production.

Co-founders Jonathan Wolfson and Harrison Dillon have taken Solazyme from an experiment in their garage to a business that looks set to transform the energy industry. The duo plan to go after three markets: skin and personal care, nutrition, and fuels and chemicals. Skin and personal care is the smallest market, but those products tend to carry higher margins. This gives the company a nice proving ground and a way to subsidize the development of its processes in the larger nutritional and fuel markets.

On the nutritional side, Solazyme has joint ventures with sugar provider Bunge and biofiner Roquette. With Bunge, the two companies agreed to build a production facility near its sugarcane mill in Brazil to produce oils for Bunge's food and agribusiness, as well as fuels in the future. Solazyme Roquette Nutritionals believes its microalgae-based food ingredients can change the way we eat by combining great taste with great nutrition. The partnerships are still young, but they continue to progress toward their manufacturing goals.

To go after the fuel market -- its largest but most difficult market -- Solazyme partnered with energy giant Chevron (NYS: CVX) through its technology venture group. The two companies worked together to learn if Solazyme's oil could work with standard refining equipment to generate commercially viable fuels. That and subsequent development work is now paying big dividends. Tests with the U.S. Navy and United Airlines have proven very successful so far. The company also continues to work with Dow Chemical to create new dielectric oils for electrical transformers. Customers see the benefits of the fuels and have expressed interest in purchasing large quantities in the future.

Solazyme is expanding its manufacturing capacity rapidly in order to meet that future demand. Expansion requires investments in both capital and people. And with limited revenue today, the company continues to consume cash as it grows. However, as capacity and utilization increase, revenue should grow and unit costs should decline.

Make no mistake -- Solazyme is a very risky investment today. There's absolutely no guarantee that it will be able to profitably meet the demands of its customers. However, management continues to take the right steps to build the business, and we believe that a small investment is worth all of the risks.

A portfolio anchor for the long term
By contrast, ExxonMobil is the largest and best-run energy company in the world. We realize, of course, that ExxonMobil is not likely to be a multibagger anytime soon. That's perfectly ok. We're more interested in what it does best: allocate capital, while taking care of shareholders. ExxonMobil offers investors an extremely attractive mix of dividend yield, dividend growth, and share repurchases. All of this promises an outstanding total return potential from its shares over the long term.

ExxonMobil invests tens of billions of dollars in energy projects around the world each year. Those investments range from exploration and production of oil and natural gas to processing and distribution of fuels and chemicals. CEO Rex Tillerson and his team continue to generate outstanding returns on invested capital, despite all of the technological and political challenges they face.

The company's acquisition of XTO Energy in 2010 could be one its most important investments yet. XTO Energy is a domestic natural gas exploration and production company. On the surface, the timing of the acquisition looks poor as natural gas prices have fallen sharply. As a result of the acquisition, however, ExxonMobil passed Chesapeake Energy (NYS: CHK) as the largest domestic natural gas producer. Both companies, of course, see natural gas as a very important fuel in the future. But unlike Chesapeake, which continues to struggle under a heavy debt load, Exxon's rock-solid balance sheet gives it time to wait for demand to pick up and prices to rise over the next decade.

ExxonMobil's return on invested capital has averaged 22% over the past five years, and has been climbing steadily since the recession in 2009. From those high returns, the company generated more than $55 billion in operating cash flow in 2011, funding about $20 billion in net capital expenditures. The company returned $31 billion in capital to shareholders: $9 billion in dividends and $22 billion in share repurchases.

We see ExxonMobil as an outstanding total return investment opportunity. Its dividend yield is currently 2.8%, and the company has been able to grow the dividend by about 8% per year over the past five years. In addition, management has repurchased 2.7% of shares annually over the same period. That gives a total return opportunity of roughly 13%, which we consider very attractive for a company of ExxonMobil's size and quality.

The yin and yang of energy
We're buying two very different energy companies for very different reasons. Taken together, they both fit perfectly within our goals for our 10-Bagger portfolio.

Alternative fuel maker Solazyme wants to change the world of energy. Rather than hunt for fossil fuels in the ground, it uses microalgae to produce oil in giant vats -- and it doesn't take millions of years to do so. Admittedly, Solazyme is a risky investment, especially compared to ExxonMobil. So sizing our investments in the portfolio will be an important. We intend to invest $4 in Exxon for every $1 in Solazyme. That way, the portfolio can reap the benefits of future returns, while not carrying too much risk.

Be sure to add Solazyme and ExxonMobil to your very own My Watchlist in order to track and monitor their progress. And you can follow all of John and David's stock picks and coverage on Twitter @TenBaggers.

The article Why We're Buying These 2 Energy Leaders originally appeared on Fool.com.

John Reeves and David Meier do not own shares of any of the companies mentioned in the article.The Motley Fool owns shares of Solazyme and Chesapeake Energy Corporation. Motley Fool newsletter services have recommended buying shares of Chesapeake Energy Corporation and Chevron. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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