The Winning Sector That's Shining Brightest

The Winning Sector That's Shining Brightest

The entire stock market has posted outstanding returns so far this year, with major market benchmarks in the U.S. having shown double-digit percentage gains. But even though most of the year's gains for the overall market came in the first quarter, one particular niche showed incredible strength in the second quarter. Can the good performance continue?

Looking for winners among ETFs
One great way to scope out potentially lucrative sectors of the market is to look at the best-returning exchange-traded funds. Ordinarily, you'll find a host of leveraged ETFs that offer double or triple exposure to various parts of the stock market. But when you discount those leveraged funds, what you'll have left are ordinary niche ETFs that shine light onto the best-performing areas of the stock universe.

During the second quarter, the big winner among ordinary ETFs was the Guggenheim Solar ETF , which gained more than 48%. To understand why the solar ETF has done so well, you need to understand two separate dynamics in the solar industry going on right now.

The sun is rising on U.S. solar
On one hand, there's been a renaissance among U.S.-based solar stocks. In particular, after years of troubling performance, First Solar finally broke out of its slump and posted returns of more than 65% during the second quarter. Given that First Solar represents almost 10% of the Guggenheim ETF's assets, that had a substantial impact on the ETF's overall performance.

First Solar recovered largely due to two things. One comes from its emphasis on massive solar projects that are so large that the capital expenditures required to build them dwarf the capacity of just about all of its competitors. Even with a strong balance sheet, First Solar has had to issue more shares in order to raise $450 million to go toward two projects in the American Southwest, yet despite the dilution, investors recognize that the scale of First Solar's ambitions help drive its competitive advantage.

The other reason for First Solar's recovery is that it has recognized the need to improve its module efficiency, buying TetraSun in April to help it match up to its rivals. The move won't solve all of First Solar's problems, but it will help the company keep up with competitors that had threatened to make its offerings obsolete.

Meanwhile, an even bigger winner in American solar was SunPower , which soared almost 80%. SunPower has had industry-leading efficiency for a long time, but even more important, the company has moved into the lucrative downstream installation business. With a combination of utility-scale projects and the fast-growing residential area, SunPower could easily see further gains as solar takes hold in the U.S. market.

The recovery of China
At the same time as U.S. solar has benefited from a reversal of downward trends, troubles in China have given way to hope that the emerging market's industry could survive its current shakeout. Despite big financial problems that have led to partial defaults from Suntech Power and LDK Solar, shares of other major Chinese producers have performed quite well over the past quarter as investors increasingly become convinced that the industry isn't doomed entirely to fail.

In particular, some solar companies have made big moves to broaden their sales. Canadian Solar yesterday announced a 91-megawatt supply agreement with Thai company Soleq Solar, showing its ability to move beyond Europe to sell in new markets like Japan and Thailand. With European tariffs looming, solar companies in China need to make moves like this in order to try to bolster profitability and turn weak margins around.

Will solar keep shining?
With such huge gains under their belts, solar stocks might look played out at this point. Yet for perspective, keep in mind that even after last quarter's rise, the Guggenheim ETF is still down by more than half even from its 2009 lows, after accounting for a 1-for-10 reverse split in early 2012. If the rebirth of solar is real, then the ETF could see much bigger gains in the months and years to come.

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Originally published