Should Investors Buy the Solar Underdogs?

Everyone loves to root for the underdog. When an underdog wins, it's a feel good story come true. It's a testament to how hard work can translate to great results.

In the stock market, every now and then, an underdog will win and become a sector leader. 

But for every underdog that overcomes the odds and wins, there are many more that don't. The stock market is basically a giant catch 22 where the winners keep winning while the losers keep losing. No matter how hard underdogs try, very few of them will become sector leaders. 

Currently, Yingli Green Energy , ReneSola Ltd , and LDK Solar Co., Ltd  are the Chinese solar sector's underdogs. All three sector laggards are over-levered with debt. All three have lower margins and slower growth rates than the sector leaders and all three companies' share prices have significantly disappointed.

If the underdogs' fundamentals are so disappointing, why do investors stick with them, and are there any scenarios where it makes sense to buy them?

Reasons why investors stick with underdogs
Because they generally have higher betas, underdog stocks may rally more if sentiment improves or if there's good news that affects the entire sector, outperforming their more stable counterparts. Some investors may also incorrectly believe that any short-term or intermediate-term outperformance of underdog stocks indicates that the underdogs are outperforming the sector leaders fundamentally.

Another reason is that everyone loves a sale. While none of the solar underdogs are currently profitable, ReneSola and Yingli Green Energy both trade at very low price-to-sales ratios. ReneSola also trades at very reasonable forward P/E ratio. For many investors, holding onto companies with low valuation metrics feels safer than holding onto companies with high valuation metrics. The downside feels more limited.

The final reason is that many investors just don't like taking losses. Many investors will hold on to their losers until they break even.

The bottom line
For the long-term investor, there are very few scenarios where it makes sense to buy solar underdogs.

The solar underdogs simply have too many competitive disadvantages. Their weak balance sheets, for example, make it difficult for them to participate in higher margin downstream solar project businesses. Their low gross margins make it tough for them to spend as much on R&D as the sector leaders do. Their frequent quarterly losses make it almost impossible to raise money through secondary offerings without significantly diluting their shareholders.

In the solar space, any competitive disadvantage will likely translate to significant future underperformance. This makes owning solar underdogs a risky proposition. In the long run, it is safer to stick with the sector leaders.

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Jay Yao has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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