The Dangers of Theme Investing

06/21/2011 10:30 am EST

Focus: STOCKS

Patrick McKeough

Editor, Successful Investor

Buying into a theme, such as green investing or emerging markets, is usually more dangerous than prudent, says Pat McKeough of the TSI Network.

Theme investing can pay off from time to time. Today’s popular investment themes include green energy stocks, such as solar, wind, and geothermal; and emerging markets, such as China and India.

However, theme investing can turn out badly for investors, especially those who get in late or forget about investment quality. Here’s how:

Popular Themes Can Distract Investors
When you indulge in theme investing, you allow a theme or concept to take a central place in your investing decisions. Usually the theme or concept includes some prediction about the future that has some truth in it, and will make noticeable changes in society.

You may assume that if you can just get aboard that theme, or find an investment whose future is tied up with it, you are bound to make money.

In other words, you are buying what you might call a “Big Idea” without making certain that a particular investment has a workable business concept, or the management strength and integrity that it needs to overcome competition and profit from it.

Themes like green stocks can cause you to overlook crucial details. A key problem: if the theme is your overriding investment consideration, it’s all too easy to get sloppy about the details.

You may come around to the view that the theme is so powerful that you can safely disregard P/E ratios and other measures of value and risk. You may wind up basing investment decisions on offhand projections or self-serving advice from promoters.

Mind you, facts support most popular investment themes. Keeping those facts in mind can help you spot stocks with extra potential. But if you let the theme make the decision for you, you are sure to overlook risk.

NEXT: How We Judge Stocks of a Popular Theme

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How We Judge Stocks of a Popular Theme
Before we give any advice on stocks that are part of a theme, we always look for clear signs of investment quality. For example, the theme of renewable energy has become more popular in the past few years, as concern over the environment has grown.

However, as with all investment themes, we’ve always recommended that you choose green energy stocks very carefully to profit. That’s because many of these companies have only limited investment appeal:

  • These firms often need a long time to move from the research or concept stage to profitability.
  • Also, many governments are cutting subsidies for renewable-energy development, as they struggle with high budget deficits.

To cut your risk, we recommend that you focus on green energy stocks that already have a sound base of other operations, preferably businesses that provide steady revenue streams. That helps offset the risks of expanding into renewable-power production.

For example: Suntech Power Holdings (STP) is a Chinese company that designs, develops, makes and markets solar cells and panels.

Its products are used by public utilities, homes, offices, and factories to generate power for the electricity grid, and also for off-grid uses, such as mobile-phone networks. The company sells its products to solar distributors, engineering and design firms, installers, and property developers.

Suntech’s revenue has moved up steadily since 2006 on strong solar-power demand, particularly in Europe and China.

The company’s shares jumped 17%, to $9.37, in the wake of the Japanese earthquake/tsunami/nuclear disaster, because some investors believe solar power could gain if the disaster slows the use of nuclear energy. The shares have since drifted down comfortably below $8.

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