The Big Names in Biofuels
So you’re hoping to strike it rich by investing in LanzaTech. Or Solazyme. Or KiOR. Or Gevo. After all, some of these companies recently had high-profile IPOs, and they are clearly “hot” given all of the press coverage devoted to them. So perhaps you have decided you want to get in on a potentially unique investment opportunity.
I get more e-mails and phone calls about investments than on any other topic. And it’s not just individual investors. I hear from institutional and private equity investors trying to determine what’s true and what’s hype, and asking whether KiOR or LanzaTech might turn out to be the Google (GOOG) or Apple (AAPL) of biofuels. Before offering any guidance, the first thing I try to do is establish your reason for investing. Are you looking for — in the words of former Fidelity Magellan’s Peter Lynch — a “ten bagger?” Are you looking for a hedge against the end of the oil age? Is this money that you are fully prepared to lose?
The second thing I would ask you is whether you really understand the company, their business model, their competition, and their potential technical challenges. (This is typically why people e-mail me — because they have questions about these things). Let me offer an example from my own investing history to demonstrate why these issues are important by telling you about the worst investing mistake I ever made.
Jumping Into Tech Stocks in the Late 90’s
Prior to 1999, what little investing I did directly with stocks tended toward blue chip stocks, or companies that were familiar to me. The risks weren’t exceptional, but neither were the rewards. Around 1999, technology stocks began to climb, and I kept hearing the “experts” talk about how the sky was the limit for companies like Cisco (CSCO) and JDS Uniphase (JDSU). I was reading stories in Money Magazine about housewives who were becoming millionaires by investing in America Online. All of the media attention made me feel like I was missing a big opportunity. I knew that the Internet was going to be huge. After all, I used the Internet frequently before the World Wide Web was invented, and once Netscape became available and made browsing the Internet much easier, the growth potential was clear. After reading one more column by Jim Jubak that convinced me that JDSU would soon be worth more than France, I finally had enough. So I bought some shares in JDSU (among others), watched them double, bought some more on margin, watched them double again, then sold a few at some point and actually made some money. Then the bottom fell out. The graphic below tells the tale.
If you had asked me about JDSU’s core business, I could have recited the description on their website. But who were their competitors? What were the threats to their business? I didn’t really know, but the talking heads on CNBC and MSN Money had convinced me that it was a no-brainer. Over time it became very clear to me that I was simply gambling, not investing. I was taking the advice of people who in many cases didn’t understand these businesses themselves, but who had an impressive track record primarily because they had been making their recommendations in the face of a rising market. When the stock price in JDSU started to fall, I was uncertain whether to sell, because I didn’t really understand the long-term prospects.
There are of course numerous tech stocks whose stock charts look like that of JDSU. And there were numerous people who rode them all the way down — convinced that a correction was just around the corner. Many people — myself included — now look at those charts in hindsight and wonder how we could have been so stupid. Ten years from now many people will look at charts of certain biofuel companies like the following one and wonder how they could have been so stupid:
Understand Where You’re Putting Your Money
I learned some hard lessons over my foray into tech stocks, but the most important one was never again to invest in something I don’t understand. It was simply too hard to sort out the pretenders from the contenders. In the case of JDSU, the company actually turned out to be a good company, and is still in business today. It just wasn’t worth what many of the analysts were suggesting, and as a result a lot of people lost money. In plenty of other cases, though, a technology company simply had a poor business model and investors bought into the hype.
In 2006, investing in the ethanol business might have appeared to be as much a no-brainer as investing in the Internet appeared to be in 1999. The Renewable Fuel Standard had been passed, mandating that growing volumes of ethanol had to be blended into the U.S. fuel supply. Refiners were phasing out the oxygenate MTBE and replacing it with ethanol. This was definitely a prescription for growth, and publicly traded ethanol companies like Pacific Ethanol (PEIX) started to ride the wave. When Bill Gates (or to be perfectly accurate, Cascade Investment, his investment vehicle) bought 25% of Pacific Ethanol in 2006, many viewed that as a sign that the smart money was moving in.
But in June 2006 — not long after Bill Gates bought in — I wrote an article when Pacific Ethanol was still trading in the $20’s in which I warned that “the underlying fundamentals (specifically of Pacific Ethanol) make it a very risky investment”, “ethanol companies are in the same boat (as dot-coms before their crash)”, and “I don’t think the underlying fundamentals warrant the valuations placed on grain ethanol producers.” (For all of the links related to the original story and follow-ups, see Investing in Ethanol: A Case Study of Terrible Investment Advice). I wrote that article in response to an article advising people that investing in ethanol companies was a no-brainer.
You can see from the stock chart of Pacific Ethanol what happened. It didn’t take place as quickly as with the tech stock bubble, but just like JDSU, Pacific Ethanol’s value declined by more than 90%. Cascade Investment finally saw the handwriting on the wall in 2008, and began to sell off their shares at under $4 a share.
What went wrong? Cascade Investment made the same mistake with this investment that I made with my tech stock investments: They invested Bill Gates’ money in something that seemed like a no-brainer, but which they did not fully understand. They did not know the real, underlying value of PEIX and their business model. Bill Gates knows enough about the computer industry that he might have had better sense than to invest into the dot-com bubble. But I knew enough about the biofuels industry to ignore all of the “Strong Buy” recommendations that popped up in the wake of Bill Gates’ investment, so I wrote the article urging caution.
Of course the ethanol industry itself continued to grow, just as the Internet continued to grow after the dot-com bubble burst. Companies like POET (which is, incidentally, privately held) have enjoyed phenomenal growth rates. But for every POET out there — a company that has solid management, knows its business well, and did not overextend itself — there are numerous companies that are filling investor’s heads with false promises. These are the companies whose stock charts will eventually look something like that of Pacific Ethanol’s.
In fact, of the existing advanced biofuel companies today, I predict that more than 90% will eventually go under. The reasons will vary, but mostly boil down to the economics of competing against even $100/bbl oil. Corn ethanol can do it as long as natural gas and corn prices are low. But not too many of the advanced biofuels can, and this is where these companies will eventually run into trouble. In some cases they will drag it out for years, but the end for most will look like the end of Range Fuels: Hyped expectations will meet reality, and investors will move on to more promising prospects.
How to Ask the Right Questions
But what if you are still interested in investing in biofuels, and just want to know how to minimize your risks? I wrote an article with that in mind called Due Diligence: How to Evaluate a Renewable Energy Technology. I expand upon this topic in my upcoming book Power Plays (scheduled to be released next week) and discuss many of the advanced biofuel options.
The short answer is that knowing which questions to ask will greatly lower your risks. Of the biofuel companies out there today, I don’t think we will see a Google or an Apple. The fuel business has always been a capital intensive, low margin business. If one could invest for the long-term in a company like POET, you would not likely see long-term explosive growth, but rather the modest growth rates that one sees in a utility or energy company.
So make sure your expectations are realistic, you understand the basic business of the company, and that you ask the right questions. Then you can make an intelligent decision on whether KiOR or Solazyme belongs in your portfolio.
Footnote: I am traveling to San Francisco on business on March 21st, returning March 24th. I won’t post a video blog this week, and my answers to e-mails and comments will be delayed.