5 tips for selecting the best energy stocks for long-term investment gains.

Tip #1 for picking the best energy stocks: Look for well-financed companies with no immediate need to sell shares at low prices.

These stocks typically have strong balance sheets with low debt. If they’re junior mines, we like to see a major partner who can finance the mine to production.

Tip #2 for picking the best energy stocks: Avoid “over-the-counter” trading.

Regulatory reporting is lax in over-the-counter trading.

Tip #3 for picking the best energy stocks: Avoid unsustainably high prices.

Unsustainably high trading prices in relation to a company’s assets are often a result of broker hype or investor mania.

Tip #4 for picking the best energy stocks: Find experienced management teams.

We seek an experienced management team with a proven ability to develop energy. We make sure they’re not in any insecure or politically unstable regions such as the Congo and Venezuela, or in countries with little respect for property rights and the rule of law such as Russia or Mongolia.

Tip #5 for picking the best energy stocks: Look at the market cap and the estimated value of the energy resource.

We look at the market cap of energy mining stocks versus the estimated value of the energy resource they have in the ground. Sometimes, a company’s marketing efforts are so successful that they drive the stock up too high in relation to the size of its reserves. We like an energy stock’s market cap to be no more than half the value of those reserves. We assume that the company will be able to expand its reserves with more exploration, but if the current reserves are double the energy stock’s market cap, it provides a margin of safety.

Note that resource and commodity stocks in general should make up only a limited portion of your portfolio—say less than 20% for a conservative investor or as much as 30% for an aggressive investor. And as part of that segment, energy stocks could make up, say half of that total.

Bonus tip: Investing in alternative energy

If you do decide to invest in alternative energy, we generally recommend that you stay away from alternative energy stocks focused on a narrow market or technology. The best energy stocks already have a sound base of other operations—such as a wind-farm operator that also operates natural-gas fired power plants. This diversification helps offset the risks of expanding into renewable-power production.

Having a sound base of other operations helps offset the risks of expanding into renewable-power production.

Focusing on renewable energy stocks that are solely focused on developing or making a single technology—and don’t have a source of conventional power production like hydroelectric or natural-gas fired plants to provide cash flow—adds a lot of risk.

That’s because they constantly risk being overtaken by competitors with a superior product. As well, customers may hold off purchasing their solar or wind equipment if they believe a new technology is about to emerge.

Renewable energy stocks and hidden environmental liabilities

Renewable energy stocks do sometimes turn out to have hidden environmental liabilities, as do companies in other industries. But the top stocks also create their own hidden assets. For instance, they accumulate rights to promising acreage for wind farms long before the land rush starts. They have the technical and political skills they need to foresee and deal with environmental and political obstacles. This hidden value can prove to be very profitable to investors who have a long term investment mindset as it can often take 20-plus years for the hidden value to reach its tipping point.

Successful renewable energy stocks pioneer technology advances with steady research spending.

Successful investors now recognize that research and development spending is today’s best-hidden asset. Companies have to treat this spending as a day-to-day expense, much like maintenance or tax payments. So research spending comes right out of current year’s earnings. But when you do it right, research and development spending is more like a long-term investment than an expense. When it pays off, it can yield dramatic long-term dividends. In many cases, today’s seemingly high-priced renewable energy stocks are much cheaper than they appear at first glance, if you give them some credit for the funds they invest every year in research and development.

Are you investing in energy stocks? How have you picked the best energy stocks for your portfolio? Share your experience with us in the comments.