Here’s a controversial recommendation: buy two small-cap stocks in highly cyclical industries that have brought investors more grief than profit over the years. Moreover, buy them while the short-term outlook for each is uncommonly bright.

These are certainly the sort of trades that can turn into widow makers if the risks are not fully appreciated and positions not properly sized.

But in the case of the two stocks described below, the risk/reward ratio looks very favorable, because the market is largely discounting the strong current fundamentals while clinging to unpleasant memories that are far less relevant.

Solar PV module makers’ unpleasant memories date back just a couple of years, to a time when the price of their increasingly commoditized product crumbled as penny-pinching European governments slashed solar subsidies just as exports-hawking China ramped up supply.

Survivors from this bust fall into two categories. Some have transformed themselves into developers of utility-scale projects. Building big solar plants required high-end operational scale and experience, deep pockets and industry relationships beyond the ken of most component suppliers. As such, this is a higher-margin business with taller barriers to entry that PC modules manufacturing.

We’ve had good luck recommending two leading proponents of this strategy of moving up the value chain. First Solar (NASDAQ: FSLR) has returned 74 percent since we urged buying the dip 11 months ago. SunEdison (NYSE: SUNE) is up nearly 20 percent for us in less than a month.

These companies have de-emphasized module manufacturing for third-party customers in favor of developing and managing large solar plants. Such huge solar arrays are being built rapidly all over the world, but the current fashion for them in the US has much to do with the looming expiration of some of the tax breaks that are making such power projects increasingly competitive with fossil fuels.

Over the longer term, US is not the most promising solar market, however. Power demand has been stagnant for years and there’s plenty competition from abundant natural gas. In contrast, many emerging markets with fast-growing electricity demand lack shale gas deposits but do enjoy plenty of sunshine: Africa, Latin America and India in particular come to mind.

Whether solar development in these countries take the shape of large plants, widely distributed rooftop installations or both, they’re going to need lots and lots of solar panels in the years to come.

Empire of the Sun

Which brings us to the second sort of survivor from the last solar crash: the (usually) Chinese panel maker efficient enough and well financed enough to outlast recently bankrupted rivals and benefiting from the global capacity reductions brought about by their demise.

That’s the profile best-placed to profit from emerging-market solar growth in the years to come, and it’s one Jinko Solar (NYSE: JKS) fits perfectly.

The Chinese module supplier has nearly doubled its sales this year, without sacrificing any of its comfortable (and gradually expanding) profit margin.

Source: company presentation

It’s not the largest Chinese panel manufacturer but is increasingly recognized as one of the most technologically advanced and cost-efficient. This recognition has benefited Jinko Solar in a number of ways as China promotes consolidation among domestic suppliers and rushes to increase solar generation as an alternative to dirty coal plants. Notably, Jinko Solar has a $1 billion line of credit from a state-owned Chinese development bank, and has taken over some of the production lines from a bankrupt Chinese competitor.

The additional production capacity will be needed to supply the growing pipeline of generation projects Jinko Solar is developing. This suggests Jinko is following First Solar and SunEdison up the value chain to into project development and management, with the added advantage of enjoying government support in what is now the top national market for solar power.

This support, and the low-cost financing it has brought, has been deemed an unfair subsidy by the US Department of Commerce, which has slapped a countervailing duty of nearly 27 percent on Jinko’s solar panel exports to the US in a move that also targeted other Chinese manufacturers. But with North America accounting for less than 15 percent of Jinko Solar’s revenue, the effect of these sanctions on its business is likely to be very modest.

Indeed, instead of limiting its support for solar manufacturers, the Chinese government has leaked a plan for major increases to subsidies on rooftop panels. For China, replacing dirty coal with clean solar not only makes great economic sense but also limits the life-threatening pollution that could further undermine the ruling party’s legitimacy.

Chinese stocks have a deservedly lousy reputation with US investors given the alarming frequency of fraud allegations they have faced, including many found to be legitimate. But the more prominent risks for Jinko are its industry’s tendency to oscillate from boom to bust and the often unpredictable politics of renewable energy subsidies.

That’s why this profitable rapid grower can still be bought for only 5 times next year’s estimated earnings. Expect that multiple to grow as Jinko Solar starts deriving more of its profits from managed projects.

We’re taking advantage of this week’s unwarranted dip to add Jinko Solar to the Aggressive Portfolio. Buy JKS below $32.  

Crushing It in California

Impressive as the solar industry’s recent comeback has been, it’s got nothing on Pacific Ethanol’s (NASDAQ: PEIX) story of near-miraculous survival. A little more than a year ago the West Coast ethanol producer was facing a liquidity crunch that threatened it with a loan default and a second bankruptcy filing in four years.

It took a last-minute investment of $14 million by outsiders and a negotiated debt extension to keep the lights on after the latest industry downturn. The price of corn from which ethanol is made was too high, the price of gasoline into which it’s blended too low and the ethanol market glutted with production capacity.

The company received multiple delisting notices because its stock was trading at around 35 cents per share, and the more than $100 million of net debt on the balance sheet exceeded the shrinking market cap.

Fast forward to last month, with only $20 million of expensive term debt not yet repaid (in addition to a lower-cost operating credit line backed by accounts receivable and inventory.) Pacific Ethanol would gladly pay off that $20 million too, if not for the prepayment penalties it would like to renegotiate. It should still have $8 million or so in cash on hand from a recent equity offering, and generated $23 million in cash from operations in the prior quarter.

The winning formula included a rally in ethanol prices to a recent eight-year high, as bankruptcies and closures of unprofitable plants curbed oversupply, much as in solar panels. Meanwhile, corn prices have been down more than 30 percent from a year ago as heavy planting and favorable weather point to a second straight bumper crop. Additionally, high gasoline prices have made ethanol blending more profitable for refiners foreign and domestic, bolstering demand  and boosting Pacific Ethanol’s production and marketed volumes 12 percent in a year’s time.

The three Pacific Ethanol plants in California, Oregon and Idaho produced nearly 40 million gallons in the first three months of the year, and the restart of a fourth long-idled plant in California at the end of April brought annual production capacity to 200 million gallons.

As a result of its bankruptcy in 2009 Pacific Ethanol owns only 91 percent of the holding company that owns these plants, though it’s been buying back some of the minority interest still held by former creditors.

Since much of ethanol production is concentrated in the Midwest Pacific Ethanol’s plants typically realize a regional premium for the gallons they produce and the two-thirds of their sales sourced from third-party producers in the most recent quarter. A California mandate requiring refiners to reduce the carbon intensity of the fuels they market is an additional support for the regional premium, which typically runs at 20 cents per gallon but doubled this spring as rail transportation snarls cut shipments from the Midwest.

Pacific Ethanol got an average of $2.70 per gallon for its sales, up just a dime a gallon from a year ago. But in a combination with strong demand and hefty discounts on the corn used, it turned a business that was struggling to break even a year ago into a generator of surprisingly robust cash flow.

Source: company presentation

The restart of the fourth plant will help, as will the installation of equipment that makes high-value corn oil alongside ethanol. The oil and a manufacturing byproduct called wet distiller’s grain are used in animal feed, and proceeds from their sales recouped more than  a third of the company’s corn procurement costs in the most recent quarter.

Pacific Ethanol further curbs its costs by mixing surplus government beet sugar into the corn feedstock at some of its plants, along with smaller quantities of sorghum and wine deemed unfit for sale. In addition to investing in corn oil manufacturing, the company is upgrading its grinding equipment to improve the yields of ethanol as well as corn oil.

Of course, there are no guarantees that the fat margins that drove the last period’s big profit will persist. But there are plenty of reasons for optimism, including plentiful cheap corn and strong ethanol demand that has so far offset recent supply increases.

It also matters hugely that the company is now largely free of debt and the heavy toll its double-digit interest rate was exacting.

Using the conservative assumption of $70 million in annual cash from operations, the enterprise value multiple is below 5, and if current conditions persist that $70 million could turn into something closer to $100 million after all the planned upgrades.

The main risk, aside from the inevitable swings in commodity prices, is of a regulatory or legislative setback undermining ethanol demand. For example, the Environmental Protection Agency still has not set its refiner biofuel use mandate for 2014, which helps shape the demand for ethanol from refineries.

Last year, the agency proposed reducing the 2014 target modestly on grounds the refiners might not be able to blend all of the ethanol they’d be required to use into fuel limited to a maximum of 10 percent ethanol content. An updated decision due any day is expected to set a target somewhere between the original mandate and the lower figure mooted last year. The ethanol industry could probably live with that, just like refiners who constantly grumble about the cost of the biofuel mandate.

Current law requires more and more biofuel to be mixed into the nation’s fuel supply in the coming years to the benefit of ethanol producers, and there is little evidence that Congress has the will or the votes to change these rules. That should help a premium producer like Pacific Ethanol over the longer-term, but our interest in the stock is tied more to the strong near-term fundamentals and the company’s under-the-radar deleveraging. We’re adding Pacific Ethanol to the Aggressive Portfolio. Buy PEIX below $18.