Put Coal in Your Stocking

 | Dec 24, 2012 | 1:00 PM EST
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As the noise and confusion pick up at Chez Melvin, I want to take a moment to look at what's going to happen in 2013. Everyone likes to engage in financial game like this at this time of the year. The airwaves and print will be full of advice about stocks to buy for 2013, how to position your portfolio for year-end gains, and all sorts of very important predictions. But just because I think all this tomfoolery is worthless as an investment guide is no reason for not to participate.

When I study the stock market, I see that all the ingredients for a major decline firmly in place. We have weak earnings, political gridlock, the risk of European contagion and the fiscal cliff all lining up to push stock prices lower. So we could easily see a new bear market in 2013.

I also see that the Federal Reserve is going to keep interest rates at near zero until the Jets win the Super Bowl or the Mets make it to the World Series. This policy is going to continue to push money into risk-based assets, especially stocks. This same policy is sparking ever so slight signs of a housing improvement. So we could easily see stock prices continue to climb the Wall of Worry and stage an impressive rally in 2013.

Or stocks could experience a gut-wrenching decline. If that doesn't happen it is highly probable that stocks trade in a range-bound fashion for much of the year. It is almost a certainty that we will not close 2013 at exactly the same level as 2012. So my prediction this year is the same as last year: Stock prices will fluctuate and there will be selloffs to buy and rallies to sell throughout the year. Some sectors and stocks will become unsustainably popular and reach unrealistic valuations. Others will be hated more than they should be and become too cheap not to buy. The key to making money as a long-term, asset-based investor is going to be reacting to the opportunities the market provides, not trying to predict the unknowable future direction of stock prices.

I do find it instructive at the end of each year to look at which groups and sectors have not done well over the previous 52 weeks. Last year's homebuilding selection worked like a charm with triple-digit gains in the suggested stocks. This year's group for mean reversion is going to be coal stocks. The sector is down about 20% on the year. I believe coal has a brighter future than traders indicate, but it's going to take time to get traction. Coal exports will eventually pick up with a global economic recovery, and domestic demand will stabilize as natural gas prices improve.

I haven't done much with coal in spite of the decline. I have a small position in Arch Coal (ACI), the result of selling puts earlier this year. I nibbled on the bonds of James River (JRCC) and Patriot Coal when the latter filed bankruptcy and coal-company bonds plunged. These positions have bounced around quite a bit but are now basically unchanged. I expect that to change in 2013 as I begin to add to coal stocks.

Arch Coal is currently the cheaper of the two largest coal companies, with shares trading at 60% of tangible book value. The company sells most of its output to electric utilities and has been hit by increased regulations that favor natural gas for generation. There are signs that the decline in coal demand is beginning to stabilize. Arch may never be a high-flying growth stock again, but the shares are too cheap and could rally sharply at the first sign of a real and lasting economic recovery.

I also like Peabody Energy (BTU), the largest coal company in the world, with operations in the U.S. and Australia, as well as joint mining operations in Mongolia and Venezuela. It has the best exposure to the higher-demand Asian markets, especially China, which should provide substantial growth opportunities for the company. At 1.2x tangible book value, this stock is not quite cheap enough to buy, but if it sells off in 2013, it will be a tremendous buy below that level.

Coal stocks have not done well for years now. They are down over the one-, three- and five-year periods and should be due to stage a recovery. But they have climbed the fiscal cliff along with the market and are up sharply in the past month. I am not in favor of chasing stocks and I would wait for the inevitable pullback to be a buyer. Buying the laggards worked in 2012, and I believe it will work in 2013 as well. Arch Coal is a buy now on the first market decline and Peabody is too cheap not to own if it slips below $20.

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volatility is quite low here, and we could see some downsides here in the short term. ...
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