I caught about the expected amount of flack from associates yesterday for my coal article. I am one of the few, it seems, who actually think coal has a future in our energy. It is a dirty, nasty business to be sure, but it is an abundant cheap fuel source that is going to be used for decades to come. The global economy runs on energy, and most energy sources are a dirty business. I am getting used to it. A good portion of deep value portfolio involves dirty businesses that dig stuff out of the ground. Fossil fuels, minerals and metals are depressed sectors right now, so naturally that is where the cheap stocks are at this moment in time.
Natural gas is cleaner than coal, but there still is a lot of controversy around the industry, particularly here in North America. Because fracking and other extraction methods have produced an excess of natural gas, the companies that produce the stuff are pretty cheap. Earnings are hard to come by as a result of the low prices, but currently the assets are valuable and underpriced. From a long-term point of view natural gas is an even bigger part of a realistic energy policy than coal. So at some point we will see prices rise as more industries, utilities and consumers turn to this important energy source.
While it is not a classic cheap stock on a book value basis I still consider EXCO Resources (XCO) one of my favorite deep value natural gas stocks. Although the stated price to book value is much higher than I would usually buy, this company was the subject of an almost $20 a share takeover offer in the not too distant past. The appraisal of asset value at the time was north of $20, and even if the asset value has declined by half they are still worth twice the current stock price. I feel like I am in pretty good company here as Wilbur Ross, Howard Marks and Prem Watsa are all substantial shareholders. As the stock has sold off on weak earnings, I am considering adding to my position; if I did not already own some I would be a buyer at this level.
Wall Street has punished shares of Swift Energy (SFY) for having too much natural gas in their production mix. The company has been working to up the output of oil and natural gas liquids but it is still not where investors had hoped to see. What many are overlooking is the fact that production was up big year over year, with a 24% gain in total production. Earnings were up 20% and cash flow grew by 24%. Conditions are improving and the future of the Eagle Ford Joint venture is pretty bright. At 50% of book value I think the stock is a tremendous bargain. So do the insiders as several, including CEO Terry Swift, have been buying the stock recently.
Shallow water drilling is something of a dirty business as well. A slowdown in drilling along with a cancelled contract in Angola have pushed shares of Hercules Offshore (HERO) down to just 62% of book value. While the short term picture might not be as bright as Wall Street likes to see, the truth is that cancelled rig will eventual come under another contract and drilling activity, particularly in the gulf of Mexico, will improve in the next year. Insiders have been buying the stock at this level and some pretty smart value finds, including Aegis Financial, Royce Funds, Tocqueville Asset Management and LSV Asset Management, were buyers of Hercules in the second quarter. The short term could continue to be bumpy but the long-term upside of this cheap stock appears to be enormous.
Not all businesses can be bright, shiny and green. Some are dirty and involve things like digging, drilling and mining. Investors tend to prefer the exciting shiny stocks but the dirty industries are among the ones that will drive the global economy. Buying them at current depressed levels should lead to big gains for patient investors willing to get a little dirty.