Staying Cautious With Chinese Coal Companies

| About: L&L Energy, (LLEN)

Shortly after publishing yesterday’s article “A Note to All Chinese CEOs”, I received a message of concern from a reader. I won’t use this person’s name, but she expressed concern that I unfairly lumped her stock holding L&L Energy (NASDAQ:LLEN) in with Puda Coal (OTC:PUDA) and other Chinese small caps accused of defrauding shareholders.

As I told this person yesterday, my intent in including LLEN with these other Chinese small caps wasn’t to defame it. To the contrary, from my perspective, LLEN seems to have all the right stuff: Good properties, good coal reserves, solid customer bases, and as far as I can tell, competent leadership. In full disclosure, I’m neither long nor short LLEN, and we don’t plan on buying or selling LLEN in any of the Wyatt Research portfolios in the immediate future, to the best of my knowledge.

As you may know, I’m also hugely bullish on coal, and since the Chinese now consume more coal than any other country, it’s a no-brainer to look for growth and value in the sector.

Unfortunately, though, for this reader specifically as an LLEN shareholder and for Chinese small cap and large cap investors, no matter how great your company is, or how honest the leadership -- how cheap on an earnings basis or how promising the story – you must understand that your Chinese shareholdings will likely suffer a similar fate as the other companies, for the simple reason that there seems to be an epidemic of fraud and uncertainty in the sector.

And the market has no love for such sectors over the short term. If you don’t plan for the likelihood that there will be significant pullbacks for Chinese stocks based entirely on anti-Chinese sentiment, or the perception of a China bubble, or the fact that many Chinese firms actively fleece American investors, then you’re not an investor. You’re a speculator.

Here’s some quick analysis and information I’ve drawn up about LLEN. If you’re going to be an investor in this company, or any company, you need to not only look at this type of information, but you need to have a plan for your shareholdings, come what may.

First let’s assume that the company is what it says it is. It’s a micro-cap coal miner operating in China with upcoming operations in the United States. Consensus estimates show revenue doubling over the next two years, with similarly paced growth in the following two years.

And today, while LLEN gets painted with the same bearish brush as Puda, you can buy it for as cheap as it’s been since April of 2009 on a normalized earnings basis.

If you’re bullish on China, bullish on coal and you believe what analysts and company representatives tell you, then you should be thrilled to pick up shares of LLEN at this price.

Your plan for this investment needs to include scenarios such as the one we’re in right now: Shares are getting slaughtered based on anti-China sentiment. The fundamentals are just as strong as they’ve ever been. China won’t stop using coal anytime soon.

You shouldn’t be upset today; today is a day to be greedy. Included in your plan should be a trailing stop once you’re in the black. Looking at projected earnings, I’d say that you might want to sell shares if they ever get above $30. That would be a smidge under 15 times earnings at projected 2012 FY earnings of $2.31 per share. Coal companies typically don’t sell for more than 15 times earnings for very long.

Another strategy might be to book half your profits once your holdings double in value. That lets you take your principle off the table and you can watch your risk-free money take the ride. In any event, if someone writes something negative about your sweetheart stock, don’t take it personally. Use that negativity to your advantage to add to your position at a cheaper valuation.

Be aware of my warning though: Chinese small cap stocks will continue to get whacked around. That’s going to continue to be a problem for good companies and fraudulent ones that have anything to do with China.