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  • The Insecurity I Like Best 2 comments
    Feb 6, 2013 9:15 AM | about stocks: ACI

    Arch Coal, Inc. (NYSE: ACI)
    $1.28 billion market capitalization
    212.28 million shares
    @ $6.04

    Arch Coal, Inc., formerly known as Ashland Coal, Inc., prior to the merger with Arch Mineral on July 1st, 1997, closed its first trading day at $2.71 on August 12th, 1988. This price of $2.71 is adjusted for a 2:1 stock split that took place on May 16th, 2006. Currently, ACI is trading at $6.04, which is a nominal increase of 122.8%. However, according to the Bureau of Labor Statistics CPI Inflation Calculator*, $2.71 in 1988 would be equivalent to $5.26 towards the end of 2012. In other words, ACI is currently trading at $3.11 when adjusted for inflation, which is an increase of only 14.7% in a quarter of a century.

    There are various methods of identifying whether a stock is undervalued or overvalued. For the purposes of this article, only a handful of vanilla filters will be applied.

    Price ÷ Earnings (P/E)
    The mean P/E ratio of the S&P 500 stretching all the way back to 1871 has been 15.49. The current S&P 500 P/E ratio is 17.19. Value investors would typically look for stocks that are trading at a P/E below the current S&P 500 ratio, and a P/E ratio that is not above 12. The current P/E for ACI is -4.63.

    Price ÷ Book (P/B)
    Another favorite filter amongst value investors is seeking out stocks trading at or below book value. What this means is that if the company were to be theoretically liquidated without having to worry about time passing by or the legal complications that may ensue, a P/B ratio above 1.0 would mean that currently the stock is valued higher than the liquidation value of the company. Alternatively, a P/B ratio below 1.0 would mean that the stock is valued lower than the theoretical liquidation value of the company. The current P/B for ACI is 0.41.

    Price ÷ Sales (P/S)
    The idea behind the P/S ratio is similar to that of the P/B ratio. In other words, a ratio lower than 1.0 indicates that the stock is valued lower than the sales that the company generates, presumably because Mr. Market thinks that sales will decline even further going forward. Value investors like to look for companies trading at a P/S ratio below 1.0. At the moment, ACI has a market capitalization of $1.28 billion and sales of $4.42 billion, placing the P/S ratio at 0.29.

    52 Week High (52WH)
    The final filter used in this article is the 52WH. Value investors and contrarians alike love looking at stocks trading 50% or below their 52WH. Psychologically, this is the point at which weak hands get shaken out of the market and the stock consolidates. ACI is presently 60.95% down from its 52WH of $15.47.

    By all the preceding measures, ACI is currently a cheap deal. The question now remains whether or not the stock is too sick to recover. After all, Patriot Coal (OTCQB:PCXCQ) was a screaming deal according to the aforementioned valuations just before it went bankrupt last year. Hopefully, the last segment of this article will explain why this will not be the case with ACI.

    100 Years of US Natural Gas: The Extraordinary Popular Delusion

    A little over a decade ago, during the aftermath of a collapsed dotcom bubble, a recession, and the more visible destruction of the twin towers, a new idea came along. The idea was that while the stock market may go up and down, real estate only goes one way: up. No one knows where this idea came from. Traditionally, housing was correctly seen as a place to live and at best as a hedge against inflation. Absent the bubble years of 1997-2007, the data seems to support the traditional view.

    (click to enlarge)
    The yellow line represents pre-bubble housing prices, which were parallel until 1997 with the blue line that represents the consumer price index. The black line represents housing prices diverging from the CPI from 1997-2007 and the red line the post-bubble collapse of housing prices converging back to the consumer price index trend line. Lastly, the purple line is a snapshot of the Wilshire Internet Total Market Index, which is a sufficient proxy for the dotcom bubble.

    Yale economist Robert J. Shiller chronicled the dotcom bubble and wrote a book about it as it was ongoing*. In the book, Shiller introduced the concept of a negative bubble. In other words, instead of prices rising for an extended amount of time, only to collapse relatively quicker, the process is reversed. The proper analogy to a negative bubble would be submerging a beach ball under water, only to see it explode upwards.

    It is not clear why people thought housing prices can only go in one direction (up) or where the idea came from. The most obvious explanation boils down to crowd psychology. For one, a lot of people had just lost money in the internet mania, the aftermath of which was large enough to bring down the S&P 500, the DJIA, and to pull the US economy into a recession. Naturally, the crowd got more conservative and wanted something more tangible. The problem, however, was that the bull market in commodities was just getting under way. Only a fool would buy commodities in 2002, or so the crowd thought.

    (click to enlarge)
    The black line represents the price of oil, which was down roughly 40% in 2002 since 1980. The yellow line represents the price of gold, which was down roughly 50% in 2002 since 1980. In retrospect, these would have been great buys. However, that is not the way the crowd functions. The crowd needs several years, if not decades, of rising prices before piling into something broad. The teal line represents housing prices, which had been up roughly 150% in 2002 since 1980. Moreover, they continued going up through the recession, which had brought down nearly everything except for the unemployment rate. The stage was set for another and bigger bubble.

    Furthermore, Greenspan, Freddie Mac, Fannie Mae, and the financial sector stepped in to help inflate housing prices. Opinion molders also got on the bandwagon, all in the name of aggregate demand. As Paul Krugman put it in 2002, 'Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble'*

    Is US Natural Gas a Negative Bubble?

    It is not clear why people think natural gas prices in the US can only go in one direction (down) or where the idea came from. As was the case with the housing bubble, the most plausible answer seems to be delusion. In other words, people think natural gas prices should keep falling because they find the thought very convenient. After a decade of persistently rising energy costs and trade deficits, who wouldn't want to believe that 100 years of energy independence is right under our feet? An abundance of natural gas would serve as a bridge fuel to the future, where dirty energy sources such as coal are no longer needed thanks to great leaps of innovation in the field of nuclear, solar, and wind. We can continue to eat our cake and have it too, or so goes the delusion.

    (click to enlarge)
    The black line represents oil prices. The green line represents US natural gas prices that roughly followed the trend of oil prices. The pink line, which begins in 2010, represents US natural gas prices that have diverged from oil prices. Oil is up well over 100% since the 2009 lows. Natural gas, on the other hand, has gone nowhere.

    One does not need to dig very far to see that natural gas prices within the US do not make much sense. It is as if someone at the head of the Kremlin had set a price on natural gas that is too low, which is in turn preventing a scarce resource from being economized, except this time around the price is being set by an irrational crowd. The BP Statistical Review of World Energy* does not support the 100 years of US natural gas meme at all. In fact, the US only has about 300 Trillion cubic feet (8.5 Trillion cubic meters) of proven reserves. This is about a 4.1% share of world reserves, which total to 7,361 Trillion cubic feet (208 Trillion cubic meters). Yet, despite this, the price of a million British thermal units (mmbtu) was $3.34 for natural gas in the US at the end of 2012, as opposed to $11.79/mmbtu in Europe and $16.49/mmbtu for liquefied natural gas in Japan*. Arthur E. Berman, a geological consultant, has been pointing out this absurdity for years.


    The US may very well have 100 years worth of natural gas. In fact, it probably has several centuries' worth of the stuff. The fine print, however, is at present rates of consumption and at prices that are subject to change i.e., rise.

    So, Why ACI?

    Natural gas is a direct competitor with thermal coal. Since natural gas prices in the US are significantly lower than in the rest of the world, it follows that US based coal stocks are the most depressed. Indeed, international coal companies like Peabody Energy (NYSE:BTU) are focused on providing energy to China via Australian reserves. As such, they are not as adversely affected by the negative bubble in US natural gas. Subsequently, international as well as the more heavily metallurgical coal companies do not have the same upside potential as ACI. In short, Arch Coal is big enough to weather the storm, and local enough to benefit from the negative bubble in US natural gas.

    Mundus vult decipi, ergo decipitatur


    * Irrational Exuberance was originally published in 2000 by Princeton University Press.


    * BP Statistical Review of World Energy, June 2012

    * World Bank Commodity Price Data

    Disclosure: I am long ACI.

    Stocks: ACI
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Comments (2)
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  • milkchaser
    , contributor
    Comments (984) | Send Message
    It is still not clear to me why it lost money and why its earnings might turn around.
    6 Feb 2013, 10:23 AM Reply Like
  • Patrik Korda
    , contributor
    Comments (35) | Send Message
    Author’s reply » YTD Update:


    Bad News: I was too early on ACI, which is trading at $4.00 today (34% decline since the article). I have stubbornly continued to cost-average downwards and will continue to do so unless the fundamentals change for the worse.


    Good News: The fundamentals have been improving. Natural gas, trading at $5.31/mmbtu today, is up significantly since bottoming out on April 20th, 2012 at $1.82/mmbtu (up 191% since). While thermal coal prices have remained flat since this article came out, in-between thermal coal prices have formed an inverse head & shoulders formation. This is definitely a bullish sign when taken along with the dramatic rise in natural gas prices.


    Conclusion: I remain a holder and buyer of ACI until and if the macro picture starts to rapidly deteriorate. I fear there is the potential for a recession in 2014, in which case I will not hesitate to sell. Thankfully, energy stocks and commodities have a habit of spiking into recessions. Thus, the macro picture is not an issue as of yet.
    6 Feb 2014, 08:33 AM Reply Like
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