A Value Play Too Good To Ignore

On June 18th of last year, I wrote a piece suggesting that selling coal stocks, and Peabody Energy (BTU) in particular would be a good idea. Not to brag, but at the time that stock was trading just below $45 and has not been higher since. Now, however, with BTU around $27, it is time to reverse that trade.

My argument then was twofold. First, from a fundamental perspective, I said that despite Donald Trump’s rhetoric and actions, the future for coal was bleak. The second point was more of a technical one, that BTU had plateaued after a run up, setting up a trade with a limited downside and big upside.

To be honest, the long-term fundamental picture for Peabody and for coal in general is still not pretty, nor is it likely to change soon. The world is simply moving away from coal as a fuel, seeing it as dirty and outdated. That doesn’t mean, however, that there isn’t money to be made by coal companies, and right now the value in Peabody is just too good to ignore.

Whatever value metric you use Peabody looks like a buy. It has a trailing P/E of just under 6 and the PEG ratio, which takes projected growth into account, is negative. (A ratio below 1 is considered to indicate value). The stock is trading at below its book value, and the price to sales ratio is just over 0.5. The company has nearly $800 million of cash on hand and generates over $647 million of free cash flow as well, so liquidity is not an issue.

The immediate value in the stock is clear, even allowing for the secular decline in the industry’s prospects. However, the real appeal of reverting to a long position here is the setup, which is almost the exact opposite of the situation in June.

As you can see from the chart above, after six months of steep, consistent declines, BTU bounced off of a bottom around $27 at the end of December. It has been close to that level twice since and the low held both times. The actual low was $26.61 immediately following the last earnings release, and after bouncing around for a couple of weeks, we are close to that again now.

That sets up a trade using that low as the level off which to set a stop loss. Of course, BTU is a volatile stock, so placing a stop too close to the existing low would be asking for trouble. Even so, if you buy here with a stop just below $25, a level that provided support back in August of 2017 just before the run up to $45, your potential losses would be limited to under ten percent.

The upside on this leg of the trade is not as much as it was on the way down, as the long-term fundamental picture will limit gains, but even a return to just below the February high at, say $34.50 would give a profit of over thirty percent. That is the kind of risk-reward ratio that makes a trade attractive enough to take even when the long-term fundamentals point in the other direction, so reversing to along here with a view to shorting again just above $30 is the preferred play.