Raise your hand if you identified with Mel Gibson's character in Conspiracy Theory. Do you see isolated facts all around you and obsessive-compulsively rearrange them until you find they fuse into a pattern? Then like me, you may be a synthesist at heart.
Over the past few months, I have been watching my natural gas bills go through the roof. Literally -- the attic insulation of our circa-1950s rambler is almost thin enough to see through. And that personal experience helped spur me to notice a few key articles in the press that help explain the situation.
A trend is born
A couple months ago, for instance, The Wall Street Journal described how electric power companies' demand for coal is booming as a result of the looming natural gas shortage. Electricity is often sold on a "dutch auction" model (similar to the method planned for selling shares in Google's IPO). Buyers run up the list of suppliers' prices from lowest to highest until they have all the supply they need. The price paid for each unit of electricity is then set, for all suppliers, at the highest "ask" price filled.
Because natural gas supplies are currently low, and because demand for natural gas is high, natural-gas-fired plants usually demand the highest prices. Suppliers using coal-fired plants fill out the lower price range, because electricity produced from coal is cheaper per unit to produce than electricity produced from natural gas. Result: Coal-fired plants get paid the same price for their low-cost energy as natural-gas-fired plants get paid for their high-cost energy. That means that coal-fired plants are making better profits than natural-gas-fired plants -- and coal-fired plants have limitless fuel supplies to boot. (The U.S. is home to 25% of the world's coal reserves.) As a further result, most new electric power plants being built these days are coal-fired plants.
One trend begets two more
Two weeks ago, the Journal provided another piece of the puzzle when it described a 30% rise in the price of coal stocks since January as a result of the rising demand for the stuff. Last week, the Journal reported on a related story, describing billionaire investor George Kaiser's plan to import liquid natural gas to the Gulf of Mexico by tanker, thaw the gas out at sea, then pipe it in to the mainland (simultaneously boosting natural gas supplies and keeping the risk of terrorist attacks on the receiving facilities away from the mainland). Why was Mr. Kaiser investing in such a venture? Because he thinks that U.S. demand for natural gas has permanently exceeded U.S. supplies of natural gas. Therefore, the price for natural gas will continue to rise. And therefore, by bringing additional natural gas supplies to the U.S., Mr. Kaiser stands to profit from the rise in price.
Last year, I wrote another article on this subject (incidentally, my very first piece for the Fool), describing America's coming natural gas shortage and its potential effects on natural gas pipeliner and potential hidden gem Kinder Morgan (NYSE:KMI). The thesis of my argument was that dwindling supplies of natural gas might hurt Kinder's business if consumers begin to switch from natural gas to coal and other alternative fuels to satisfy their energy needs.
Synthesis
Now fuse all of the above factoids into a single picture of what is happening. The key concept here is "cross elasticity of demand." It means that when two different goods, A and B, have essentially the same purpose -- for example, both can be burned to create electricity -- a price increase in A will generate an increase in the demand for B. According to the laws of supply and demand, if the supply of B stays constant or declines, then this increase in demand for B will also push up the price of B. Hence, the increasing demand for natural gas, which has caused the price of natural gas to increase, is destined to produce an increase first in the demand (for example, to fuel the new coal-fired electric plants), then in the price, of coal.
Coal and diamonds
At Motley Fool Hidden Gems, we tend not to base our investment decisions on "top-down" research such as what I have laid out above. Rather, we focus on buying good companies for great prices. (Here's an example from Matt Richey, who wrote aboutJohnson & Johnson (NYSE:JNJ) and ValueClick (NASDAQ:VCLK) a couple of years ago.) We want to buy companies that Wall Street will ultimately acknowledge to be diamonds when they are still selling for the price of a hunk of coal.
Still, when an emerging trend hits you with the force of conviction, perhaps it is worth looking into. It certainly cannot hurt to sift the coal and gas industries in particular, searching for gems. As a matter of fact, during a recent screen for small-cap companies with low enterprise value-to-free cash flow ratios, high returns on equity and high insider ownership, one of the first companies I came across was a natural gas producer!
Meet Mr. Williams
Clayton Williams Energy (NASDAQ:CWEI), of Midland, Texas, has a market cap of just $225 million. Despite a considerable debt load, its enterprise value-to-free cash flow ratio is still just 7.4. And when you consider that the lone analyst following the company thinks it can increase its profits by 18% a year over the next five years, that yields an EV/FCF/G ratio of just 0.4. If Clayton Williams can manage anywhere near that performance, the stock could be a bargain at its current price of roughly $23 a stub.
The company is reasonably well run, with a return on equity of 11.5. But another metric we like to look at in Hidden Gems is insider ownership. At Clayton Williams, that's a double-edged sword. On the one hand, insider ownership is quite high at 52%. On the other hand, almost all of that 52% is in the hands of the founder and namesake of the firm. Minority shareholders, beware.
Meet the competition
Believe it or not, we have been inspired to write about coal stocks here before. Exactly once. (It was a really well-done piece, though.) So clearly, if this coal thing is a real trend in the making, it is also a trend still in its infancy -- the 30% rise in coal stock prices notwithstanding.
So before we close out this article, let's take a quick look at a few of the more likely hidden gems in the sector. I'll warn you ahead of time that none of these companies meets the seven requirements I ordinarily seek in a small-cap hidden gem prospect (although one comes close):
- Alliance Resources (NASDAQ:ARLP)
- Arch Coal (NYSE:ACI)
- Headwaters Inc. (NASDAQ:HDWR)
- Natural Resource Partners (NYSE:NRP)
- Westmoreland Coal (AMEX:WLB)
Out of these five small-cap coal companies, if I were forced to pick just one as an investment, I would probably go with Alliance Resources -- even though its EV/FCF ratio of 13 is not quite as low as I would like, and its 6% projected annual growth rate is too low. In the end, the company's 5.7% dividend tips the scales in Alliance's favor.
Fortunately, however, as individual investors, we have the luxury of not investing in any of these companies until the time appears right. I've outlined the trend for you as I see it. If you agree with my reasoning, then the best thing to do at this point is sit tight, monitor the players in this industry, and wait for one to fall to your own personal buy price.
You're invited to take a no-risk, nongaseous free trial to Tom Gardner's Motley Fool Hidden Gems.
Fool contributor Rich Smith owns no shares in any company mentioned in this article. The Motley Fool is Fools writing for Fools.
