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ETF Sector Focus: Investors Will Like This Coal in Their Stockings This Holiday Season

Coal ETFs carry above-average risk but offer compelling reward potential right now.

Robert Goldsborough, 11/30/2011

The stock prices of companies engaged in exploring for or mining coal have been hammered in recent weeks.

Since July, coal companies' seesaw-like share prices have been more down than up, amid investor concern about broad macroeconomic uncertainty. In the last three months, a basket of coal industry companies found in a popular exchange-traded fund is down 15%, while the S&P 500 is actually up 2%.

While coal demand itself isn't necessarily highly volatile, there is no question that coal companies themselves have become more volatile in recent years, as the firms have become more reliant on the production of higher-margin metallurgical coal, which is used in steel making, and have become more exposed to metallurgical coal's inherent operating leverage. Particularly since the start of November, as investors have been spooked about a financial crisis in Europe and slowing steel demand in China, they have driven down the share prices of coal companies.

And more broadly, investors have a right to be concerned about a host of unfavorable dynamics in the coal space--not least of which has involved U.S. power plants' continued switching of their fuel sources to natural gas, given historically low prices of natural gas. That transition has in particular whacked the share prices of coal companies with heavier exposure to Appalachian mines.

On top of all of this, demand by U.S. power plants for coal is lower than it has been in the past, owing to the still-weak economy and greater energy-consciousness.

Powerful Dynamics Still Favoring Coal
In the medium term, however, there are some powerful and favorable trends favoring U.S. coal, including increased demand by China and India, along with proposed new coal export terminals on the West Coast (plus, expansions of some existing West Coast terminals) to help ease the transport of U.S. coal from Wyoming’s Powder River Basin to Asia. In addition, coal remains a generally inexpensive way to generate energy whether it is higher-sulfur coal extracted from the Appalachian region or whether it comes from the Powder River Basin where coal has a much lower-sulfur content (making it better suited for greater regulatory environment) and is far cheaper to extract but carries with it far higher transportation costs on U.S. railroads. An investor taking a tactical position in a basket of coal companies must hold the belief that metallurgical prices will rebound and that growth in China will continue.

Using an ETF to Invest in a Basket of Coal Firms
If one totals up the debits and credits above, one sees that the coal industry has all the hallmarks of an industry that is badly out of favor right now. And Morningstar's equity analysts generally agree. Most of the U.S.-based coal companies that our analysts cover, such as Consol Energy CNX, Peabody Energy BTU, and Arch Coal ACI, are trading substantially below our analysts' fair value estimates.

For those investors who feel that coal companies' share prices are overdone, the exchange-traded-fund structure may be the best option. ETFs allow investors to diversify their risk within an industry by buying a basket of stocks. And for investors wanting to make a tactical bet on companies involved in mining so-called "black diamonds," there are two coal ETFs that offer broad exposure to the global space. Neither fund holds enough companies that Morningstar's equity analysts cover for us to be able to compute fair value estimates for the funds, which are calculated by aggregating and weighting our equity analysts' estimates of fair values for the ETFs' underlying constituents. But we can gain some idea of the relative attractiveness of coal companies right now by looking at our analysts' price/fair value measures for the coal firms that Morningstar does cover. Right now, small-cap Powder River Basin miner Cloud Peak Energy CLD, which my colleague, Morningstar coal analyst Michael Tian, calls his favorite name in the industry, trades at 62% of its fair value. And coal industry giant Peabody Energy is trading at 63% of its fair value, while coal and natural gas industry titan Consol Energy trades at 72% of its fair value. In all three cases, the firms trade at significantly greater discounts to fair value than the S&P 500's current valuation, which is 81% of Morningstar equity analysts' estimate of fair value. (To be fair, one larger coal player, Alpha Natural Resources ANR, which significantly overpaid, in our analysts' view, for its recent acquisition of Massey Energy, trades above our analysts' estimate of fair value, while small-cap and worst-in-breed Central Appalachian miner James River Coal JRCC also trades above our estimate of fair value.)

Both coal ETFs unquestionably own the major players in the coal space. As a result, as the coal industry goes, so too should these ETFs go. (We should remind investors that neither of these funds holds physical coal; instead, they own publicly traded companies whose operations are heavily related to coal.) And investors in these funds should be prepared for volatility; over the past year, their volatility has been twice that of the S&P 500.

The two coal ETFs have highly correlated performance (98% over the last three years). However, there are important differences between the two funds that investors should be aware of before considering a position. Here are some details:

Market Vectors Coal ETF KOL
This fund is the larger of the two ETFs. KOL holds about 35 companies engaged in the coal industry. The ETF tracks a modified market-capitalization-weighted index. So while larger firms tend to dominate (the top-five holdings comprise more than 41% of assets, whereas the top-10 holdings make up almost 65% of assets), the largest holdings are capped to ensure diversification. Big holdings include Joy Global JOYG, Consol Energy, and Peabody Energy, plus China-based firms such as China Shenhua, China Coal Energy, and Yanzhou Coal Mining YZC. The fund also holds some smaller coal firms such as Patriot Coal PCX, and it also owns some unexpected holdings such as small-cap hopper car manufacturer FreightCar America RAIL. KOL has a fairly heavy exposure to U.S.-based firms, which make up 41% of assets. Chinese firms comprise another 21% of the fund, followed by Australia and Indonesia (15% each). Over the last three years, KOL's performance has been 85% correlated with the performance of the S&P 500. The ETF charges 0.59%. Since the start of the year, KOL has been crushed, falling more than 28% while the S&P 500 has been off a little less than 5%.

PowerShares Global Coal PKOL
This fund tracks a modified market capitalization-weighted index of 31 companies that are involved in exploring for and mining coal, as well as some other related activities in the coal industry. Larger firms here also dominate, with the top-five holdings making up almost 38% of assets and the top-10 holdings comprising more than 58% of assets. Large holdings include China Shenhua Energy, Coal & Allied Industrials, Consol Energy, and Peabody Energy. Unlike KOL, the PowerShares offering also holds uranium companies such as Cameco CCJ, Uranium One, and Denison Mines DNN. Geographically speaking, the fund spreads its assets a bit more evenly, with U.S. firms making up 25% of assets and Chinese companies comprising another 25%. Other major countries where constituent holdings are domiciled include Australia (20% of assets), China (20%), Indonesia (16%), Canada (9%), and Thailand (4%). Over the last three years, PKOL's performance has been 84% correlated with the performance of the S&P 500. With a 0.75% fee, PKOL is slightly more expensive than the Market Vectors fund. And since the start of 2011, PKOL has fallen 32%, obviously severely underperforming the broader market. One final note: This ETF is fairly thinly traded, so watch bid-ask spreads closely.

Other Alternatives--Both Inside and Outside the ETF Structure
Another ETF option for investors interested in broader exposure to metals and mining companies is SPDR S&P Metals and Mining XME, which charges 0.35%. We should note, however, that coal companies make up just 16% of XME; the fund’s biggest subindustry weighting is to steel companies (almost 37% of assets).

Still another possibility is single-stock investing. Investors could consider making investments in industry players such as Consol Energy, Peabody Energy, Cloud Peak Energy, or Yanzhou Coal Mining.

Robert Goldsborough is an ETF Analyst at Morningstar.
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