Take-Home Investing Lessons From The Collapse Of Coal

From the end of World War II through 2007, coal industry stocks returned an average of 6.8% per year. Peabody, Patriot, Arch Coal, Alpha Natural Resources, and Walter Energy returned 8.7% over the same time period. It sounds almost crazy to express now, but for the second half of the 20th century, you could meet your investing goals by owning coal stocks.

Had a kid born in 1989 that started college in 2007? Someone that purchased $150 of coal stocks each month would have earned 8.9% returns and built up a college fund of $79,500 by the kid’s first year at the university. This information doesn’t seem to compute. Coal stocks + $150 per month = Financial Goal Realized is not an equation that improves our intuitive confidence in the rationality of math. It just doesn’t seem to add up.

Although coal stocks never outperformed for the Dow Jones Index for any rolling twenty-year period with the measurement begun in the 1890s, it is worth asking: How did things go so wrong in the industry, and what can be learned from it so that we could enjoy better investment fates than those of the coal-mining shareholders?

According to a chart created by Sam Batkins of the American Action Forum, the combined market capitalization of the coal industry in 2011 was $35 billion. As of this year, the coal industry market cap is $350 million. We are talking about a 99% collapse in value in just under five years. If there was no child in my above hypothetical that required the sale of the coal stocks in 2007, and the money instead got to compound indefinitely from 1989 through 2016, the ending result would have been just hundreds of dollars (about $700-$900).

From the point of view of a coal investor, the three boogiemen are: (1) cheaper alternative energy sources, namely natural gas which has declined in price by 70% since 2008 and became so preferred to coal that it cut the demand for coal by more than half from peak to trough; (2) high debt loads in the tens of billions of dollars that didn’t permit much wiggle room in good times let alone adverse conditions; and (3) 234 regulations, primarily from the EPA, that demanded over 31 million paperwork hours and an estimated lifetime compliance cost of $314 billion for the industry.

Also, part of the backdrop is that the coal producers generated almost all of their revenues in the United States and made themselves extremely susceptible to what Graham called “the political question” that overhangs every industry. It’s not like Peabody had hundreds of millions in profits coming from Mexico or Canada that could put up a shareholder-friendly firewall against faltering conditions in the United States.

Imagine, for a moment, that instead of being an international juggernaut with centuries of operating history tracing back to its early American roots, Colgate-Palmolive was a thirty-year old Venezuela-domiciled company that sold toothpaste, detergent, mouthwash, and floorcleaners in Caracas, Maracaibo, Ciudad Guyana, and Maracay. Millions in infrastructure investments, sales networks developed, and equity built up through the past record of growing sales of household cleaners.

All of that would now be destroyed. Gone. Poof. The men and women who spent the decades of their prime years giving their best to the growth of this Venezuela enterprise? Nothing to show for it. The well-tended garden became a desert virtually overnight.

The Guardian reports that mobs of hungry Venezuelan citizens have seized supermarkets to scavenge for food, as rice and bread are now delivered through armored car. If, somehow you owned a Venezuelan business, you would have to deal with a 482% inflation rate. Charge 80 bolivar for a basic car repair? Come July 1st, make it 90 bolivar. Then 100 for August.

The reason I refuse to get behind socialism is because the result is always misery. Why? Because it rejects the premise of human nature that we almost all have a desire to create better things for ourselves tomorrow than we have today–an unquenchable thirst to find ourselves in better shape than we were previously. The profit motive, properly harnessed to limit harm, allows you to acquire material benefits through your own labor efforts and fruit of ownership interests such that the material baselines are always increasing (the United States sextupled its material living standards during the 20th century).

I used to get about 350 page views per month from Venezuela. Now, I don’t get any noticeable views from Venezuela. The last search engine result from a Venezuelan IP that ended up on my site contained the word “lottery.” Ambitions of long-term wealth creation has been entirely displaced due to a Maslow shift in favor of basic survival.

But the Venezuela Colgate-Palmolive example? You’re looking at total wipeout. If the company only existed in Venezuela, you’d have nothing to show for it. Your entire investment would be lost, and it would be the least of your problems. Now, as a factual matter, the Colgate-Palmolive that actually existed was just one individual subsidiary of the American parent Colgate-Palmolive. As such, the harm is able to be overcome.

In April, Colgate-Palmolive announced that it would discontinue to report its Venezuelan results in its consolidated financial statements and took a 100% impairment charge on their last year’s report. They haven’t shut down in Venezuela yet, but they are treating it as a total loss for accounting purposes (Coca-Cola, meanwhile, has pulled out of Venezuela).

Having an ownership stake in businesses that operate in dozens of countries is underrated. Absent a civil war, no one has had stock ownership positions forcibly seized from them since the Chinese factory nationalization initiative during WWII.

Diversification of geography interests provides an opportunity for replenishment. If Peabody owned European oil interests, or Australian mining interests, and low debt, the shareholders would have survived. Their earnings power would have debased; but it is obviously far superior to have a $500 million earnings base turned into a $250 million base growing at 6% than to have your entire base destroyed and completely wiped out for good.

And another obvious point: You can’t go bankrupt if you don’t owe anybody anything. The only time I ever lost money on an investment involved a high debt burden. There is no slack for downturns in a business cycle when your debt is high. Every adverse business development is a high-stress situation because a failure to come up with cash for debtholders at any time will vest an authority to shut down your business and wipe out the equity holders.

There aren’t many ways to gain a market edge with large-cap stocks, but one of them is to focus on cash-rich companies that have their earnings power discounted as the stagnant cash doesn’t get fully valued. You know I admired the $34 billion cash hoard at Johnson & Johnson, which has almost half of it in the United States.

Well, earlier this month, Johnson & Johnson announced a $3.3 billion deal to purchase Vogue International. And it still has $10+ billion in cash available to make new acquisitions towards anything that catches its fancy. That’s why you keep dollar-cost-averaging into more and more shares of Johnson & Johnson, as it is one of the top ten companies in the entire world adjusted for earnings quality, balance sheet strength, and future growth prospects.

Also, from a psychological perspective, it is more fun to own things that play self-funded offense rather than a business perpetually crouched in defense. Berkshire Hathaway shareholders wake up once or twice per year to learn of a new company added to the earnings power base that is funded through a $60+ billion cash hoard that is being replenished at a rate of around $24 billion per year.

Finding out that you now own a partial interest in Kraft-Heinz, Lubrizol, and Precision Castparts is a lot more fun than owning a highly leveraged company where your basis for joy comes from learning that a long-term note due in 2016 got rolled back to 2021 in exchange for a point higher interest rate.

And lastly, the flipside of the Colgate-Palmolive. Most of the time, politics work out in the favor of companies like Colgate-Palmolive regarding political questions. It is preferable to own businesses like Colgate-Palmolive and Nike that lack government scrutiny compared to businesses like Philip Morris International and Coca-Cola where the effects of ordinary product usage invite the harsh glare of government regulation.

Of course, the implied language in the above paragraph is “all else equal” which things are most certainly not. Nicotine and caffeine are addicting, or to use the more fashionable term, “habit-forming.” Marlboro and Coke have decades, going on centuries, of built-up brand equity. The cost of production are virtually nil compared to the end cost of each product. The purchases are repeatable and part of daily life, as there are loyal demographics that transfer part of their own wealth to the shareholders of these corporations every day of their lives. These countervailing forces more than offset the regulatory gaze, but just because they can overcompensate for the disadvantages created by government action shouldn’t lead us to conclude that the political factor doesn’t exist.

The worst case, politically, with Nike is that may have to pay workers more when the media shines on a spotlight on the deplorable factory conditions measured by the decency standards of the industrialized West. What’s the political risk to Colgate-Palmolive specifically? Maybe minimum ingredient quality components for toothpaste or certain disclosure requirements for a tube of toothpaste? But it is hard to imagine Colgate-Palmolive ever having to deal with something analogous to the Philadelphia soda tax that will affect shareholders of Coca-Cola.

That is why I talk about Nike so much. It has a cash-rich balance sheet, diversified sports product lines, extreme geographic diversity of profit sources, has a brand name that permits very high profit margins throughout the entirety of the business cycle, sells a product that is purchased multiple times per year by customers, and faces little regulatory risk in its industry. It’s funny that, even as Under Armour has risen in fashionability over the recent years, Nike still has a higher five year projected growth rate than Under Armour.

Moving away from that armour, an investor’s armor is exposed when he owns assets that: (1) carry high debt compared to earnings, especially if the business is cyclical (2) sell indistinguishable products such that a cheaper producer will steal nearly all market share; (3) has undiversified geographic sources of profit when there is a political question about the integrity of the system; and/or (4) operates in an industry whose products impose externalities and personal harm while generating low profit margins such that there is little slack to absorb additional government intervention, taxation, and regulation. Those are my take-home general rules from the collapse of coal that I would use as a pattern for analyzing similarly situated investment opportunities in the future.

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Originally posted 2016-06-22 19:50:31.

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