If You Can Bear Sleepless Nights, Buy These 2 Coal Stocks

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If you are able to restrain your emotions and deal with the sudden ups and downs in equities, coal may be for you. For everyone else, coal stocks are to be avoided. In my view, investors would be wise to put aside emotions and back producers that have showed a strong ability to control costs while investing in their business's future. Below, I review three stocks with this in mind.

Peabody Energy (NYSE: BTU): A Mixed Bag

At only 8.5x past earnings and a free cash flow yield of 9.2%, Peabody would seem like an obvious "buy" for the casual investor. But coal is highly volatile, and the story can change overnight. So, fundamentally, how does Peabody look? In my view, it's a mixed bag.

A judge recently added a Wyoming coal lease claim to an environmental lawsuit. This lawsuit challenges Peabody's 1 billion tons worth of coal in the Powder River Basin. In addition, rising environmental regulations worldwide are strangling the sector. The conditions have gotten so bad that Peabody has called for a commission to address higher costs and the introduction of new taxes on coal and carbon emissions. Analysts have been downgrading the stock amidst free cash flow growth concerns.

On the other hand, management has showcased confidence in the long-term fundamentals. The decision to repurchase $54 million worth of shares in the third quarter was designed to relay to the market that management truly finds the company's stock price undervalued. In addition, the company is making aggressive attempts to spread out resources. The firm expects to resume talks in early 2013 with the Mongolian government about acquiring a stake in the western Tavan Tolgoi deposit. In addition, the company has kept costs under control, which is well timed for a recovery in met coal prices. And then there is excellent performance against a challenging market environment--in the third quarter, EPS of $0.51 came out 17 cents ahead of consensus estimates. Howard Weil rates the stock "market outperform" with a $51 price target. The stock currently trades at $24.90.

Buy Arch Coal (NYSE: ACI), Avoid CONSOL Energy (NYSE: CNX)

And what about Peabody's competitors? While Arch has slid 60.8% from its 52-week high, CONSOL is actually closer to its 52-week high. In my view, Arch could make for a surprising "buy" while CONSOL is to be avoided. Arch has been in the red for some time now, with a loss of $1.50 per share over the TTM, but it has no business being valued for less than one-half of book value. BMO Capital Markets has upgraded the stock to "market perform" with an $8 price target. Argus is calling it a "buy" at $10. And Global Hunter Securities is even more bullish at $18. The stock currently is worth $6.51.

Arch will benefit from the up-tick in domestic thermal coal demand, coupled with lower cash costs per ton. Production and costs have been prudently managed, so the company can invest in more profitable business environments. In particular, management is giving a bright outlook on the Powder River Basin and has argued that this is not exclusively due to favorable summer weather. In the longer-term, administration of shale gas will attract industrial activity back into the United Stated and, in that way, benefit coal. At the same time, Arch has estimated that 45 gigawatts worth of coal capacity may be retired by 2018, largely as a result of stringent EPA regulations, so there is plenty of risk.

As the largest underground producer of coal, CONSOL has a large economic moat. But the idling of mines, extended labor leave, and operation setbacks disrupt the upside story. Weak global steel markets have further exposed the company's vulnerabilities. Add in management's weak outlook in 4Q12, when it expects a loss, and you have a stock to avoid.

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