A perplexing dynamic

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Yesterday I received a ton of emails after writing that coal would once again surpass oil as the world's dominant source of energy supply.

I'm glad you're listening.

I was speaking with my friend and colleague Gregor Macdonald the other day. Gregor is a leading oil analyst and energy sector investor. He invests his own money in energy stocks, and has been quite successful. I value his opinion, and have profitably acted on his advice on numerous occasions.

Both he and I are perplexed by the fact that more investors aren't aware that coal is staging a comeback. We both agree that investors need coal exposure, but that very few have it. And one of the best ways to gain exposure is through small cap coal mining stocks with operations in China.

The World Coal Institute has some compelling data to support the claim that world coal demand is surging. According to the group, "In recent years, coal use has risen by 4.9% per year, faster than any other fuel. The use of coal is expected to rise by over 60% from 2006 to 2030, with developing countries responsible for 97% of this increase."

After completing my research, it's clear that all arrows point to China when considering a coal mining investment. As I wrote yesterday, China gets around 78% of its electricity from coal. Over the last fifteen years, coal has helped the country double energy output. This energy boom has brought electricity to more than 450 million people in the country. That's more people than in the entire United States - 47 percent more.

But there are 1.32 billion people in China, meaning that more than 60% of the population is still without electricity. And that's just the people - manufacturing demand uses around half of China's electricity production. Unless manufacturing contracts in a massive way - a highly unlikely scenario - energy demand will continue to rise.

***There are a few ways you can play the coal boom. Most coal companies are engaged in one or more coal operations, including mining, wholesaling, coking and washing. Recently we've seen companies with coking coal operations do extremely well. Coking coal is used in steelmaking, and with the infrastructure boom in China, these companies have seen demand soar.

I like that angle, but right now I'm more bullish on mining operations. Growing energy demand for coal is the catalyst that I want exposure to, and mining is the way to get it.

The small cap company that I alluded to yesterday makes most of its money from mining and coal wholesaling. These are operations that have 70 percent and 12 percent operating margins, respectively, versus around 9.5 percent for coking and washing. Other companies have different operating margins, but most are around the same as these for the respective activity.

I love cash flows, and it's hard to argue that this company, with a 70 percent operating margin, increasing coal prices, and skyrocketing demand for coal isn't a good investment!  Last Friday I pulled the trigger and added this small coal mining company to the Small Cap Investor PRO portfolio. You can get my full research report here.

Many investors are concerned with putting new money to work in China right now, and I agree there is cause for concern in certain sectors. I've discussed these issues in the past so I won't repeat them again today. The bottom line is that there are opportunities in China right now if you know where to look.

Many small cap stocks in the country have fallen hard, in many cases the stock slides were accelerated when companies completed secondary offerings. Shareholder dilution came at a time when investors were expecting greater earnings per share numbers.

But I sense that secondary offerings are starting to wane. And given that the Shanghai index has significantly lagged U.S. indices since the March 2009 lows, and has fallen over 20% in 2010, I believe it is a good time to be establishing, or adding to, positions in high growth China stocks.

***Paul had a comment on coal. He wrote: "You may be correct, if they clean up coal. I prefer natural gas. We never dreamed that the U.S. had supply. Now that we do I am sure a lot of our energy will convert to natural gas in the upcoming years."

You're absolutely right Paul, natural gas companies are compelling investments right now too. Paul's referring to the natural gas supplies that have been found in shale deposits, including the Marcellus reservoir in New York and Pennsylvania. But don't limit yourself to just one energy investment. It's challenging picking winning stocks, and even more so if you have too narrow of an investment window. I'd recommend coal, oil, and natural gas exposure. Find the best one in each sector and you're likely to have a winning strategy.

You can get the full research report on my favorite small cap coal investment, as well as all the other small-cap stocks I follow, when you sign up for a risk free trial subscription to Small Cap Investor PRO. Click here to get started.

As always, feel free to send me in your small cap investment ideas. My address is: editorial@smallcapinvestor.com.