Patriot Coal Bankruptcy Is A Reminder For Investors

Even while saying that opportunity could perhaps emerge on the coal stocks, I have kept warning that Patriot Coal (PCX) had short term bankruptcy risk, and as thus it had to be avoided. I said this on several articles, most notably on " Patriot Coal Shareholders Should Switch To James River Coal" and " James River Coal: Now Might Be A Good Time To Go To Cash" .

Unfortunately, this risk has now materialized. Yesterday's 72% plunge on PCX stock was a prelude, and soon after the market closed the news was announced: PCX filed chapter 11, after having lined up DIP financing.

This event is a powerful reminder for investors, particularly those who dabble in cyclical stocks: for a shareholder to realize the upside of a cyclical turnaround, the company has to survive the bottom of the cycle. And those that are worst capitalized or higher cost usually don't.

Any investor that chooses to invest in these very though cyclical environments can never take his eyes off this basic reality. He has to check balance sheets current assets and liabilities upcoming debt maturities cash flow generation cash on hand debt covenants etc. Nothing can be left out - particularly a simple Altman Z-Score should not be left out.

This due diligence is necessary not just to establish the likelihood of a near-term bankruptcy, but also to defend against a very powerful psychological mechanism - the mechanism which tells us to buy more to lower our average price on the losing positions and which keeps us from assuming our mistakes and cutting the losses. This is a mechanism that most investors fall prey to, so every measure that can be taken against it should be taken.

It was not a coincidence that I wrote an article saying Patriot Coal shareholders should switch to James River Coal (JRCC). I wrote that article because I knew how hard it would be for someone with deep losses in PCX to get out of the stock. So I put an alternative in the table where someone in that position could avoid being subjected to the near term bankruptcy risk, while keeping a similar upside in another beaten-down, high-risk, coal stock ...

What's there to be learned?

Having arrived at the logical conclusion for Patriot Coal, this should be an important lesson for those who fell prey to it, as well as those that managed to avoid its ultimate fate. Next time, if you can't bring yourself to sell out of a stock with near-term bankruptcy risk, then simply find a very similar stock without that risk and switch into it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.