If you’re a skeptic, then you probably get a little nervous when you see lots of headlines about a stock or industry that are all positive. To the skeptical investor, this suggests an investment has peaked and is set to drop. Well, it’s like that right now in one popular segment of the energy sector. These stocks have gotten lots of press lately because, as a group, they’ve risen nearly 60% in the past 12 months. The best ones have doubled or tripled during that time.

Investment dollars have been flowing to this energy source because many people consider it the best available alternative to oil. It has enjoyed high demand globally, particularly in China, where it accounts for as much as 70% of energy consumption.

I’m referring to coal, and I think it’s an investment to be wary of right now.

Coal’s on my “watch list” not just because it seems overly popular, but because of a disturbing trend — high-priced, potentially unprofitable acquisitions. The coal industry has been steadily consolidating for the past several years, and the price tags for the companies being acquired are often excessive. This type of dealmaking is a bearish indicator because it can severely hinder the bottom line for a company.

Here’s a prime example: On May 2, the second largest coal producer in the United States, Arch Coal Inc. (NYSE: ACI) bought West Virginia-based International Coal Group Inc (NYSE: ICO) for $3.4 billion, or 11 times International Coal’s projected 2011 earnings before interest, taxes, depreciation and amortization (EBITDA). Arch probably far overpaid for this acquisition, shelling out $14.60 a share for International Coal when its stock was only trading for $11 a share (more than a 30% premium). Moreover, the deal was based on optimistic EBITDA estimates International Coal will only be able to achieve if it has its best year ever. Mind you, this is a company that lost money in three of the past five years leading up to 2010.

Here’s another example… On January 29, the third largest U.S. coal producer, Alpha Natural Resources (NYSE: ANR), bought Massey Energy (NYSE: MEE) for $69.33 per share — more than a 20% premium at the time. The deal totaled $7.1 billion, or about eight times Massey’s 2011 EBITDA, a multiple that initially seems a bit more reasonable than the one paid in the Arch Coal-International Coal deal. However, it’s based on a very ambitious 2011 EBITDA projection of $924.6 million. To achieve that, Massey will have to more than triple EBITDA from $267.3 million last year.

That doesn’t seem terribly likely, especially now that overall economic growth appears to be slowing — or that Massey slashed its 2011 guidance barely a month after the merger.

Post-deal stock performance for Arch Coal and Alpha Natural Resources suggests a downturn in coal is already underway. On May 2 when the Arch Coal-International Coal deal was announced, Arch Coal was trading for $33.53 per share. Now? Not even $27 a share — about a 20% loss in just over a month. Since the January 29 acquisition of Massey Energy, Alpha Natural Resources is down from $57.88 per share to about $51 a share — a 12% drop. The industry as a whole is off 7% in the past month.

 

In addition to overpriced acquisitions, a major concern for the coal industry is weak U.S. demand, which hasn’t been offset by higher exports. Nevertheless, say analysts, industry management remains unrealistically bullish, possibly overestimating future profits because prior profits were so robust. I think Morningstar analyst Mike Tian explains it best: “When prices are high, commodity producers generate a lot of profits, and it’s easy to foresee rosy times stretching as far as the eye can see,” he writes.

Action to Take –> Don’t be fooled by all the headlines touting coal stocks. There are a lot of overpriced, potentially unprofitable acquisitions happening in the coal industry right now, and they could end up dragging down individual players and the industry as a whole for a long time. Arch Coal and Alpha Natural Resources are just two of the most recent examples of coal companies hurt by poor acquisitions. If you’re thinking of investing in energy anytime soon, you might want to consider looking elsewhere in the sector. And if you’re feeling particularly adventurous, you could short the industry through an exchange-traded fund (ETF) such as the Market Vectors Coal ETF (NYSE: KOL).

P.S. — I don’t know if you’re aware of this or not, but a 20-year energy agreement between the United States and Russia is about to expire. The problem is, this deal supplies 10% of America’s electricity. When the Russians refuse to renew the agreement, the U.S. will face an entirely new kind of energy crisis. This disruption could send a handful of energy stocks through the roof. Keep reading…