Caterpillar (CAT, Financial) has been a value creator over the years, and I have a positive outlook on the company from a long-term investment perspective. However, I believe that the stock is unlikely to trend higher in the coming quarters, and the stock is likely to trade in a narrow range. This article discusses the reasons for this view on Caterpillar and the investment strategy.
The first factor and the most important factor for being relatively bearish on Caterpillar for the near term is China. The country was the key growth driver for Caterpillar after the crisis of 2008-09. However, China’s growth has stalled and expansionary monetary policies have done little to revive real economic activity. According to IMF’s world economic outlook, China’s GDP growth in 2015 and 2016 is likely to be lower than 2014. In other words, China’s economy is still far from bottoming out.
While I am optimistic on China’s growth for the long term, the country has grown at over 10% for decades and a period of cooling off was entirely likely. Therefore, Caterpillar’s revenue from China in the coming quarters will remain depressed.
The second factor for being bearish on Caterpillar is the recent decline in energy industry activity. The energy sector was also one of the key growth drivers for Caterpillar with the company deriving strong benefits from the U.S. shale boom. While oil prices have trended higher to $63 per barrel from $45 per barrel in January 2015, the outlook for oil remains bearish in the foreseeable future.
I am bearish due to supply side excesses and the key factor to watch for over the next few months will be the nuclear deal with Iran and the resumption of oil exports from Iran. The country claims that it can pump 1 million barrels of oil within one year of resumption of exports. If this holds true, global oil prices will remain under pressure and the sector’s growth will remain sluggish.
Therefore, investors need to keep a close watch on both these external factors before considering exposure to Caterpillar. In particular, oil price downside can be the near-term bearish trigger for Caterpillar with China’s slowdown factor largely discounted in the stock price.
Among these negative external factors, I must point out here that Caterpillar has a good dividend payout of $2.8 per share and a dividend yield of 3.2%. For dividend investors, Caterpillar remains a good stock to consider with strong cash flows and high financial flexibility.
From a valuation perspective, Caterpillar is likely to report an annual EPS of $4.98 per share in 2015. Considering the current stock price of $86.15, Caterpillar is trading at 17.3 times FY15 earnings, and these are not very expensive valuations considering the broad market valuation. However, as I mentioned above, the stock might still remain in a narrow trading range in absence of any meaningful positive trigger.
Another point that I want to mention is that the company’s retail statistics for April 2015 have been muted. This is an indication of continued weakness in the resource industry and is also an indication that the coming quarter results will be subdued. Investors should therefore not expect any positive surprises in the near term.
Caterpillar is likely to see further challenges in the coming quarters in terms of the overall business environment. While the company’s fundamentals remain strong and are likely to remain strong, external factors will keep the stock depressed. I believe that, once there is more clarity on the oil price trend, investors can consider exposure to this long-term wealth creator. However, investors can remain in the sidelines in the coming months or consider very gradual accumulation for a 3-5 year investment horizon.
