As a value investor, I am continuously on a lookout for sectors and stocks that are depressed and hold long-term value. Sectors in limelight tend to have stretched valuations and it’s better to avoid stocks with premium valuations when markets are trading near record high levels. Yesterday, I discussed why Walmart (WMT, Financial) is a value investment and a good dividend stock. My focus today is on another stock that holds tremendous long-term value and is undervalued at these levels.
Caterpillar (CAT, Financial), which primarily caters to the construction, mining and oil and gas industry globally, needs little introduction. However, the last 12-18 months have been challenging for the company due to a slowdown in China and decline in oil and gas prices. As a result, Caterpillar has declined by 24% in the last one year and currently trades at $84.5.
If the Peter Lynch earnings line from Guru Focus is compared with the current price, Caterpillar is undervalued and even on a trailing 12-month PE valuation perspective, Caterpillar is trading at a PE of 13.5, which is very attractive in my opinion.
Just like Walmart being a dividend stock, Caterpillar is also not a high growth stock, but the company offers a healthy dividend payout of $3.08 per share, and the company has created continued value through share repurchase. However, there are other factors that make me bullish on the stock for the coming years.
I am also encouraged by comments from Bill Nygren (Trades, Portfolio) on Caterpillar –
We prefer to value cyclical businesses on their earnings potential throughout the cycle, and we think that Caterpillar’s mid-cycle earnings will be considerably higher than current levels. With the Caterpillar share price falling to multi-year lows, the business is now attractively valued at just 10x our forecast of mid-cycle earnings. When we combine this attractive valuation with a 3.4% dividend yield and a strong balance sheet, we find Caterpillar to be a compelling investment.
With the signing of the nuclear deal with Iran, I believe that the coming years will be beneficial for Caterpillar. The company has presence in Iran before sanctions and once sanctions are lifted, the business opportunity in Iran will be big. It was reported by Reuters on February 24, 2015 that Iran will be spending $4.8 billion from the sovereign fund for oil sector development. The country’s oil infrastructure is poor and Caterpillar will find good business in the country.
Another reason to believe that Caterpillar is a value investment is the recent growth trend in China. China’s manufacturing PMI has been stable in the last few months and the country’s non-manufacturing PMI increased for the first time in June 2015 after four months. This is an indication that economic growth might have reached a bottom in China. China’s second quarter GDP has also increased by 7%, indicating that the country will be meeting its 2015 GDP growth target. Therefore, I expect Caterpillar’s revenue from China to stabilize, before increasing in the coming years. As growth in China bottoms out, Caterpillar stock might also bottom out.
The oil and gas sector also impacted Caterpillar’s growth and is one area of concern even for the near term. Lower oil prices have made investments slow in the sector, and that has affected the company’s revenue. The positive point is that crude oil prices will discount the Iran deal factor and crude has remained stable after the deal announcement. This makes me believe that oil might not see lower levels and investments in the sector will be higher in the coming years.
All these factors would not immediately mean that Caterpillar’s growth is robust in the coming quarters, but it means that Caterpillar might not have further downside from these levels. I therefore see the current market price as an opportunity to accumulate the stock for long-term value investing.
Another long-term positive about Caterpillar is that the company’s balance sheet has remained strong in the crisis. As of March 2015, the company had cash of $7.5 billion and current finance receivables of $9.0 billion. The company also generated an operating cash flow of $1.2 billion for the first quarter of 2015.
With a strong balance sheet and liquidity position, Caterpillar will continue to pay high dividends and create value through share repurchase even in these difficult times. The company is therefore a dividend stock for the portfolio very similar to Walmart.
Since Caterpillar seems to be undervalued, I am of the opinion that investors can buy and hold the stock at current levels. In the next 1-2 years, I expect good returns from capital appreciation as well as from higher dividends.
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