Back in January, when trade tensions between China and the U.S. seemed to be moving out of the bluster phase and into the realm of possible imposition of tariffs, the stock of Caterpillar Inc. (CAT, Financial) served as a bellwether for deteriorating investor sentiment concerning resolution of the trade issues and its impact on U.S. heavy equipment and manufacturing companies. After news of any deterioration — either real or imagined — in the trade relationship, Caterpillar stock would predictably drop in response.
Since no definitive resolution has occurred since the beginning of the year, the downward pressure on Caterpillar continued unabated, regardless of whether the extent of the decline bore any rational relationship to the potential harm that would be visited upon the company. Regardless of the U.S.-China antagonism related to trade issues, the pivotal question for value investors presently is: does the current price of the stock adequately reflect only the potential trade fallout risks to the company while completely ignoring analysts’ bountiful earnings projections for 2019 as well as actual business conditions? If investors' answer to the question is in the affirmative, now may be an auspicious time to buy.
Since January, when it comes to assessing trade-related risks, investors have overreacted, using a blunderbuss approach for shooting targets they indiscriminately select in economically sensitive industrial sectors. Caterpillar has taken fire repeatedly. The stock is down 22% this year. When volatility became persistent at the beginning of October, Caterpillar dropped twice as much as the overall U.S. market.
There are other hard equipment and industrials stocks that have taken a hard fall as well. The average price-earnings ratios of Eaton (ETN, Financial), Parker-Hannifin (PH, Financial) and Terex (TEX, Financial) have fallen from 19 to 12 this year, according to JPMorgan. Caterpillar has been the hardest hit as its price-earnings ratio has declined from 20 times estimated next four quarter earnings to 10 times. In the case of Caterpillar, there seems to be a disconnect with investors between its current price and the fact it is expected to produce record operating earnings on revenue that is $10 billion less than what the company earned in the prior economic cycle’s peak. Part of this increase is because of cost cutting; the company has learned to do with less.
Caterpillar’s stock seems to be locked into an institutional investor paradigm that ignores its increasingly robust operating margins and instead focuses purely on the stage of the economic cycle. Many analysts have missed the company’s dramatic and continuing improvement in its operating margins. In 2012, Caterpillar turned $65.9 billion in revenue into $8.6 billion in operating profit. This year, the company is projected to generate $54.8 billion in revenue and clear $8.9 billion in operating profit. GuruFocus notes the company’s operating profit ranks higher than 76% of companies within the farm and heavy equipment sector.
Compare the current price of the stock against the following third-quarter results.
Caterpillar’s third-quarter earnings of $2.86 per share represent a 47% increase from the same period last year. Revenue increased by 18% to $13.5 billion. Due to the company’s solid order rates, backlog and improving end-markets, it maintained its guidance for 2018 of $11 to $12. For the first 11 months of the year, Caterpillar's average sales growth increased by 25%.
When all the solid reported results are taken into consideration, along with the trade pitfalls, the company appears to be the victim of overreaction by investors. The 52-week high for the stock is $173; the 52-week low, $112.
The stock has a Pitroski F-Score of 8. The current yield is 2.8%. Caterpillar ended the quarter with $8 billion in free cash.
Caterpillar could present a classic value scenario where the stock, despite the company’s solid financial footing and prospects for the future, has fallen so far out of favor with the market, it provides a compelling buying opportunity for enterprising investors.
Disclosure: I have no positions in any of the securities referenced in this article.
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