Build­ing the way back

The Washington Post Sunday - - BUSINESS - BY JAMES K. GLASS­MAN

Cater­pil­lar’s re­cov­ery of­fers key lessons for in­vestors.

Still reel­ing from a ter­ri­ble re­ces­sion, the U.S. job­less rate is at a painfully high 9.8 per­cent, with hous­ing starts near a record low and com­mer­cial con­struc­tion lan­guish­ing. But shares of a Peo­ria, Ill.-based maker of heavy equip­ment — the stuff used to build roads and apart­ment build­ings and to mine cop­per — re­cently reg­is­tered their high­est clos­ing ever. What gives?

The spec­tac­u­lar re­cov­ery of Cater­pil­lar of­fers four im­por­tant lessons for in­vestors:

First, share prices are based not on the here and now but on ex­pec­ta­tions of fu­ture profit.

Sec­ond, al­though the U.S. is the largest mar­ket in the world, it no longer drives the global econ­omy.

Third, in re­ces­sions, the strong get stronger.

Fourth, if you love a stock that’s on the mat, you should ig­nore the doom-say­ers and buy it cheap.

Cater­pil­lar, the world’s largest man­u­fac­turer of con­struc­tion equip­ment as well as diesel and nat­u­ral-gas en­gines, has al­ways been a great buy-and-hold stock for in­vestors with the courage of their con­vic­tions. The ups and downs of the econ­omy dras­ti­cally af­fect Cater­pil­lar’s earn­ings. The stock has a his­tory of sharp de­clines, then strong re­cov­er­ies, with an over­all up­ward march. At the start of 1990, the stock, ad­justed for splits, was trad­ing at about $7 a share. Within 10 years, it was over $20, and in 2008, it peaked at $86, giv­ing long-term share­hold­ers what Peter Lynch, the for­mer man­ager of Fidelity Mag­el­lan Fund, would call a 12bag­ger.

Cater­pil­lar re­ported record sales of $51 bil­lion in 2008. The next year, those sales skid­ded to $32 bil­lion. By March 2009, the stock had dropped to $22 — a de­cline of about three-fourths from its high. Still, even in the depths of the fi­nan­cial cri­sis, there were signs that Cat would come back strong. The com­pany re­mained in the black, and it gen­er­ated im­pres­sive cash flow (earn­ings plus de­pre­ci­a­tion and other non­cash charges). The bal­ance sheet was solid, with cash ris­ing in 2009. And Cat con­tin­ued to raise its div­i­dend, as it has each year since 1993.

In the spring and sum­mer of 2009, it was be­com­ing clear to in­vestors that the set­back was tem­po­rary and that Cater­pil­lar’s lay­offs were mak­ing it a more pro­duc­tive firm. In­vestors be­gan to fo­cus on the prof­its that the com­pany would likely earn in the fu­ture, and they be­gan to buy the stock with gusto. In early De­cem­ber, the stock closed at an all-time high of $89.

With rev­enue and earn­ings re­cov­er­ing sharply, Cat an­nounced in Novem­ber its plans to buy Bucyrus In­ter­na­tional, a large min­ing equip­ment man­u­fac­turer, for $7.6 bil­lion. The pur­chase will en­able Cater­pil­lar to ex­pand its min­ing of­fer­ings and will pro­vide more bal­ance for the com­pany’s prod­uct line, with di­ver­si­fi­ca­tion away from the trac­tors, graders and bull­doz­ers that have been its sta­ples. Cat is pay­ing a hefty pre­mium for Bucyrus — $92 a share, or about one-third more than the mar­ket price be­fore the deal was an­nounced. And speak­ing of spec­tac­u­lar comebacks, in March 2009, Bucyrus traded for fewer than 11 bucks a share.

Ev­i­dence of the sever­ity of the re­ces­sion is that Cat and Bucyrus are hardly out­liers; the stocks of other mak­ers of in­dus­trial equip­ment were also crushed. Cum­mins, the en­gine man­u­fac­turer, fell by more than half from early Au­gust to early Oc­to­ber of 2008. Deere, the world’s largest maker of farm equip­ment, did even worse. Both have ral­lied strongly and are back near all-time highs.

It’s safe to say that these com­pa­nies would not have re­cov­ered so briskly had they been re­ly­ing solely, or even pre­dom­i­nantly, on the U.S. mar­ket. While more than half of Cater­pil­lar’s 93,000-plus em­ploy­ees are in the United States, two-thirds of its sales come from abroad. As 2010 was end­ing, de­mand was strong­est in Latin Amer­ica and Asia, and in Novem­ber Cat an­nounced the open­ing of a $300 mil­lion large en­gine plant in Tian­jin, China, as well as a bond is­sue in Hong Kong in Chi­nese cur­rency.

In an en­thu­si­as­tic anal­y­sis in the Value Line In­vest­ment Sur­vey, David Reimer notes that at the peak of the last busi­ness cy­cle, Cater­pil­lar suf­fered from con­strained ca­pac­ity. “ This time around,” he writes, “ the com­pany is be­ing more proac­tive.” It’s ex­pand­ing man­u­fac­tur­ing not only in China, but also in In­dia (min­ing trucks) and Brazil (back­hoe load­ers). And, in ad­di­tion to Bucyrus, Cat re­cently bought Elec­tro-Mo­tive Diesel, a pro­ducer of diesel-elec­tric lo­co­mo­tive en­gines.

Cat’s con­fi­dence in the global econ­omy is re­as­sur­ing, and its ex­ten­sive cap­i­tal in­vest­ments will be re­warded if the economies of China and In­dia grow about 9 per­cent in 2011, as ex­pected. But I worry that Cater­pil­lar’s stock price — like that of Deere and Cum­mins — de­pends on the op­po­site of a per­fect storm. Let’s call it per­fect sun­shine.

The stocks of Cat and the oth­ers have ben­e­fited from growth in emerg­ing mar­kets, prospec­tive growth in de­vel­oped mar­kets, and the cost cut­ting and pro­duc­tiv­ity boost­ing that ac­com­pany re­ces­sions. But has per­fect sun­shine been so thor­oughly built into Cat’s stock that the thinnest cloud would lead to a se­ri­ous de­cline?

Fig­ure it this way: Cater­pil­lar was ex­pected to have earned about $4 a share in 2010. At $89, the price-earn­ings ra­tio is 23. If 2011 brings earn­ings of $5.72 (the av­er­age of an­a­lysts’ es­ti­mates), then the P/E would be 16 (Cat has never earned more than $5.32 per share in a sin­gle year). For a cycli­cal com­pany, that’s not too ex­pen­sive, but it’s cer­tainly not cheap.

On the other hand, Cat’s sec­tor may be in a sweet spot. It’s helped by swift ad­vances in technology for ma­chines such as earth­movers and con­struc­tion equip­ment, by huge de­mand for min­er­als, and by a de­sire for ever more en­vi­ron­men­tally friendly power gen­er­a­tion. Even at a lofty price, Cater­pil­lar is a solid choice for in­vestors who are happy to col­lect a 2 per­cent div­i­dend yield at a time when five-year Trea­suries are yield­ing 1.6 per­cent and who plan to buy more shares when Cat’s price takes an in­evitable dip.


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