Caterpillar, Inc.: A Stock for Contrarians

Recent articles on "A Dash" have covered topics like sentiment, negativity, exposing analytic flaws in research about the Fed, and a lot of what we call "pundit errors."  This is a blog about a book and these are all important themes.

Some readers have requested that I translate our recent commentary into some specific suggestions.  Normally this is a subject for the private commentary available to our clients, but it seems appropriate to give an example.  Many names in the transports or cyclicals would be good choices, but I am going to mention a favorite, Caterpillar, Inc.

In our individual portfolios we select stocks that we expect to double in three years, a compound growth rate of about 24%.  We re-evaluate these stocks constantly.  We bought CAT for clients in mid-February of 2004 at a (split-adjusted) price of about 40.  We have not sold it because the picture continues to improve and we expect the growth to continue at our benchmark pace.

CAT stock has been part of the mid-year selling as the hot money decided that the economy was about to collapse.  What if the pundits and rookie hedge fund managers are wrong?

• CAT has been sold partly because of the link to housing, something that has been given too much weight.  This is a global company, benefitting from worldwide strength indicated by the Baltic Dry Index, truck engines (still going great), and energy reconstruction.
• CAT trades at 12 times current year earnings and less than 11 times 2007 earnings, which people magically start talking about after Labor day.
• CAT management says that business is great and there is no sign of a decline.  Analysts choose not to believe this, because they are pretending they are economists and using criteria from Internet stocks in 2000.  Do they really think that management learned nothing from the Sarbannes-Oxley era?
• Analysts are pricing the company at peak cycle, while management thinks they are only in the fourth or fifth inning.
• CAT, a local company for me, has good control on the labor situation, falling prices for inputs, and some pricing power for their products.  Sales continue to be strong.

Earnings estimates already reflect a predicted decline in the growth rate, as we can see from data taken from the wonderful Zack's service.  (click to enlarge)

The chart, log scale on both price and earnings, shows how the multiple has not reflected the earnings growth and the projected decline in earnings momentum.

If analysts are wrong about the cycle timing, we will see both increased earnings estimates and an increased multiple.  Even if they are correct, a lot of the predicted "bad news" has already been priced in.

This stock is typical of a lot of other names in the space, but the special considerations make it a favorite.