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, MaxKapital (511 clicks)
Long-term horizon, value, growth at reasonable price, capital & stock allocation
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Summary

  • Caterpillar has outperformed markets over the past month, quarter, half year and year. This signals market conviction in forward expectations.
  • However, the momentum seen also suggests that forward expectations are fully priced. Simply meeting high expectations or even a small beat could disappoint investors.
  • Caterpillar is expensive in comparison with peers in the farm & construction machinery industry and trades at a slight premium to fair value: alpha is absent.
  • Caterpillar's beta shows signs of contracting from 1.40 to 1.22. If this is sustainable, it presents an interesting alpha opportunity.

Caterpillar (NYSE:CAT) reports earnings on Thursday, 4/24/14. The stock looks very good on value compared with the market or industrial goods sector. But when we view value viewed versus other members of the farm & construction machinery industry, it looks no more than reasonably valued: in fact slightly expensive relative to the industry peer group.

Source: Alpha Omega Mathematica

On growth too, the stock is just below in-line with industry participants, having underperformed the industry since Q4 2012 on account of what was said to be a "deliberate, multi-year, coordinated accounting misconduct" at its Chinese subsidiary, ERA Mining Machinery Ltd (and its subsidiary Siwei) which were acquired in June 2012. However, they are past that misfortune and markets expect Caterpillar's earnings to outperform the industry peer group in the coming year, and over the coming five years. The quarter-on-quarter growth reported in the quarter just past demonstrated some of that potential.

As far as growth is concerned, the future expectations matter most. And while I remain concerned about Caterpillar's past poor capital allocation decisions, I am willing to give them the benefit of the doubt for the coming years.

Source: Alpha Omega Mathematica

The key quality indicators, like the growth and value indicators also indicate scores just below in-line in comparison with industry peers.

Source: Alpha Omega Mathematica

The key momentum indicators are strong with Caterpillar outperforming the industry peer group on all fourteen key momentum indicators which we track. The market has very high conviction in expectations. And I suspect that anything short of a big beat will hurt the stock.

Source: Alpha Omega Mathematica

Screener

I screened for stocks with better value, growth, and quality scores than Caterpillar in the farm and construction machinery industry. And this is what I came up with:

(click to enlarge)

Source: Alpha Omega Mathematica

I'll eliminate Columbus McKinnon and Art's-Way Manufacturing because those fall within my definition of small and nano-caps respectively. And I don't believe it's right to compare them with large cap stocks like Deere & Co (NYSE:DE) or Caterpillar, or with a mid-cap stock like AGCO Corp (NYSE:AGCO).

But let's have a look at Caterpillar versus Deere & Co and AGCO Corp.

Relative Value

Everyone knows how to calculate the P/E Ratio: simply divide the price by trailing-twelve-month earnings. AGCO Corp with a PE Ratio of 9.42 wins versus both Deere & Co with a PE Ratio of 10.11 and Caterpillar with a PE Ratio of 17.88.

When we look at the current year P/E ratio, we simply divide the price by current-year earnings estimates. Based on 2014 estimates, we have AGCO Corp in the lead with a Current Year PE Ratio of 10.25, followed by Deere & Co with a Current Year PE of 11.07, and Caterpillar coming in last with a Forward PE Ratio of 17.26.

When we look at the forward P/E ratio, we simply divide the price by forward-year earnings estimates. Based on 2015 estimates, we have AGCO Corp in the lead with a Forward PE Ratio of 10.71, followed by Deere & Co with a Forward PE of 12.17, and Caterpillar coming in last with a Forward PE Ratio of 14.92.

In the 1960s a smart gentleman called Jim Slater realized that there is more to the math of the multiple. And he came up with the Price Earnings Growth Ratio [PEG]. This is a lovely ratio to use because it brings the growth differential in as an investment consideration. It is simply the PE Ratio divided by the long-term growth rate expectation. The PEG Ratio for AGCO Corp is in the lead at 0.97, followed by Deere & Co at 1.26, and with Caterpillar coming in last with 1.33. If we look at the PEG ratio based on 2014 earnings expectations, we see a slight change in rankings: this time we have AGCO Corp in the lead at 1.06 with Caterpillar coming in second with 1.28, and Deere & Co. bringing in the rear with 1.38.

What is missing in the PEG ratio is risk adjustment. I thought it might be worth multiplying the PEG Ratio by Beta to develop a P-RAGE ratio: that would be Price/Risk Adjusted Growth & Earnings Ratio. This ratio would simply multiply the PEG ratio by Beta to introduce an element of risk adjustment. I accept that beta and volatility may not be seen by many as a measure of risk. However, for better or for worse, beta pays an important role in investor return expectations: and investor expectations are what I seek to measure. Caterpillar comes with a Current Year PEG Ratio of 1.28 and a Value-line beta of 1.40, and a P-RAGE ratio of 1.80. Deere & Co comes with a Current Year PEG Ratio of 1.38, a Value-line beta of 1.25, and a P-RAGE ratio of 1.73. AGCO Corp comes with a Current Year PEG of 1.06 and a Value-line beta of 1.45, and a P-RAGE ratio of 1.54. Thus far as value adjusted for growth and risk is concerned I would rate them AGCO Corp, Deere & Co, and Caterpillar in that order.

Absolute Value

I will accept Reuters consensus estimates of $5.92 as representing sustainable earnings. I will use the Reuters long-term growth estimate of 13.45% as a reliable estimate of forward five year growth. I compute a composite very long-term growth rate of 8.53%, based on an assumption that growth will revert to being in-line with potential global nominal GDP growth rates of 8% in the sixth year.

I will expect Caterpillar to earn a return on equity of 21.50%: a level consistent with industry five year average return on equities reported on Reuters. To grow at a long term rate of 8.53%, the company would need to re-invest 39.70% (39.70% * 21.5% = 8.54%) of earnings. The remaining 60.30% of earnings represents the adjusted payout ratio: this is the amount shareholders can expect to receive from the company via dividends and buybacks, net of dilution resulting from employee and other issuances. Assuming a long-term risk free rate of 4.5% and an equity risk premium of 5.75%, an investor in a stock with a beta of 1.40 should demand a return of 12.55%.

Mathematically, the worth of Caterpillar is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate]. Thus Caterpillar would be a decent buy at $96.50 [108.53% * $5.92 * 60.30% / (12.55% - 8.53%)].

This is the price a buy and hold style investor should be prepared to pay. A person seeking alpha of 100 basis points would raise their long-term return expectation to 13.55%, such a person would want to buy the stock closer to $77.

The Beta Opportunity

Today Value-line reports a beta for Caterpillar of 1.40. This is close to the beta I calculate based on a five-year regression of the weekly closing prices of the stock, versus the weekly closing price of the S&P 500, adjusted for beta's tendency to converge towards 1.00.

However, the three-year regression beta adjusted for its tendency to converge towards 1 has contracted to 1.22. Beta tends to be influenced by changes in the operational mix of the business, changes in the capital structure, and investor perception of management competence. Time has now passed since the Bucyrus acquisition, and the smaller China acquisition lies in the past too. This faster than expected convergence in beta could be sustainable if it is arising as a consequence of a stabilizing operation mix and capital structure, and as management regains credibility after past poor capital allocation decisions. If the beta contracts to 1.22 on a sustainable basis, investors buying today while betas are higher, will benefit because as the beta declines in future periods, so will investor return expectations. I am a bit skeptical about the beta contraction opportunity, but thought it is worth highlighting to readers.

The investor return expectations based on a beta of 1.22 would drop to 11.515% from 12.55% today. This presents potential of just over 100 basis points of alpha through beta. To put this into perspective: had the investor long-term return expectation been 11.515% today, Caterpillar would have traded at a price attractive to long-term buy and hold style investors seeking a return of 11.515% at $130 [108.53% * $5.92 * 60.30% / (11.515% - 8.53%)].

To conclude, given five-year growth expectations are somewhat enthusiastic today, I remain cautious on Caterpillar for now: there is scope for a minor sell-off if these expectations are merely met. And there is plenty of scope for a fear trade should fears of a Chinese slow-down sustain. And of course the stand-off with Russia over Ukraine could work against Caterpillar too. Finally, if you look hard and long, there are some alpha opportunities available in today's expensive markets, along with better opportunities in the farm and construction machinery industry too: there is no compelling reason to buy Caterpillar.

For these reasons, while I like Caterpillar the company, I don't see it as trading at a good price. At $96.50 it would trade at a fair price, somewhat above what I see as a good price.

Source: Caterpillar: No Alpha, But A Possible Beta Contraction Opportunity