Wow, the market has been volatile of late. While the S&P 500 and its tracking exchange traded fund, SPY, has generally consolidated around 1400, sectors such as the financials and industrials have sold-off by over 10% in the last month.
While some market leaders like Apple (AAPL), Citigroup (C), and JP Morgan (JPM), have reported strong earnings, many industrial stocks have underperformed the broader indexes by a fairly significant margin since the market sell-off began several weeks ago, and the weak recent earnings report of Caterpillar (CAT).
The most cyclical part of Caterpillar's business is their industrial equipment business in China and India. Not surprisingly, since China's real estate and construction industry began to experience significant weakness nearly a year ago, and the Baltic Shipping Index has been very weak all year, Caterpillar reported significant weakness in industrial equipment business in China.
Still, the company's report across their other business segments was fairly strong, and most analysts think the company will hit their previous guidance for 2012.
The biggest problem that Caterpillar has had over the last several years has been showing consistency in their earnings. While Caterpillar's stock traded up to nearly $120 a share just a couple years ago, the stock sold off to around $60 a share, and today trades at $102.
Obviously, some of the sell-off in Caterpillar was because of fears surrounding the European debt crisis last summer. Still, the higher than normal levels of volatility in Caterpillar's shares suggests the market is having trouble valuing their business model even today.
To me the primary reason for the volatility in Caterpillar shares is because the company's strongest earnings growth over the past couple years has come from the real estate and construction sector in Asia. With governments and central banks in China and other Asian countries continually trying to inflate their country's growth numbers by encouraging new real estate and infrastructure projects the country did not need.
The result of the heavy involvement in the real estate and construction sector by the Chinese central government and the Chinese central Bank is that Caterpillar's strongest business segment, industrial equipment sales in Asia, is seeing artificially short business cycles.
Indeed, even though other industrial companies may not have had earnings growth as strong as Caterpillar's in 2009 and 2010, companies like Cummins (CMI) and Eaton (ETN), have shown much more steady and consistent growth over the last several years. Given the consistency of these companies' business models, the current valuation of these stocks at around 8-9x an average estimate of next year's earnings seems cheap.
The market has always been willing to assign higher multiples to stocks with more steady business models. Today companies like IBM and McDonald's (MCD) are at 12x and 15x next year's average earnings estimates, despite each company showing barely showing double digit earnings growth over the last several years. The fact these stocks are trading at a premium to companies such as Caterpillar suggests that the market is giving some more stabile companies a valuation premium.
However, while companies like Cummins and Eaton don't have business models that are as stabile as McDonald's, these companies still have much more consistent business models than Caterpillar.
Cummins is an engineering company that is the largest maker of diesel engines in the world. The company makes standard gas engines in addition to being well positioned to enter the natural gas engine market because of their partnership with Westport Innovations (WPRT). Cummins' conservative management team has guided to 12-15% revenue growth over the next five years.
While obviously, Cummins is exposed to truck sales in the U.S. and Europe, demand for new trucks even in the U.S. and Europe has held up fairly well. Even though the economic outlook in Europe and the U.S. has oscillated significantly in the last couple years, the primary appeal of Cummins' products is cost reduction since its products' main appeal is their fuel efficiency.
While a weak economy obviously affects the shipping numbers of many companies, low interest rates and high energy prices has kept demand for new trucks fairly strong.
The second company whose business model has also been strong even during periods of economic weakness over the last several years is Eaton. Eaton's core businesses are in the electrical, hydraulic, and aerospace sectors. Eaton has raised guidance twice this year, and the company already reported a strong first quarter.
Eaton's business model is also built on cost reduction, and should be appealing to companies and governments since energy costs remain high and interest rates are low. Eaton also has a number of multi-year contracts that involve updating the power systems of companies and governments over longer periods of time.
To conclude, earnings misses by leading companies often cause sector wide sell-offs, not all companies are created equally. Still, companies that reduce the cost of doing business are likely to see much more steady earnings as energy and other commodity costs remain high while rates are low.
With leading industrial companies like Boeing (BA) and GE having recently reported strong industrial demand for their products in Asia, industrial sector earnings may be stronger than recent reports from companies like Caterpillar would suggest.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
