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Overview

The past year has been moderately turbulent for Caterpillar (CAT). The stock ranged from just above $70 to a little over $115 before dropping and rising again to its current range between $90 and $95. As a DOW component, Caterpillar has plenty of analyst coverage and is generally considered lower-risk although the pricing makes it a somewhat less attractive option for the beginning investor who may wish to purchase more than just a few shares per month. That being said, the company displays some numbers that may make the case for an investment here, or especially if the stock price dips in the coming weeks. Additionally, Caterpillar could make a decent longer-term options candidate.

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Caterpillar manufactures and sells large construction/mining equipment, diesel engines, gas turbines, and locomotives. The company's stock tends to rise and fall with the overall economic outlook, as when the economy is booming and there is a large need for raw materials or massive building projects, there is a higher demand for the equipment they manufacture. The opposite also generally holds true.

Financials

The first thing we need to remember when looking at the numbers is that there are no guarantees. Estimates are just that, estimates. However, we can identify certain trends that can indicate a stock may be a potential candidate for our portfolio.

The TTM P/E ratio currently stands at 10.26 as compared to the DOW average of 15.5. For an even larger comparison, the average P/E for the S&P 500 is over 17. This indicates that in general, investors are willing to pay less for this stock relative to earnings than other stocks in that same basket. If we assume that this will remain true in the future and hold this ratio compared to anticipated earnings for the fiscal years ending in 2012, 2013, and 2014 we observe the numbers in the following table.

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Again, these are estimates based completely on an assumption that the market will continue to place the exact same numerical value on Caterpillar's earnings -- we know this will not be the case, but we have to start somewhere. What is clear is the significant upward trend in earnings that occurs through the fiscal year ending in 2014. Caterpillar is a profitable company and earnings are anticipated to rise for the next 24 months. It seems unlikely that the P/E ratio would dip very far into single digit territory, and in fact the P/E would have to fall below 8 by 2014 just for the price to remain where it is today. If this were to happen, I would expect increased demand in the stock as it would become a better value relative to other companies, driving the price upwards. You can do your own calculations on what could happen if the P/E were to rise instead of decline.

Looking for further trends in the financial statements, we observe several items worth noting. First of all, the company has not significantly changed the amount of cash kept on hand. There was a spike in 2009, but following 2008 everybody kept additional cash on hand. Total assets have increased by a large percentage (27%) the last 12 months. Total debt has remained statistically similar for the entire period, but short term debt has been cut almost in half -- although most of that between 2008-2009.

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This table indicates that the company appears to be in a decent position financially. What is worrisome about this stock is how it is treated during times of economic uncertainty. The fact that there is currently significant turmoil in the world economy is clearly holding this stock back. Unfortunately, this could cause the stock to withdraw back to the $80 range or potentially even lower.

Possible Strategies

The most straightforward strategy would be to either purchase and hold, or more likely buy this stock when it dips below $90. Buy-and-hold is no longer the proven recipe for portfolio management, but there are stocks that belong in that category if you have the luxury of a longer time horizon. An increase from $90 to $120 over two years does not seem unlikely given how recently it hit $115. Factoring in the dividend would result in a 38% gain over this time period. Not a home run by any means, but I would much rather score consistent gains if able.

An additional method to capitalize on this stock's potential is to consider some type of hedged option trade. For example, the January 2014 $60 calls are trading for approximately $32.80. This places a time value on the option of only $1.53 over fifteen months. If you offset the cost by selling an at-the-money call for the same date at $90, you receive a premium of about $12.55, which results in a net cost of $20.25. If this is held to just before expiration it should result in a profit of $975 or 48% as long as the stock remains over $90. The advantage to this type of trade is that it only requires $2000 to execute as opposed to the $9000 that would be required to buy 100 shares of the stock. The disadvantages are that your profit potential is limited to the spread between the strike prices, and that smaller movements downward will quickly erode the investment.

Conclusion

Examining Caterpillar's financial statements shows that the company is in a solid position with respect to debt compared to assets. The company's current P/E ratio is lower than that of many others, and with the projected earnings increases over the next two years there is potential for the share price to increase. It seems that the stock is being held back by economic uncertainty, but the potential does exist to profit on this company if you are able to be patient with it.

Source: The Case For Caterpillar