Caterpillar: Dividend Going Nowhere But Up

| About: Caterpillar Inc. (CAT)

Summary

The heavy machinery manufacturer skipped its annual dividend increase this year.

Not too worry though, Caterpillar has done this twice before and managed its way through the downturns.

Caterpillar has increased its dividend for 23 years. As an S&P 500 component, it's due to become a Dividend Aristocrat at the beginning of 2019.

If you've read my recent review of dividend increases in June or followed the news from Caterpillar, you know that the heavy machinery company passed on increasing its dividend this year. But for investors with a long-term mindset, this is a well-managed dividend growth company with a good future.

Keeping Dividend Growth Investors Happy

Caterpillar (NYSE:CAT) has paid a cash dividend since 1925 and grown dividends since 1993. Although skipping its dividend increase might seem like a bad omen and a signal of trouble at the heavy machinery company, it isn't unprecedented. Caterpillar has skipped the annual dividend increase before - twice, in fact, over the last 15 years.

Across 2002 and 2009 - years when the U.S. and world economies were recovering from significant downturns - the company held the dividend flat and managed its way through the downturn. In both cases, Caterpillar resumed its annual dividend increase the following year. Because the company increases the dividend in the middle of the year, Caterpillar kept its dividend growth streak alive by continuing to show year-over-year growth.

In addition to historical precedence, I believe that there's one other very important reason to assume that the company will resume its annual dividend growth: as a member of the S&P 500, once it completes 25 years of dividend growth it'll become a member of the elite S&P 500 Dividend Aristocrats index. With 23 years of dividend growth under its belt, this puts Caterpillar on track to become a Dividend Aristocrat at the beginning of 2019. To give up on becoming a member of the elite Dividend Aristocrat index less than 3 years away from qualifying as one would require significant problems at the company, not just a routine or even severe downturn.

As you might expect, part of the way Caterpillar manages through earnings downturns is to slow the dividend growth. And just like the company's earnings growth, Caterpillar's dividend increases are cyclical:

Year-over-year dividend growth for Caterpillar stock. Data from Caterpillar investor relations website.

The red markers in the chart above show when Caterpillar skipped its annual dividend increase. (As noted above, the company shows YOY dividend growth due to the mid-year dividend increase.) Given the cyclical nature of the YOY dividend growth and the pattern above, it's likely we're a year or two away from the bottom of the cycle.

Does Skipping the Dividend Increase Mean Outperforming the S&P 500?

An interesting artifact of Caterpillar's cyclical dividend growth is the stock's performance relative to the S&P 500. By comparing the stock's performance to the company's dividend increase, a pattern emerges:

The annual dividend increases and relative outperformance/ underperformance of CAT stock vs. the S&P 500 index, represented by the SPY ETF. Data from stockcharts.com & Caterpillar investor relations website.

(2016 year-to-date performance as of July 20, 2016)

The key conclusion that jumps out is Caterpillar's dramatic outperformance of the S&P 500 in 2003 and 2010 - both years when the company resumed its annual dividend increase after skipping it the prior year. Intuitively, it makes sense that when earnings rebound, allowing the company to resume its annual dividend increases, that the price of the stock should follow. And while the dividend growth trails the earnings growth, the stock performance does not.

While there are no guarantees of similar performance, if the pattern continues CAT is likely to significantly outperform the S&P 500 in 2017. So far in 2016 (as of July 20th), CAT is outperforming the S&P 500 by roughly 12%.

My Strategy

As I write this article, CAT has broken out of a 3 month trading range between roughly $68.50 and $79; if it can hold the breakout, the stock could see a measured move to $89 - $90. However, with the post-Brexit run-up in the market, the stock is showing signs of being overbought.

If the breakout holds, I will look for an entry point in the $79 - 80 range (giving the stock a yield of 3.8%). If it fails however and ends up back into the trading range, I will look to pick up some CAT around $69. At that price, it'll have a really nice yield of 4.5%.

Conclusion

Despite its current troubles, this future Dividend Aristocrat has a bright future and will maintain the dividend growth. At the current yield of 3.9% it would be the 4th highest yielding stock among the group (behind HCP, T and CVX).

In the current low-yield environment, getting this cyclical company towards the bottom of the cycle should reward investors for years to come.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CAT over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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