What Should I Buy After Selling Caterpillar? 2 Strong Candidates

| About: DowDuPont Inc. (DWDP)

Summary

Combined portfolio holdings reviewed.

Understanding stock classification systems.

Diversification and portfolio holdings.

Review of two stocks for addition to Rollover401K portfolio.

In mid-November I discussed my purchase of Ventas (NYSE: VTR) and how I likely overpaid for those initial shares in my 11/18/16 article. The Seeking Alpha community responded with great feedback offering comments that I will not regret the purchase even at the price I paid. Within the comments I mentioned the possibility of selling my long time Caterpillar (NYSE: CAT) holding primarily as my return on CAT had been extremely poor.

CAT was initially purchased in my Rollover401k portfolio in 2011 and dividends were automatically reinvested for (time period). My cost basis was $95.41 per share. On November 23, 2016, I sold my position out for $95.00 per share. I reviewed several articles by Michael Boyd (11/2/16) and Ron Honig (11/15/16). Michael's thesis was that the dividend is safe regardless of the current payout ratio because of the cash flow. His point was cash flow is king and CAT produced over $1B in cash in excess of dividend and its business obligations. Ron focused on the declining earnings per share since 2012 highs and the price per earnings (PE) ratio being about 3 times above historical PE. Since selling, CATs performance has been mediocre. My total return with dividends was a measly 4.5%. The dividend yield at the time of selling was 3.3%.

The first purchase I made was to double down on VTR giving me a cost basis of $63.60, down from my previous $72.11. Currently, I am still underwater with VTR. However, I am much happier with the overall potential as I lowered my book value ratio to 2.1 and the price per funds from operations ((P/FFOS)) to 15.5. Two ratios closer to my criteria.

I have four portfolios that I manage, two of which are a Rollover 401k and a spouse Roth IRA. Multiple comments in my Ventas article indicated that I did not have any utilities in my portfolio. These comments got me thinking about needing to review the sectors included in both portfolios and that I really should be managing the holdings as one combined portfolio. My original thought process was to keep them separate. The current holdings of the portfolios with the sectors are listed in Table 1.

Table 1. Portfolio Holdings

Rollover401k

As of

1/5/17

Symbol

Dividend Yield

Weight

Portfolio Yield

Sector (GICS)

Industry (NYSE:ICB)

Apple (NASDAQ:AAPL)

1.96%

10.39%

0.20%

Technology

Technology

Berkshire Hathaway (NYSE:BRK.B)

0.00%

20.08%

0.00%

Financials

Consumer Services

Chevron (NYSE:CVX)

3.68%

5.05%

0.19%

Energy

Oil and Gas

Intel (NASDAQ:INTC)

2.86%

4.68%

0.13%

Technology

Technology

Johnson & Johnson (NYSE:JNJ)

2.74%

7.64%

0.21%

Healthcare

Healthcare

Coca-Cola (NYSE:KO)

3.35%

5.43%

0.18%

Consumer Staples

Consumer Goods

McDonald's (NYSE:MCD)

3.14%

11.77%

0.37%

Consumer Discretionary

Consumer Services

Proctor & Gamble (NYSE:PG)

3.15%

5.56%

0.18%

Consumer Staples

Consumer Goods

Qualcomm (NASDAQ:QCOM)

3.23%

4.11%

0.13%

Technology

Technology

Suncor Energy (NYSE:SU)

2.57%

2.05%

0.05%

Energy

Oil and Gas

AT&T (NYSE:T)

4.60%

5.80%

0.27%

Telecommunications

Telecommunications

Ventas (NYSE:VTR)

4.91%

3.65%

0.18%

Real Estate

Financials

Wells Fargo (NYSE:WFC)

2.75%

1.49%

0.04%

Financials

Financials

Wal-Mart (NYSE:WMT)

2.89%

1.70%

0.05%

Consumer Staples

Consumer Goods

Exxon Mobile (NYSE:XOM)

3.39%

5.67%

0.19%

Energy

Oil and Gas

Cash

$4020.90

Dividend Yield

2.37%

SpouseRothIRA

Duke Energy (NYSE:DUK)

4.40%

14.28%

0.63%

Utilities

Utilities

International Business Machines (NYSE:IBM)

3.32%

23.83%

0.79%

Technology

Technology

Southern (NYSE:SO)

4.56%

19.43%

0.89%

Utilities

Utilities

AT&T

4.60%

22.89%

1.05%

Telecommunications

Telecommunications

Wells Fargo

2.75%

16.37%

0.45%

Financials

Financials

Cash

$226.59

Dividend Yield

3.81%

Over the years I have discovered that the list of sectors varies between brokerages. These two portfolios are housed in two different brokerages and both appear to have their own classification system. This is somewhat of a frustration to me. In my research I came across the Global Industrial Classification Standard (GICS) providing for 11 sectors, 24 industry groups, 68 industries, and 157 sub-industries. My research also found the Industrial Classification Benchmark (NYSE:ICB):

In 2008, the ICB used a system of 10 industries partitioned into 19 supersectors, which were further divided into 41 sectors, which then contain 114 subsectors. ((Note: These numbers are subject to change.))
Source: Investopedia.

According to Investopedia the ICB has been adopted by stock exchanges globally.

Both of these classification systems offer four groupings, but a closer look indicates an inverse in naming. The GICS uses 11 sectors and ICB uses 10 industries, hence the reason it can be very confusing. Also, ICB rates over 70,000 companies, almost twice as many as the GICS.

So, to clear this up the GICS is used by the S&P 500 and the Dow Jones Industrial Averages indices. The stock exchanges that list those companies, such as the New York Stock Exchange (NYSE) and NASDAQ, use the ICB. To the best of my research I included both classifications in the table.

Diversification

One of my lesser qualities in constructing portfolios is my lack of attention to diversification. It is years like this that contributes to my minimal devotion as I achieved an unrealized gain of 17.9% in the Rollover401k portfolio compared to the S&P 500 11.96% total return.

William Bernstein's "The Intelligent Asset Allocator" was my first real introduction to asset allocation or diversification. Mr. Bernstein introduced me to the 'efficient frontier', mean-variance, standard deviation, and risk. He breakdowns diversification between stocks and bonds, then by domestic and international, and finally by the types of stocks and bonds.

A case can be made that bonds can be eliminated from your portfolio or at least if bonds are going to be considered, one should start with their estimated social security income as this is a fixed annuity. The challenge with this is estimating the value in an effort to determine the percent contribution to the portfolio. For both of the portfolios, I plan to ignore the inclusion of bonds or fixed income securities and focus on stocks.

I believe a good place to start with building a diversified stock portfolio is to focus on sectors GICS and industry ICB. A quick review of the two portfolios reveals that I have two sectors missing, industrials and materials and two industries, basic materials and industrials. When looking at what I should be adding to the portfolio, it seems logical to start with stocks falling into either of these two sectors and industries. The other consideration to diversification would be the weightings given to the various sectors or industries, but for now, I am electing to ignore this consideration.

Industrials Sector

Obviously I need to look at possible stocks in the industrials sector and industry classifications since CAT was my only holding representing these classifications.

I reviewed the S&P 500 holdings based on the GICS and found 69 companies with the industrial classification. Of the 30 Dow Jones Industrials there were 5 companies. I then ran a basic screen on the combined holdings with the following criteria 5-year earnings growth of <25%, PE <20, and dividend yield <5%. This produced 11 holdings as presented in Table 2 sorted by PE.

Table 2. Industrials Screen

Symbol

Name

EPS Growth (Last 5 Years)

P/E Ratio (TTM, GAAP)

Dividend Yield

Pitney Bowes Inc. (NYSE:PBI)

Pitney Bowes Inc.

5.02%

11.5897

4.79%

Ryder System, Inc. (NYSE:R)

Ryder System, Inc.

19.33%

13.5998

2.38%

Ingersoll-Rand PLC (NYSE:IR)

Ingersoll-Rand PLC

2.85%

13.885

2.04%

Eaton Corporation (NYSE:ETN)

Eaton Corporation

9.14%

15.9469

3.37%

Rockwell Collins (NYSE:COL)

Rockwell Collins

6.91%

16.1884

1.48%

General Dynamics (NYSE:GD)

General Dynamics

5.88%

18.4072

1.71%

Honeywell International (NYSE:HON)

Honeywell International

19.40%

18.4242

2.26%

Kansas City Southern (NYSE:KSU)

Kansas City Southern

3.48%

18.7397

1.56%

Snap-on (NYSE:SNA)

Snap-on

20.46%

19.5123

1.62%

Raytheon Company (NYSE:RTN)

Raytheon Company

7.12%

19.7312

1.99%

Northrop Grumman (NYSE:NOC)

Northrop Grumman

10.12%

19.8266

1.55%

Source: TD Ameritrade

There were 5 stocks that stood out PBI, ETN, R, HON, and IR. Further research into PBI revealed the dividend had been cut in the last 3 years. A look at ETN, R, HON, and IR showed some promise.

Materials Sector

There are 25 stock holdings in the S&P 500 index with one crossover in the Dow Jones Industrials index. I modified my screen on the first pass to 5-year earnings growth of <100%, PE <50, and dividend yield <5%. This produced a list of 13 stocks as shown in Table 3.

Table 3. Materials Screen

Symbol

Name

EPS Growth (Last 5 Years)

P/E Ratio (TTM, GAAP)

Dividend Yield

Dow Chemical Co (NYSE:DOW)

Dow Chemical Co

27.82%

9.2622

3.21%

Eastman Chemical Co (NYSE:EMN)

Eastman Chemical Co

0.11%

13.1236

2.68%

Air Products & Chemical Co (NYSE:APD)

Air Products & Chemical Co

5.89%

20.8755

2.36%

Avery Dennison Corp (NYSE:AVY)

Avery Dennison Corp

5.46%

20.968

2.26%

Sealed Air Corp (NYSE:SEE)

Sealed Air Corp

2.29%

21.779

1.33%

Praxair, Inc. (NYSE:PX)

Praxair, Inc.

6.88%

21.9962

2.58%

International Flavors & Flagrance (NYSE:IFF)

International Flavors & Flagrance

9.64%

23.3415

2.18%

Sherwin-Williams Co (NYSE:SHW)

Sherwin-Williams Co

21.54%

23.7231

1.19%

International Paper Co (NYSE:IP)

International Paper Co

6.98%

25.1608

3.51%

PPG Industries, Inc (NYSE:PPG)

PPG Industries, Inc

17.25%

32.7785

1.64%

Ecolab Inc. (NYSE:ECL)

Ecolab Inc.

8.30%

32.9315

1.25%

Martin Marietta Materials (NYSE:MLM)

Martin Marietta Materials

15.31%

35.5042

0.74%

Nucor Corporation (NYSE:NUE)

Nucor Corporation

21.59%

37.6766

2.51%

Source: TD Ameritrade

A quick look at this list presented only 2 stocks of interest to me, DOW and EMN based primarily on their PE and dividend yield.

Potential Stock Additions

After performing the stock screens I have narrowed the list down to 6 potential stocks, 4 Industrials (ETN, R, HON, and IR) and 2 Materials (DOW and EMN). These are based on having a PE of <20. Since CAT had a dividend yield of 3.3% at the time I sold, my next review was to see which ones come close to this yield. This lead me to ETN ((3.37%)) and DOW ((3.21%)).

Eaton Corporation

The Eaton Corporation is a power management company headquartered in Dublin, Ireland. Eaton provides energy-efficient solutions that help their customers effectively manage electrical, hydraulic and mechanical power more efficiently, safely and sustainably. The company operates worldwide (175 countries) in four segments Electrical Products and Electrical Systems and Services, Hydraulics, Aerospace and Vehicle. The economic moat of ETN contributes to the company's continued success.

The company is lead by CEO and Chairman Craig Arnold.

As a global power management company, we help our customers solve their greatest power challenges through our industry leading electrical, aerospace, hydraulic and vehicle businesses. We are dedicated to manufacturing excellence and to providing innovative products that make our customers more successful.
We transfer knowledge, learnings and successes through the Eaton Business System, a standard system of processes and procedures that drives consistent execution across all our businesses and regions of the world. This integrated operating focus allows us to deliver strong, consistent results to our shareholders.
Source: Eaton Corporation - Our Company - About Us

Mr. Arnold became the CEO as of June 2016. He joined Eaton back in 2000 serving in lead roles for the Hydraulics Group and Industrials Sector before becoming the President and Chief Operating Officer in September 2015.

I like to take a look at analyst research reports. I have listed multiple reports and a synopsis of their recommendations in Table 3.

Table 3. Analyst Research

Analyst Research Report

Recommendation

Smart Consensus

Buy

Thomson Reuters

Positive

S&P Capital IQ

Hold

Market Edge

Long

Ford Equity Research

Buy

TheStreet

Buy

Jaywalk Consensus

Hold

Research Team

Hold

Credit Suisse

Outperform

The Market Edge is a combined look at the Smart Consensus, Thomson Reuters, and S&P Capital IQ reports. The Research Team reports on the combination of S&P Capital IQ, Ford Equity Research, Jaywalk Consensus, Market Edge, and The Street reports. The one takeaway from the reports is the lack of a sold or reduce recommendation.

I do have some reservations given S&P Capital IQ provides a hold recommendation. Their main rationale is their belief that ETN is fairly valued at $63 and that global markets will remain challenging with minimal improvement. They expect ETN to use excess cash for share

repurchases, dividend hikes, and opportunistic acquisitions. One of the main reason I like the S&P Capital IQ report is it contains 10 year values for some key financials.

The dividend has grown at a compound annual growth rate (CAGR) of 11.5% while earnings per share have only grown by a 2.2% CAGR. This is also reflected in the dividend payout ratio which was 52% at the end of 2015 and was only 24% in 2006 for an 8.0% CAGR. ETN's cash flow has also grown by 3.5% CAGR.

The high PE ratio ranged from 13 to 30 with an average of 18.1. The low PE averaged 11.1 and ranged from 6 to 15. S&P Capital IQ estimates 2016 earnings to be $4.20 and 2017 earnings of $4.50. Using the 11.1 and 18.1 PEs and the 2016 earnings of $4.20 provides a valuation range of $46.62 to $76.02. A $61.32 price would provide a 14.6 PE. Sticking with the 14.6 PE and using the 2017 earnings of $4.50 equates to a price of $65.70. It would seem that any purchase of ETN should be purchased at a price below $65.70. This would also provide a dividend yield of 3.47%.

DOW Chemical Company

The Dow Chemical Company is the largest U.S. chemical manufacturer and operates five different segments, Consumer Solutions, Infrastructure Solutions, Performance Materials & Chemicals, Performance Plastics, and Agricultural Sciences. Like ETN, DOW has a significant economic moat as a global leader in chemical products, such as, chlorine, ethylene oxide, polyethylene plastics and coatings materials.

Back in December 2015, DOW agreed to merge with DuPont forming a new publicly traded entity DowDuPont. This merger is expected to close around mid-year 2017. DOW shareholders will be granted 1.0 share in the new DowDuPont company. What makes this merger unique is the announcing of breaking the combined company into three separate companies, Agricultural Company, Material Company, and Specialty Products Company. The breakup is expected to occur 18 months after the formed merger. I did not go searching extensively for the anticipated share breakdown for the combined company shareholders once the breakup is finalized.

Once the DowDuPont is formed, DOW chairman and Chief Executive Officer (NYSE:CEO), Andrew Liveris, will be the Executive Chairman. The newly formed DowDuPont will have a new board of directors comprised of 8 DOW board directors and 8 DuPont board directors.

Some might be afraid to invest in DOW at this time given the pending merger and the unknown shareholder transaction in the eventual breakup of DowDuPont. As a Dividend Growth Investor ((NYSE:DGI)), an investment in DOW really does not make the best sense as a DGI's primary objective is growing dividends. If a DGI does make an investment, it should be stringently monitored to ensure the dividend does continue to grow.

Table 4 lists out the analyst research recommendations.

Table 4. Analyst Research

Analyst Research Report

Recommendation

Smart Consensus

Buy

Thomson Reuters

Buy

S&P Capital IQ

Buy

Market Edge

Long

Ford Equity Research

Buy

The Street

Buy

Jaywalk Consensus

Buy

Research Team

Accumulate

Credit Suisse

Outperform

The surprise here is that the analyst research reports are all positive as of January 29, 2017, even despite the merger. My review of the research reports indicates that analysts believe the combined merger will result in operational synergies that will reduce expenses and improve profits.

Using the S&P Capital IQ report earnings per share have only grown over the last 10-years by a mere 1.6% CAGR and cash flow has seen negative growth during this same period. The dividend has a 10-year CAGR of 1.2%, a little below earnings per share CAGR. The dividend payout ratio in 2016 was 52% and back in 2007 it was 55%. It is worth noting that over the last 10 years, DOW has cut their dividend in 2009 and 2013 and froze it in 2010. Over the last 4 years, DOW has produced a 9.5% dividend CAGR.

The high PE ratio ranged from 9 to 70 with an average of 26.2. The low PE averaged 15.9 and ranged from 6 to 39. S&P Capital IQ estimates 2017 earnings to be $3.99 and 2018 earnings of $4.26. Using the 15.9 and 26.2 PEs and the 2017 earnings of $3.99 provides a valuation range of $63.44 to $104.54. A $61.31 price as of January 27, 2017, would provide a 17.4 PE based on 2016 earnings per share of $3.52. Sticking with the 17.4 PE and using the 2017 earnings of $3.99 equates to a price of $69.50. It would seem that any purchase of DOW should be purchased at a price below $69.50. This would also provide a dividend yield of 2.65%, which is definitely below the 3.3% replacement dividend yield I was looking for.

Which stock(s) would you choose?

If I am looking at just the analyst research, my choice between ETN and DOW would simply be DOW. When I examine the numbers between the two stocks, my preference would be for ETN.

I would like to hear from the SA community what they would look to purchase at this time. I also realize that retaining cash for future purchases is a viable option as is the possibility of initiating small positions in both stocks. This latter position would also allow me to improve sector diversification.

Feel free to comment and I will do my best to respond, but responses will likely be in the late evenings.

Disclosure: I am/we are long AAPL, BRK.B, CVX, INTC, JNJ, KO, MCD, PG, QCOM, SU, T, VTR, WFC, WMT, XOM, DUK, IBM, SO.

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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