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Become A Cat Lover

|Includes: Caterpillar Inc. (CAT)

Paul Price is SELLING one CAT Jan. 2014 $100 Put in the Market Shadows Virtual Put Selling Portfolio.

Featured in: MarketShadows February 24 2013 Newsletter: Not Done Rising, But Night Will Come

Become a Cat Lover

By Paul Price

The world's largest producer of earthmoving equipment has dropped dramatically since early 2012 as fears of a global economic slowdown have taken hold. Caterpillar (CAT, $91.45) topped out at $116.95 less than a year ago and was $99.70 as recently as February 1, 2013. The stock was trading for $91.45 at 3:15 pm EST on Friday.

The three best buying opportunities of the past 26 months all came at P/E multiples and yields very similar to those now. Prior selloffs were associated with similar a negative psychological environment as present today.

The riskiest times came from buying Caterpillar when all the news was positive. At those junctures, CAT sported higher P/Es and lower yields than now (see chart). Apple (NASDAQ:AAPL) was a similar story last fall. Traders were fearless going into AAPL above $700 last September, yet hesitate to plunge in today at around $445.

CAT is rated A+ for financial strength and has outperformed 90% of Value Line's 1700 stock research universe over the long haul. Investors have been well-rewarded for taking on CAT's high beta (@ 1.35) and its inherent lack of near-term predictability in earnings.

With CAT trading for $91.45, it offers a very sustainable 2.27% yield at only a 22.2% payout ratio based on the already reported, trailing 12-month earnings of $9.36. Dividend grew 197% since 2002. The annual rate climbed from $0.70 to $2.08.

Even though CAT's earnings may dip in 2013, the 13% drop in profits expected by Zacks would still put CAT at just 11.1x its already reduced forward estimate. That is far from a scary valuation.

Morningstar sees fair value as $106 or about 16% above Friday afternoon's price of $91.45. Standard & Poors takes a slightly more positive view with its 12-month target price of $117.

Caterpillar offers solid upside through outright purchase. Selling one January 2014 $100 Put is a conservative way to play CAT's upside.

Here's what the math looks like for writers (sellers) of a January 2014 $100 Put contract at current quotes.

If we sell one Jan. 2014 $100 Put for $14.60 now, and CAT is trading below $100 at expiration, then 100 shares of CAT will be "put" to us at expiration - i.e., we will buy 100 shares for $100 on Jan. 18, 2014.

Our net cost (break-even) will be $85.40/share because we keep the $14.60 premium for selling the Put. The $14.60 offsets the $100 share price we pay if CAT is trading below $100. Thus, as long as CAT is above $85.40 at expiration, we have broken even (CAT at $85.40) or achieved a profit (CAT above $85.40).

If CAT rises to $100 or above by Jan. 18, 2014:

  • Jan. 2014 $100 strike-price put expires worthless
  • We keep $1,460 as pure profit (the put contract is $14.60 per 100 shares - a contract is for 100 shares)
  • Our obligation to buy CAT below $100 disappears

This best-case scenario will occur on any move up of $8.55 or greater (+ 9.35% from the trade inception price of $91.45).

If CAT remains below $100 on Jan. 18, 2014:

  • Jan. 2014 $100 put is exercised by the buyer
  • We will be forced to buy 100 shares of CAT per put contract sold for $100/share
  • We will need to lay out $10,000 in cash per put contract
  • Our final position will be 100 CAT at a net cost of $8,540 - i.e. we owe $10,000 for 100 shares, but that is offset by the $1,460 we collected for selling the put.

The worst-case scenario purchase price of $85.40 per share is 6.6% below the trade inception price. It's closer to the 52-week low of $78.25 than to CAT's yearly peak of $116.95. The effective yield would be 2.44% based on the current payout level. Our P/E would be reduced to just 9.12x the actual 2012 reported EPS.

We are going to SELL one CAT Jan. 18, 2014 put @ $14.60 /share to our Virtual Put selling portfolio today, Feb. 22, 2013.

Disclosure: Long CAT shares at the time of publication.