Big Machinery Gears Up
These companies would not have recovered so briskly had they been relying solely on the U.S. market.
Still reeling from a terrible recession, the U.S. jobless rate is at a painfully high 9.8%, with housing starts near a record low and commercial construction languishing. But shares of a Peoria, Ill.-based maker of heavy equipment -- the stuff used to build roads and apartment buildings and to mine copper -- recently registered their highest closing ever. What gives?
The spectacular recovery of Caterpillar (symbol CAT) offers four important lessons for investors: First, share prices are based not on the here-and-now but on expectations of future profits. Second, although the U.S. is the largest market in the world, it no longer drives the global economy. Third, in recessions, the strong get stronger. Fourth, if you love a stock that's on the mat, you should ignore the doomsayers and buy it cheap.
Rocky ride. Caterpillar, the world's largest manufacturer of construction equipment as well as diesel and natural-gas engines, has always been a great buy-and-hold stock for investors with the courage of their convictions. The ups and downs of the economy drastically affect Caterpillar's earnings. The stock has a history of sharp declines, then strong recoveries, with an overall upward march. At the start of 1990, the stock, adjusted for splits, was trading at about $7 a share. Within ten years, it was over $20, and in 2008, it peaked at $86, giving long-term shareholders what Peter Lynch, the former manager of Fidelity Magellan Fund, would call a 12-bagger.
Caterpillar reported record sales of $51 billion in 2008. The next year, they skidded to $32 billion. By March 2009, the stock had dropped to $22 -- a decline of about three-fourths from its high. Still, even in the depths of the financial crisis, there were signs that Cat would come back strong. The company remained in the black, and it generated impressive cash flow (earnings plus depreciation and other noncash charges). The balance sheet was solid, with cash actually rising in 2009. And Cat continued to raise its dividend, as it has each year since 1993.
In the spring and summer of 2009, it was becoming clear to investors that the setback was only temporary and that Caterpillar's layoffs were making it a more productive firm. Investors began to focus on the profits that the company would likely earn in the future, and they began to buy the stock with gusto. In early December, the stock closed at an all-time high of $89 (all prices and related data are as of December 3).
With revenues and earnings recovering sharply, Cat announced in November its plans to buy Bucyrus International (BUCY), a large mining-equipment manufacturer, for $7.6 billion. The purchase will allow Caterpillar to expand its mining offerings and will provide more balance for the company's product line, with diversification away from the tractors, graders and bulldozers that have been its staples. Cat is paying a hefty premium for Bucyrus -- $92 a share, or about one-third more than the market price before the deal was announced. And speaking of spectacular comebacks: In March 2009, Bucyrus traded for less than 11 bucks a share.
Evidence of the severity of the recession is that Cat and Bucyrus are hardly outliers; the stocks of other makers of industrial equipment were also crushed. Cummins (CMI), the engine manufacturer, fell by more than half from early August to early October of 2008. Deere (DE), the world's largest maker of farm equipment, did even worse. Both have rallied strongly and are back near all-time highs. (Stocks in boldface are the ones I recommend; more on Deere below.)
It's safe to say that these companies would not have recovered so briskly had they been relying solely, or even predominantly, on the U.S. market. While more than half of Caterpillar's 93,000-plus employees are in the U.S., two-thirds of its sales come from abroad. As 2010 was ending, demand was strongest in Latin America and Asia, and in November Cat announced the opening of a $300-million large-engine plant in Tianjin, China, as well as a bond issue in Hong Kong in Chinese currency.
In an enthusiastic analysis in the Value Line Investment Survey, David Reimer notes that at the peak of the last business cycle, Caterpillar suffered from constrained capacity. "This time around," he writes, "the company is being more proactive." It's expanding manufacturing not only in China but also in India (mining trucks) and Brazil (backhoe loaders). And, in addition to Bucyrus, Cat recently bought Electro-Motive Diesel, a producer of diesel-electric locomotive engines.
Cat's confidence in the global economy is reassuring, and its extensive capital investments will certainly be rewarded if the economies of China and India grow about 9% in 2011, as expected. But I worry that Caterpillar's stock price -- like that of Deere and Cummins -- depends on the opposite of a perfect storm. Let's call it perfect sunshine.
The stocks of Cat and the others have benefited from current growth in emerging markets, prospective growth in developed markets, and the cost cutting and productivity boosting that always accompany recessions. But has perfect sunshine been so thoroughly built into Cat's stock that the thinnest cloud would lead to a serious decline?
Figure it this way: Caterpillar was expected to have earned about $4 a share in 2010. At $89, the price-earnings ratio is 23. If 2011 brings earnings of $5.72 (the average of analysts' estimates), then the P/E would be 16 (Cat has never earned more than $5.32 per share in a single year). For a cyclical company, that's not too expensive, but it's certainly not cheap.
On the other hand, Cat's sector may be in a sweet spot. It's helped by swift advances in technology for machines such as earthmovers and construction equipment, by huge demand for minerals, and by a desire for ever more environmentally friendly power generation. Even at a lofty price, Caterpillar is a solid choice for investors who are happy to collect a 2.0% dividend yield at a time when five-year Treasuries are yielding 1.6% and who plan to buy more shares when Cat's price takes an inevitable dip.
Better priced right now are companies that are in the same business but haven't bounced back as much. Consider Terex (TEX), a maker of cranes, aerial platforms and construction equipment. The stock fell from a high of $97 in 2007 to a low of $9 in 2009. It's come back, to be sure, but at $27 it's far below the record. Terex, with a market capitalization of $3.0 billion, is one-twentieth the size of Caterpillar. It suffered losses in 2009 and 2010, it doesn't pay a dividend, and its business is concentrated in developed nations: Two-thirds of sales are in Europe and the U.S. But Terex also had $1.8 billion in cash at last count, and it has excellent prospects in developing markets. Terex has room to grow, and you buy it on the chance that it will.
A similar choice is Manitowoc (MTW), a Wisconsin maker of cranes and excavators, with a market cap of $1.6 billion. At $12, it's priced at 76% below its 2008 peak. Again, finances aren't the best, but cash flow remains strong. If the company can regain its record 2007 earnings level, then, at today's price, it's trading at a P/E of 4 (!).
I am also enamored of Deere, a class act with only 42% of its sales abroad -- again, indicating room to grow in emerging markets. The stock, at $78, trades at 15 times estimated year-ahead earnings, and it yields 1.5%. Also attractive is AGCO (AGCO), a company based in Duluth, Ga., that makes tractors and other farm machinery, with 78% of its sales outside the U.S. and a large footprint in Latin America. At $46, it trades at 16 times estimated 2011 earnings and is well below its 2008 high of $72. Analysts expect earnings to grow at a healthy annual pace of 14% over the next three to five years.
Oh, there's a fifth lesson to be learned from Caterpillar and its rivals: When it comes to manufacturing high-end business equipment, never count out U.S. companies.
James K. Glassman is executive director of the George W. Bush Institute in Dallas. His new book, Safety Net, will be published this month by Crown.