It’s Looking Like There’s More Juice in the Rally For Caterpillar Stock

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Even amid economic headwinds, Caterpillar (NYSE:CAT) stock has shown strong resilience. On one hand, the probability of recession as predicted by Treasury spreads is at 30%. On the other hand, CAT stock has moved higher by 27% in the last three months. I remain bullish on Caterpillar stock with a view that the concerns are largely discounted in the valuations.

It's Looking Like There's More Juice in the Rally For Caterpillar Stock

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Speaking of valuations, analysts are forecasting mean earnings per share of $10.81 for Caterpillar in 2020. At a current stock price of $148, CAT stock is trading at a forward price earnings ratio of 13.5. With the S&P 500 index trading at a PE ratio of 23.1, Caterpillar stock does seem inexpensive.

Economic Recovery Likely in 2020

Another factor that has kept sentiments bullish for CAT stock is expansionary monetary policy pursued by the Federal Reserve. As easy money flows into the economic system, growth is likely to be supported.

As a matter of fact, the International Monetary Fund expects advanced economies to grow at 1.7% in 2019 as well as in 2020. However, IMF expects emerging economies growth to accelerate to 4.6% in 2020 from 3.9% in 2019. Since this is an October 2019 forecast, it discounts all the factors related to trade war. The key point is that the downturn might not be as bad as its being feared.

In particular, if the United States and China gradually move toward trade war resolution, stocks in the industrial sector stand to benefit. Therefore, the worst might already be discounted in the stock even as Caterpillar faces sluggish sales.

My point is underscored by the fact that Caterpillar was downgraded to hold by Morgan Stanley analyst Courtney Yakavonis in Oct. 18. However, the stock has moved higher by 11.5% since the downgrade. CAT stock is refusing to go lower with valuations already at attractive levels.

The trend in few other cyclical stocks also indicates that the worst might be over in terms of discounting the downturn. Freeport-McMoRan (NYSE:FCX) has been trending higher in recent weeks with the company expecting higher copper prices.

Overall, the economic downturn fears have translated into attractive valuations and present a buying opportunity.

Credit Health Remains Strong

Even as Caterpillar faces economic headwinds and slowdown in sales, the company’s credit health remains strong. I believe its one of the key reasons for CAT stock remaining resilient.

As of September 2019, Caterpillar reported cash & equivalents of $7.9 billion. Importantly, the company’s operating cash flow for the first nine months of 2019 was $4.5 billion. This implies an annualized cash flow of $6.0 billion.

Caterpillar is therefore positioned to generate free cash flows, maintain dividends and potentially accelerate share repurchase even in a downturn.

Further, with an annual dividend of $4.12; it makes sense to remain invested in the stock even if it remains sideways. With CAT having a strong credit profile a dividend yield of 2.85% is better as compared to holding Treasuries or cash for a one year period.

Overall, Caterpillar has no concerns from a balance sheet or debt servicing perspective. Instead, shareholder value creation will continue through dividends and repurchases. As a matter of fact, Caterpillar didn’t cut dividends even during the financial crisis of 2008-09.

Final Views on CAT Stock

If we look at the monthly retail sales statistics for 2019, resources and construction industry sales have been strong in North America. However, Asia/Pacific has effected sales growth. In addition, with a decline in oil & gas prices, the energy sector sales have suffered.

With the global economy in a manufacturing sector recession, there is no doubt that sales will remain weak. However, CAT stock seems to have discounted the concerns. In addition, the company does not have any balance sheet stress and dividend growth might continue in 2020.

I will be slightly cautious since the stock has trended higher by 27% in three months. However, investors can continue to hold the stock and any correction on profit booking is an opportunity to accumulate.

It is worth noting that out of 28 analysts, 14 analysts recommend hold on Caterpillar stock with six analysts giving it a buy rating. Therefore, the sentiments are positive and CAT stock should move in-line with this view.

As of this writing, Faisal Humayun did not hold a position in any of the aforementioned securities.

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