Is Caterpillar A Bargain After Its Recent Plunge?

Caterpillar (CAT), a leading construction stock, has significantly underperformed the market since it peaked, in early October. During this period, the stock has plunged 24% whereas the S&P has lost 11%. As the company is on track to post record earnings this year, it is only natural to wonder whether the stock has become a bargain.

Caterpillar is the leading global manufacturer of construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives. The company is exhibiting strong performance in all its segments this year, with the strongest trends observed in the construction segment in North America and China and the onshore oil and gas activity in North America.

In the third quarter, Caterpillar grew its revenues by 18% over last year and thus posted the highest third-quarter earnings per share in its history. Despite increased material costs due to the recent tariffs and higher freight costs, the industrial manufacturer greatly increased its sales volume and thus offset the effect of these headwinds. In addition, its order rates and its backlog remain elevated while its management reaffirmed its guidance for record adjusted earnings per share for the full year, between $11.00 and $12.00.

Risks

As Caterpillar is trading at approximately 10 times this year’s earnings per share, its valuation seems quite cheap. However, investors should note that this is a highly cyclical stock, which is very sensitive to the underlying global economic growth. Consequently, its results can be markedly volatile. To provide a perspective, its earnings per share plunged 75% during the Great Recession and 46% in the recent downturn of the oil market.

Since early October, the price of oil has plunged almost 40%, from $75 to $46. This is a negative trend for the company, as it adversely affects many of its customers, namely the oil producers. However, we believe that the current level of the oil price is unsustainable in the long run. Moreover, shale oil producers have proved remarkably resilient, even at oil prices around the current level. The U.S. oil production has reached new all-time highs this year and is expected by EIA to climb to new record levels, around 12.0 M barrels per day, in 2019. Therefore, we do not expect material setbacks in this segment of Caterpillar for the foreseeable future.

On the other hand, S&P has fallen 18% in the last three months and thus it is on the brink of ending an almost decade-long bull market, the longest in history. The recent plunge has resulted from the aggressive stance of Fed, which has been raising interest rates aggressively. Higher Interest rates tend to suppress the total amount invested in the economy and hence they are likely to cause a recession at some point in the future. The recent sell-off indicates that the market now sees an increased chance of a recession at some point in the next two years.

While Caterpillar is trading at a markedly low price-to-earnings ratio, investors should note the increased risk facing the stock. As the market is on the verge of entering a bear market phase, the negative market sentiment is likely to continue to weigh on cyclical stocks for a considerable period. This means that the stock price of Caterpillar will probably remain under pressure for the foreseeable future and hence those who believe in the long-term prospects of the stock will be given the chance to initiate a position at a much lower entry point.

Final thoughts

Caterpillar is firing on all cylinders right now and thus it is on track to post record earnings this year. However, it is a highly cyclical stock and thus it is highly vulnerable to recessions. As the market seems to be poised to enter a painful bear market phase, Caterpillar is likely to remain under pressure for a great part of next year. Therefore, the stock is not a bargain yet and hence we advise investors to wait for a lower entry point.