Jim Simons and Ray Dalio Love Caterpillar, Should You Invest?

Caterpillar Inc (NYSE:CAT) has been a shoddy stock to hold since the start of 2012, returning -5.7%. In a time where the world’s largest manufacturer of heavy construction machinery is generally thought of as a good investment, its poor performance year-to-date probably comes at a surprise to most. Some of the world’s most prominent money managers likely agree, as heavyweights like Ken Fisher, Jim Simons, Steven Cohen, and Ray Dalio hold a collective stake in the company in excess of $600 million. Sentiment amongst these fund managers was mixed at the end of last quarter, with Fisher (-3%) decreasing his position, and Simons (+212%), Cohen (+561%), and Dalio (+103%) adding to theirs.

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More intriguingly, the company has seen a mixture of insider buys and sales over the past few months; here’s a full look at the insider trading activity at Caterpillar.

Currently priced in the $85 range, the question remains: what are individual investors to do with the stock at the moment? It seems that even Wall Street cannot agree, with prominent analysts at Barclays reiterating an “overweight” rating with a price target of $118 late last month, on the heels of Longbow’s downgrade of the stock to “neutral”  just a couple months earlier. Let’s take a look at the company’s growth prospects and valuation to determine if there’s a strategy that perplexed investors can use.

Since the recession, Caterpillar has been a splendid member of any portfolio, generating a three-year appreciation of 64.6%, far above the farm and construction equipment industry’s average (24.0%). With regard to its closest peer, this return looks middle-of-the-road though, as Deere & Co (NYSE:DE) has outperformed the stock by close to 30 percentage points over this time. Additionally, competitors like CNH Global NV (NYSE:CNH) and Terex Corporation (NYSE:TEX) have given investors an appreciation in excess of 75% over this time frame.

From a revenue standpoint, Caterpillar has been above-average quite significantly, as it has grown its top line at an average rate of 5.4% a year since 2009. As can probably be expected, this is more than five times that of the industry average, and larger than Deere, CNH, Terex, and AGCO Corporation (NYSE:AGCO). Of these competitors, Deere is the closest, having averaged 4% revenue growth over the past three years, while Terex’s top line has shrunk by 8.1% a year over this time. While it has focused extensively on international markets, a rebound in its North American sales has been a primary driver for this growth.

Caterpillar has been unable to translate these superior revenues – which surpassed $60 billion last year – into overly-impressive earnings. The company has averaged EPS growth a shave under 10% a year post-recession, far below the industry average (17.3%) and that of Deere (12.2%). Part of this blame can be placed on Caterpillar’s margins – operating and net of 13.1% and 9.0% respectively – which are middling at best. Now, some of this margin compression can be attributed to the company’s acquisitions over the past few years, which include: mining equipment manufacturer Bucyrus International, various engine facilities in Brazil, China and India,  fire and explosion prevention company Pyroban Group, and locomotive engine maker Electro-Motive Diesel.

Partially a result of improving economic times and further integration of its aforementioned acquisitions, early estimates predict that Caterpillar will experience much more impressive earnings growth over the next half-decade, to the tune of 14% a year. This five-year expected EPS growth trumps the likes of Deere (8.9%), Terex (8.0%), and AGCO (11.0%). Only CNH, at 14.7%, is expecting better bottom line expansion.

In the shorter term, the Street is predicting that Caterpillar finishes the current quarter (Q3) with an EPS of $2.26, up 17.1% from last year’s third quarter total of $1.93. The company is currently on a four-quarter positive surprise streak, last missing analysts’ estimates in the second quarter of 2011. While it remains to be seen how Caterpillar’s results will fare when it releases them later this month, it’s worth mentioning that its expected YOY growth is larger than the current quarter estimates of Deere (+15.4%), AGCO (+16.1%), and CNH (+3.5%). Only Terex (+66.7%) has a higher expected YOY growth, with present estimates averaging $0.50 a share.

All of this talk of growth would be null and void if we didn’t mention Caterpillar’s valuation, which is surprisingly cheap. Keeping forward-looking estimates in mind, its shares trade at a PEG ratio of 0.68; typically any figure below 1.0 signals an undervaluation. More importantly, this is below its peer average quite significantly, at more than a 40% discount. Caterpillar shows similar, slightly less pronounced, discounts when looking at traditional metrics like trailing and forward P/Es. The company also sits on over $1 billion in free cash at the moment, which is more than Deere (-1.3B), Terex (174M), AGCO (97M), and CNH (-383M) combined. Likewise, it trades at 10 times its cash flow, which is more than 30% below the industry’s average P/CF multiple.

To recap: Caterpillar has seen mixed sentiment in the hedge funds and insiders we track, as well as analysts on Wall Street. The company has generated less than stellar EPS growth over the past few years, though we believe that this looks set to improve quite significantly over the next five or so years. Valuation metrics show that investors have yet to appreciate Caterpillar’s full growth prospects, especially from an earnings and cash flow standpoint. These are likely the key reasons why famed fund managers like Fisher, Simons, and Dalio hold large positions in the company. For a complete look at the sentiment surrounding Caterpillar, continue reading here.

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