Why CAT’s 20% drop could be a value trap

August 3, 2018

Why CAT’s 20% drop could be a value trap

When you put a big part of your investing focus on bargains, emphasizing value-based fundamental analysis to determine whether a stock is worth your time and money, you inevitably end up filtering through a lot of different stocks, but cast most aside. I think that is useful, because being more selective helps you narrow the universe of stocks you’re paying attention to at any given time. The problem, however is that sometimes the metrics a value investor learns to rely on can give you a false sense of whether a stock really fits a good description of a good value. That can lead you to make an investment in a stock that might be down from a recent high because it looks like it’s available now at an attractive price compared to where it was; but in reality it’s a bit like trying to catch a falling knife – the only real way to avoid getting cut is to get out of the way and let the knife fall to the floor. These kinds of situations are also called value traps, because they provide numbers that lure less careful investors in and motivate them to make an investment at some of the most dangerous times possible.

I think Caterpillar Inc. (CAT) is actually one of those traps right now. My opinion differs from most other analysts and “experts” out there, who point to the company’s solid earnings growth over the last year, and the stock’s decline in price since January of this year of more than 20% as reasons that investors should be treating the stock as a great value opportunity right now. They’ll also point to a popular valuation metric, a stock’s P/E ratio, as a clear indication that the stock is undervalued and something you should be paying attention to right now. I’ll admit that at first blush, I thought the stock might be a good opportunity, too; but the more I drilled down to really look at some of the other data points that are important to me, the more concerned I got.

Another risk element that investors seem to be trying to shrug aside right now when it comes to stocks like CAT is the fact that while the U.S. seems to have found some sense of resolution – or at least a path to it – in trade with the European Union, the same can’t be said of discussions with China. Today, on top of existing tariffs that already amount to more than $34 billion against its single largest trading partner, President Trump proposed another $200 billion in new tariffs, prompting what seems like the customary Chinese response to retaliate in kind. The market’s reaction was pretty ho-hum; could it mean the investors are beginning to accept trade tension as a normal state of affairs? If they are, then I think it means they are becoming desensitized to that risk, and that is a troubling indication all by itself.

Multinational stocks, and especially those with major operations in China, remain at risk if trade tensions continue as they are, or escalate even further. And let’s not forget that while the E.U. have, for now at least, agreed to hold off on further tariffs against each other and work toward compromise, it doesn’t mean that situation has been resolved. CAT is one of the companies that I think could be the most dramatically affected. That affect may not be showing up in earnings reports or sales numbers yet; but the risk that it will increases more and more with every week, month, and quarter that continues with trade affairs as they are. To my way of thinking, that puts something of a jaundiced eye on any currently glowing numbers. Just about every analyst report I’ve been able to find on CAT forecasts stable to growing revenues along with continued earnings growth for the foreseeable future, and under most circumstances I think that should be a good thing; but the thing that is setting off warning bells for me is that none of the reports I have found discuss trade or tariffs as risk factors.

Fundamental and Value Profile

Caterpillar Inc. (CAT) is a manufacturer of construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives. The Company operates through segments, including Construction Industries, which is engaged in supporting customers using machinery in infrastructure, forestry and building construction; Resource Industries, which is engaged in supporting customers using machinery in mining, quarry, waste and material handling applications; Energy & Transportation, which supports customers in oil and gas, power generation, marine, rail and industrial applications, including Cat machines; Financial Products segment, which provides financing and related services, and All Other operating segments, which includes activities, such as product management and development, and manufacturing of filters and fluids, undercarriage, tires and rims, ground engaging tools, fluid transfer products, and sealing and connecting components for Cat products. CAT has a market cap of $82.5 billion.

  • Earnings and Sales Growth: Over the last twelve months, earnings grew by almost 100%, while sales growth was almost 24%. Growing earnings faster than sales is hard to do, and generally not sustainable in the long-term; however it is also a positive mark of management’s ability to maximize their business operations. Net Income as a percentage of Revenues also improved from about 6% for the trailing twelve months to more than 12% in the most recent quarter.
  • Free Cash Flow: CAT’s free cash flow over the last twelve months is more than $3.7 billion. Cash and liquid assets are also more than $7.8 billion, which does give the company quite a bit of financial flexibility; however these numbers are offset in my analysis by the stock’s very high debt to equity ratio
  • Debt to Equity: CAT has a debt-to-equity ratio of 1.59. Their long-term is more than $23.5 billion and marks CAT as one of the most highly leveraged companies in the Heavy Machinery industry.
  • Dividend: CAT currently pays an annual dividend of $3.44 per share, which translates to an annual yield of 2.49% at the stock’s current price.
  • Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but one of the simplest methods that I like uses the stock’s Book Value, which for CAT is $24.99 per share. At the stock’s current price, that puts the Price/Book ratio at 5.52, versus a historical average of 3.62. The historical average puts the stock’s “fair value” a little above $90 per share – more than 34% below the stock’s current price. Some analysts like to point out that the stock is trading about 32% below its historical Price/Earnings ratio as an indication the stock is undervalued, but I view Book Value, and the Price/Book ratio as a better measurement and more indicative of a company’s intrinsic value.

Technical Profile

Here’s a look at the stock’s latest technical chart.


  • Current Price Action/Trends and Pivots: The diagonal red line traces the stock’s upward trend until January of this year and provides the reference for calculating the Fibonacci retracement levels indicated by the horizontal red lines on the right side of the chart. The stock’s decline from late January’s high at around $173 puts the stock in a clear, intermediate-term downward trend, with the stock trading near to the lowest point of that trend around $135 per share. The stock is hovering around a major support point, marked by the 61.8% Fibonacci retracement line, and if that line holds, it could give the stock some momentum to start pushing higher to reclaim its highs from earlier in the year. On the other hand, a drop below $135 would mark a clear break through support that would give the stock room to drop as far as the 88.6% retracement line around $120 in fairly short order. That’s more than $15 of near-term risk if support is broken, and about $18 of legitimate risk right now. Even if the stock does rally from that support point, it should find major resistance in the $150 range, where the 38.2% retracement line sits, meaning that a bullish investor stands to make about $12 per share if he’s right; but he could lose $18 per share if he’s wrong. That’s easy math that should make anybody hesitate.
  • Near-term Keys: If you’re looking for a good reward: risk trade opportunity for CAT, watch to see if the stock pushes below support around $135. If it does, there could be a very good opportunity to short the stock or use put options, with a target price around $120, and a stop loss a little above $136 per share. That’s a set up that offers $15 of reward, against only a couple of dollars per share of risk.