FOOLISH FOUR PORTFOLIO

<FOOLISH FOUR PORTFOLIO>

What's up with CAT?
Fundamental Analysis of the Foolish Four

by Chris Rugaber (TMF RFK@aol.com)

Alexandria, VA (March 4, 1999)-- Even though the Foolish Four is a mechanical stock buying strategy, and therefore one does not need to do more than calculate the RP scores, rank the stocks, make the buys, and then forget about it until a year and a day later, the Foolish Four can also be a teaching tool for those just beginning their investing. Therefore, starting today, I'll be periodically looking at the balance sheets, income statements, and cash flows of our Foolish Four stocks.

Given that these are larger, international corporations with time-tested business models, they will be good companies to learn from -- we won't have to worry about quantifying Internet "mindshare" or figuring out the value of "registered users." However, I will also try to do a lot of comparisons between our companies and some of the "new economy" corporations, such as Amazon.com (Nasdaq: AMZN) and Dell (Nasdaq: DELL), as another way of learning about investing. And in many cases, the "new economy" companies will look pretty good.

But I digress. Let's begin with our best-performing stock so far, Caterpillar (NYSE: CAT), which is up almost 10% since our December 24th purchase. In fact, so far, our Foolish Four are up a little over 3%, as opposed to the Standard & Poor's 500 Index's 0.44%. Of course, if you're like me, and actually purchased your Foolish Four stocks in mid-January rather than the end of December, then you may not be doing as well. Forget it; there are nine months to go.

Anyway, Caterpillar benefited last week from the release of its 1998 Annual Report, which painted a rosy picture of "five years of focused growth," resulting in record revenue in 1998 of $20.98 billion. We'll have to look at its discussion of new products and so forth another day. For now, let's begin our fundamental analysis of the company.

Despite its revenue, other aspects of its 1998 performance weren't so great. Take a look at some year-over-year changes from 1997 to 1998:

(in millions, except for EPS)
                                 1997   1998  change
Revenue                         18,925 20,977  10.84%
Profit                          1,665  1,513  -9.13%
EPS (earnings per share)         4.37   4.11  -5.95%
CoGS (Cost of Goods Sold)      13,374 15,031  12.39%
SG&A (Sales, General & Admin)   2,232  2,561  14.74%
Gross Margin                   29.33% 28.35%  -3.36% 
Profit Margin                   8.80%  7.21% -18.02%

Already, we can get some idea of what's going on at Caterpillar. First, while its revenue rose almost 11%, its profits and EPS fell. Caterpillar noted in mid-December of last year that it was forced to offer "continuing high sales discounts" because its rivals had been cutting prices. The difference in revenue and profits illustrates the effects of those price cuts, especially when you also consider the increase in the cost of goods sold.

In other words, as a result of the price cuts, Caterpillar's CoGS increased more than its revenues, which cut into its gross margins. (Gross margins are simply the difference between a company's revenues and its CoGS).

Caterpillar's profit margins declined even more, which is partly a result of the company's significant jump in SG&A expenses (though other factors probably played a role). SG&A expenses, which are fairly self-explanatory, are more the fault of Caterpillar than any of the familiar bogeymen such as "Asian flu." We'll be looking for that to decline in the upcoming year. If a company is experiencing falling prices, and a big drop in sales in one of its markets -- Caterpillar's sales to Asia dropped 33% in 1998 -- then it would seem a little more belt-tightening is appropriate.

On a good note, the fact that EPS declined less than profits demonstrates the benefits of Caterpillar's share buyback program. Caterpillar reduced its fully diluted shares outstanding from roughly 381 million in 1997 to 368.1 million last year. This is important, because share buybacks are a way for a mature company like Caterpillar, which isn't going to have the hyper-growth of a Dell or Cisco, to increase its earnings per share at a greater rate than its profits.

Overall, does this preliminary survey of Caterpillar's income statement mean we should panic and sell our Caterpillar shares? Certainly not! Remember, this is a mechanical strategy. But more importantly, these numbers help illustrate why Caterpillar's stock went nowhere in 1998, despite its "record revenues," and how it ended up as a Foolish Four company. We'll track these numbers as Caterpillar releases its quarterly reports this year, and this will help us see if the company is getting back on the right track. As a result, instead of just hoping that the strategy "works" and having to wait until next January to find out, we can get an idea as the year progresses.

Keep in mind, Caterpillar has returned an average of 17.73% per year to its shareholders for the past five years, with dividends reinvested. Its -2.89% return in 1998 is ideally the exact kind of aberration that the Foolish Four was meant to find.

Fool on!

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Today's Stock Lists | 1998 Dow Returns

03/04/99 Close
Stock  Change   Last
--------------------
CAT  +  11/16  47.94
JPM  +   1/2   112.94
MMM  +   3/8   75.19
IP   -   1/4   40.06


                   Day   Month    Year   History
        FOOL-4   +0.50%   1.06%   2.09%   3.61%
        DJIA     +2.06%   1.73%   3.27%   2.86%
        S&P 500  +1.54%   0.67%   1.74%   1.98%
        NASDAQ   +1.22%   0.21%   4.57%   6.00%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     47.94    11.28%
 12/24/98    9 JP Morgan    105.51    112.94     7.04%
 12/24/98   14 3M            73.57     75.19     2.20%
 12/24/98   22 Int'l Paper   43.55     40.06    -8.01%


    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1150.50   $116.50
 12/24/98    9 JP Morgan    949.62   1016.44    $66.82
 12/24/98   14 3M          1030.00   1052.63    $22.63
 12/24/98   22 Int'l Paper  958.12    881.38   -$76.75

              Dividends Received      $15.04
                             Cash     $28.26
                            TOTAL   $4144.24

</FOOLISH FOUR PORTFOLIO>