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Everyone would love to find the perfect stock. But will you ever really find a stock that gives you everything you could possibly want?
One thing's for sure: If you don't look, you'll never find truly great investments. So let's first take a look at what you'd want to see from a perfect stock, and then decide if Caterpillar (NYSE: CAT ) fits the bill.
The quest for perfection
When you're looking for great stocks, you have to do your due diligence. It's not enough to rely on a single measure, because a stock that looks great based on one factor may turn out to be horrible in other ways. The best stocks, however, excel in many different areas, which all come together to make up a very attractive picture.
Some of the most basic yet important things to look for in a stock are:
- Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
- Margins. Higher sales don't mean anything if a company can't turn them into profits. Strong margins ensure a company is able to turn revenue into profit.
- Balance sheet. Debt-laden companies have banks and bondholders competing with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
- Money-making opportunities. Companies need to be able to turn their resources into profitable business opportunities. Return on equity helps measure how well a company is finding those opportunities.
- Valuation. You can't afford to pay too much for even the best companies. Earnings multiples are simple, but using normalized figures gives you a sense of how valuation fits into a longer-term context.
- Dividends. Investors are demanding tangible proof of profits, and there's nothing more tangible than getting a check every three months. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.
With those factors in mind, let's take a closer look at Caterpillar.
What We Want to See
Pass or Fail?
|Growth||5-Year Annual Revenue Growth > 15%||1.3%||fail|
|1-Year Revenue Growth > 12%||0.7%||fail|
|Margins||Gross Margin > 35%||26.2%||fail|
|Net Margin > 15%||5.2%||fail|
|Balance Sheet||Debt to Equity < 50%||291.1%||fail|
|Current Ratio > 1.3||1.42||pass|
|Opportunities||Return on Equity > 15%||22.1%||pass|
|Valuation||Normalized P/E < 20||33.44||fail|
|Dividends||Current Yield > 2%||1.9%||fail|
|5-Year Dividend Growth > 10%||13.6%||pass|
|Total Score||3 out of 10|
Source: Capital IQ, a division of Standard and Poor's. Total score = number of passes.
With just 3 points, Caterpillar clearly isn't our perfect stock. But the equipment maker has made its way through tough economic times, and it's making moves that could put it in a better competitive position going forward.
As a cyclical stock, Caterpillar tends to move up and down with overall economic conditions. When times are good, customers are in a better position to buy its construction and mining equipment; when the economy slows, orders slow down and profits follow suit. As a result, Caterpillar's long-term revenue growth is low, although not much lower than competitors CNH Global (NYSE: CNH ) and Deere (NYSE: DE ) , which face roughly the same customer demand fluctuations.
In particular, the recession hit Caterpillar hard, with sales falling 37% from 2008 to 2009. The company has become more internationally focused, with around two-thirds of revenue coming from outside the U.S. last year. That has left the company exposed to the fluctuations of not just the U.S.'s but also the global economy.
To bolster growth, the company has turned to M&A strategies. In November, the company announced it would buy mining-equipment maker Bucyrus (Nasdaq: BUCY ) in a deal worth $8.6 billion. The move should help Caterpillar respond better to the booming mining industry, which is enjoying record or near-record prices on many products.
Caterpillar won't always look perfect, especially as it comes out of an economic slump. But over the long haul, the equipment maker's shares have served investors well -- and should continue to do so.
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.
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