Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?
One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if Caterpillar (NYSE: CAT ) fits the bill.
The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:
- 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 mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
- Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
- Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
- Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
- Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. 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%||6.8%||Fail|
|1-Year Revenue Growth > 12%||47.8%||Pass|
|Margins||Gross Margin > 35%||26.4%||Fail|
|Net Margin > 15%||7.8%||Fail|
|Balance Sheet||Debt to Equity < 50%||233.2%||Fail|
|Current Ratio > 1.3||1.46||Pass|
|Opportunities||Return on Equity > 15%||35.2%||Pass|
|Valuation||Normalized P/E < 20||18.36||Pass|
|Dividends||Current Yield > 2%||1.7%||Fail|
|5-Year Dividend Growth > 10%||10.4%||Pass|
|Total Score||5 out of 10|
Source: S&P Capital IQ. Total score = number of passes.
Since we looked at Caterpillar last year, the equipment maker has picked up two more points. A big pickup in revenue growth in 2011 combined with a more attractive valuation earned Caterpillar a midrange score of five.
The story of Caterpillar's success is pretty simple, and it's one that you can see duplicated throughout the agricultural sector. With high crop prices and strong growth in emerging markets, Caterpillar has simply gone where the profits are -- and has done a good job of bringing them home to investors. Yet shareholders haven't rewarded the company with a higher stock price, potentially creating a big value opportunity.
Of course, Caterpillar will have to keep dealing with competition. Deere (NYSE: DE ) has also fought hard to innovate, with new agricultural equipment that incorporates technological advances and other innovations. Crane-maker Manitowoc (NYSE: MTW ) already has a presence in both China and India and is now seeking to add Brazil to its list with a big crane-construction project under way there.
One big question is how the company's recent buyout of Bucyrus will affect results going forward. Mining activity has been strong, but Joy Global (NYSE: JOY ) represents a constant threat. For the moment, though, strength in mining has been enough to support both companies, as well as engine-maker Cummins (NYSE: CMI ) , which cited strong mining and energy markets as a key component for its own sales surge.
With all this, Caterpillar has some tailwinds pushing it forward. But it needs to keep working to boost margins and get its debt down to more manageable levels. If it can do that, Caterpillar could become a perfect stock in the future.
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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