Why Deere & Company Is a Better Value Than Caterpillar

Investors often obsess over the short-term profitability of an equity, rather than considering the bigger picture of how the stock will work in their portfolios over the longvterm. Such thoughts spring to mind when I consider buying Deere & Company (NYSE: DE  ) instead of a peer like Caterpillar (NYSE: CAT  ) . In short, Deere is facing a number of short-term negatives, but there is a growing case for buying the stock as a long-term hold.

Caterpillar and Deere, a tale of two markets
Any analysis of these two stocks will show that they tend to be highly correlated, but that doesn't mean they will be so in the future. Simply put, Caterpillar is much more of a play on construction and resources, with the two segments combining to generate 58% of product revenue in its first quarter. Meanwhile, Deere is more focused on agriculture and turf, which made up 83% of its machinery sales in its recent second quarter.

While, construction, mining and agriculture tend to be cyclical industries, there is no specific reason why they must all operate within the same cycle. However, investors don't always see it that way. Indeed, Deere and Caterpillar are often seen as de-facto plays on global growth, and in particular in China.

The idea being that the growing middle class in emerging markets will create more food demand, particularly for protein, which in turn demands more feed production. Meanwhile, the same growing middle class will demand more construction activity and therefore mining materials.

A quick look at their price charts reveals their stock price correlation. Readers should pay particular attention to the first quarter of 2008, when investors were still bidding up Caterpillar and Deere in the hope that China would offer a safe haven from the great financial crisis. Note how these dreams were crushed in due course.

DE Chart

DE data by YCharts

Near-term risk, near-term opportunity?
Paradoxically, Caterpillar offers more near-term opportunity, but more long-term risk. However, with Deere it's the other way around. Caterpillar has significantly outperformed Deere this year, thanks to its upgrading of its guidance for construction machinery sales. Investors can read about that in more detail in an article linked here, while Deere is seeing tougher conditions in its core agriculture and turf segment, and faces near-term uncertainty over the outlook for farming commodities.

Deere's management recently outlined its forecast for full-year net sales growth of 10% for its construction and forestry segment (Caterpillar is also forecasting a 10% increase in its construction machinery sales), but considering that the segment only contributed 17% of second quarter sales, it's not enough to offset a weak agricultural outlook. Deere's full-year forecast for full-year agriculture and turf net sales is for a decline of 7%, culminating in a forecast of a total net sales decline of 4% for the full year. Moreover, conditions appear to be getting worse, as weakness in the CIS countries and Brazil caused a downgrade to Deere's expectations.

In addition, Deere is forecasting all of the four major farming commodities that drive demand for its agricultural machinery to be lower over the next two years -- not good news.

  2012-2013 2013-2014 Forecast 2014-2015 Forecast
Corn $6.89 $4.70 $435
Wheat $7.77 $6.90 $7.00
Soybeans $14.40 $13.00 $10.25
Cotton $0.73 $0.77 $0.63

Source: Deere Company Presentations, dollars per bushel except cotton, which is dollars per pound.

With this level of near-term difficulty, why is Deere attractive?

Deere looking a good value
A quick look at the P/E 10 ratios (a valuation method designed to value a company over its last 10 years of earnings) reveals that Deere and Caterpillar are looking relatively cheap right now.

DE PE 10 Chart

DE P/E 10 data by YCharts

However, the difference in long-term outlook relates to investors perception on risk. Simply put, if China enters into a long-period of slow growth caused by a slowdown in housing and fixed asset investment -- and legendary investors like Jim Chanos believe this is a distinct possibility -- then Caterpillar is likely to suffer inordinately as construction and mining demand will falter.

On the other hand, soft commodity demand could remain relatively better, as China's growth shifts away from fixed asset investment. but remains strong enough to support increased protein consumption by the middle classes. Moreover, weather is always a great imponderable with agriculture, which gives the sector an opportunity to outperform, or underperform, irrespective of the economy.

The bottom line
All told, if China's growth falls off a cliff in the next few years then investors probably won't want to be holding equities anyway, but given the scenario discussed above, Deere looks better placed than Caterpillar on a risk and reward basis. The problem is whether investors can tolerate some near-term uncertainty, as grains look set to fall in price over the next two years.

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