Why Caterpillar's Q3 Earnings Beat Was Just the Start of the Good News

In this Market Foolery podcast segment, host Chris Hill is joined by Motley Fool investor at large Tim Hanson to talk about construction equipment stalwart Caterpillar (CAT 1.85%), which turned in a strong earnings report and raised guidance again. After a dismal five years or so, U.S. housing is booming, and some of its investments are finally paying off. This Dow stock is up around 50% this year. So how is the valuation today?

A full transcript follows the video.

This video was recorded on Oct. 24, 2017.

Chris Hill: We're going to start with Caterpillar. Third-quarter profits came in higher than expected. They reported an increased demand for their construction equipment, and for the third time this year Caterpillar raised guidance. I'm not entirely sure they raised guidance three times in the previous five years combined.

Tim Hanson: They're having a really good year. They're firing on all cylinders. Part and parcel because, probably, the last five years or so were so abysmal for them. But the narrative with Caterpillar was, they came through the real estate downturn fairly well, and then they had cash on the books, and they invested aggressively to grow their businesses through acquisition, particularly in emerging markets and the resources sectors. And then they got hit because emerging-market economies were weak -- Brazil, China -- and then also, obviously, there's been a prolonged resource downturn. The former CEO retired a year early. They lost half a billion dollars buying that fraudulent company in China. I mean, it was a bad period of time for them.

But as they got all that stuff organized, China has recovered a little bit, housing in the U.S. is in a boom right now. I think it's one of those under-reported things. Residential construction is growing at double-digit rates year over year, 10% to 12%. And obviously, Caterpillar benefits directly from that, because they are literally selling the picks and shovels that people are using to build those homes. 

Hill: I'm glad you mentioned the China incident, because when we say on this podcast and others that investing in China is hard, we're not messing around. When you consider the fact that an established, steady-performing stock, blue-chip company like Caterpillar, had the other debacle that they had, where they all of a sudden realized that they had sunk so much money into, as you said, a fraudulent company in China. 

Hanson: I mean, when you're desperate, you do stupid things. That's a truism of life, right?

Hill: [laughs] That's true in investing, and it's true in life.

Hanson: And that's compounded, if you're desperate for growth in China, you're going to get taken pretty easily by the people over there. So yeah, it was a misstep, but kudos to them for, they wrote it down, and they've recovered from it.

Hill: The stock is up nearly 50% this year. Again, this is a Dow -- when I think about Dow stocks, I think, they're not going away anytime soon, they're not in any imminent danger. One of the top two or three reasons to invest in one of those companies is the dividend. I don't ever expect a Dow stock to have a year like this. Is this overpriced right now? Or is this just, as you said, they've had a rough five years and they're back to where maybe they should be?

Hanson: I'd say it's a combination of factors. Arguably every large-cap stock in America is overpriced right now for a variety of reasons. Interest rates being what they are, people have gone hunting for yield out in the stock market, the amount of passive investing that's happening that's going into market cap or price-weighted indices continues to push up, all those inflows push up the prices of these large-cap companies. And then Caterpillar, unlike some of its peers in the tech sector, so on and so forth, was coming off a somewhat lower valuation. So you put all that stuff together, and yeah, you've had a pretty bonkers year. But let these things ebb and flow.

Hill: But you don't look at it and think, "Wow, this is incredibly overpriced?"

Hanson: I mean, am I actively short in Caterpillar right now? No. Am I wary of the market writ large? Yeah. That's been a tough position to be in over the last year or so, because the market keeps trudging upwards despite the fact that there's been a lot of volatility in global politics, the weather, energy markets, so on and so forth. There's been a lot of uncertainty. But there's been a lot of certainty with the stock market. It goes up. Until it doesn't. [laughs] 

Hill: Until it doesn't, yeah, at some point. I will say, the last couple of years, at the start of the year, I've thought, this is probably the year the bull run ends. Maybe it'll be 2018.