After beating the market in 2020, Caterpillar's (CAT -0.55%) stock is off to another great start this year. Shares surged over 5% on Jan 6. then passed $200 a share intraday on Wednesday, marking a new all-time high.
Last week's surge came in response to news from the Georgia runoff elections that the Democratic Party has flipped the Senate and now controls Congress and the Executive Branch. This control should make it easier for President-elect Joe Biden to execute his "Build Back Better" plan, which is "a national effort aimed at creating the jobs we need to build a modern, sustainable infrastructure now and deliver an equitable clean energy future." The plan would involve massive government stimulus and the creation of millions of jobs. Biden won Caterpillar's home state of Illinois and other Midwest states like Wisconsin, Minnesota, and Michigan -- and wants to make good on his promises for job creation. Here's why the plan is just one of many tailwinds that could propel Caterpillar's stock even higher.
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North American sales desperately need a recovery
The prospect of building stuff is always music to Caterpillar's ears. But it's especially important today. Caterpillar's second and third-quarter profit declined by 70% and 54%, respectively, year over year. Its international sales now make up over half its business and are doing OK. The main problem is North America, which is dragging down its overall business. Usually, North America is Caterpillar's best region, so the idea is that a stimulus package has the potential to rebound those sales while the rest of its business continues to grow.
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Upside potential for oil and gas
Caterpillar has made key moves since 2019. Its investments in China are paying off and have been rare bright spots during the pandemic. It has also made timely acquisitions, such as its purchase of Weir Oil & Gas. Caterpillar is often thought of as a construction stock, but its largest segment by revenue is actually energy and transportation. Purchasing Weir's well service assets on the cheap would be timely if oil prices continue to rebound. WTI oil prices crossed the $50 per barrel mark for the first time since February 2020 as Saudi Arabia and Russia cut production. Widespread distribution of a COVID-19 vaccine could spur increased demand for oil in industrial processes and transportation. The prospect of Americans resuming their morning commutes and allocating savings toward long-awaited vacations would be great for the oil industry and is another tailwind that could help Caterpillar's business.
Valuation
Caterpillar is a cyclical stock that has the potential to surprise to the upside while underperforming to the downside. Trading at an all-time high after such poor 2020 sales is cause for concern. However, its valuation looks more reasonable if future performance is considered.
Caterpillar had 2019 sales of $53.8 billion and net income of $6.1 billion. At today's market capitalization of $105 billion, this would give the company around a 1.95 price to sales (P/S) ratio and a price to earnings (P/E) ratio of just 17.2. However, its current P/S ratio is 2.48 and its P/E is 32.7. Valuation metrics for cyclical companies like Caterpillar can vary depending on the market cycle. Caterpillar's valuation looks high today because its stock price has increased even though its sales and earnings have decreased. However, Caterpillar appears to be headed for what could be a multi-year-long growth trend, which makes its valuation attractive even at today's record-high price.
A reliable Dividend Aristocrat
2020 marked the 27th consecutive year that Caterpillar has increased its annual dividend, earning it a spot on the esteemed list of Dividend Aristocrats. Aside from extra income for shareholders, the track record symbolizes Caterpillar's consistency throughout market cycles. This is all the more important for a cyclical company because it tells investors that Caterpillar prioritizes its dividend and has increased its payout even during years when profits declined. It also shows that the company's balance sheet is strong and has the capacity to take on debt when needed. Although Caterpillar's surging stock price has reduced its dividend yield, its $4.12 annual dividend still returns 2.2% a year, which is above the market average.
The recipe for a breakout year
Caterpillar's ideal year would go a little something like this:
- The Biden administration funds infrastructure stimulus that creates jobs, bolsters the economy, and generates more business for Caterpillar.
- Caterpillar's energy and transportation business benefits from higher oil prices as air traffic, ground transportation, and industrial oil consumption improve.
- Weir's well service assets integrate well in Caterpillar's business to further drive sales.
- International sales (particularly in China) continue to grow.
- 2021 sales and profit meet or exceed 2019 levels, giving the stock an inexpensive valuation.
Caterpillar's failsafe is low interest rates. The Federal Reserve has made it clear it intends to keep short-term interest rates near zero for at least the next three years -- which benefits industrial stocks like Caterpillar's because it can use its investment-grade balance sheet to access cheap debt if needed. In sum, Caterpillar has a lot of upside in 2021 and 2022. Its valuation may look high right now, and it may take a full year or two for its recovery to play out. In the meantime, Caterpillar will pay you a sizable dividend as compensation for your patience.
