Investors buy stocks for all types of reasons, so whether Caterpillar (CAT 1.59%) is a buy will depend on an investor's aims. The world's largest maker of construction equipment isn't a "buy" for most investors, but it will suit patient, less-aggressive investors looking for long-term income. Here's why.
Why Caterpillar isn't a buy for most investors
While it's impossible to know the exact motivations of the investing public, I believe most investors prefer to buy undervalued stocks. This holds whether they are growth or value-oriented investors; neither style of investing makes sense if you can't get the stock on a reasonable valuation.
In the case of Caterpillar, unless you believe in a long-term uptrend in infrastructure/construction spending and the commodity supercycle argument, then the stock looks fairly valued.
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A quick look at Caterpillar's long-term revenue, earnings before interest, taxation, depreciation, and amortization (EBITDA) and free cash flow (FCF) demonstrates just how cyclical the company's end markets are. Of course, unless you believe its end markets will break out of the cycle and go to an extended uptrend of infrastructure spending (the commodity supercycle), there's no reason not to think of Caterpillar as a cyclical stock.
Data by YCharts
Pricing a cyclical stock
Books have been written on this subject, and there's no end of ongoing debate on how to price a cyclical stock. As such, it makes sense to try and keep things simple. It's an approach Caterpillar's management favors, too, because its guidance implicitly recognizes the cyclicality in its earnings.
For example, at its investor day presentation last year, management confirmed that it expects free cash flow to range between $4 billion and $8 billion through the cycle. As discussed, Caterpillar is taking active steps to reduce the cyclicality in its business, notably by aiming to double its services revenue from $14 billion in 2016 to $28 billion in 2026.
As a rough approximation, a price-to-FCF multiple of around 20 is often seen as a fair value for an industrial stock. So, taking the midpoint of the FCF guidance of $6 billion gives a target market capitalization of $120 billion for Caterpillar.
Given the current market cap of $121 billion and share price of $234, Caterpillar looks fairly valued on this basis. However, most investors don't want to buy a fairly valued stock; they want to buy an undervalued stock.
Why some investors will love Caterpillar stock
That said, there's still a strong case for buying the stock, and it rests on the company's excellent track record of returning cash to investors via dividend growth. In fact, Caterpillar has increased its dividend for the last 29 consecutive years.
Data by YCharts
As such, following a strategy of reinvesting the dividends in the stock would have resulted in vastly superior returns than merely buying and holding the stock. While this seems straightforward, it's worth recalling that Caterpillar has tended to be highly cyclical.
Consequently, there will likely be moments when its earnings trajectory looks horrible, earnings are collapsing, and its valuation looks extremely high. At such times, it's easy to lose discipline, sell the stock, or refuse to use the dividend to buy more stock.
Similarly, there'll be moments when the stock's earnings are on a hot uptrend, and the valuation looks very cheap due to cyclically high earnings -- it's easy to lose discipline and pile into the stock.
A stock to buy?
All told, most investors won't want to buy the stock. However, if you think we are heading for an extended upcycle in Caterpillar's markets, then buy the stock. Finally, Caterpillar is an excellent option if you are the sort of investor looking to follow a "buy, hold, and reinvest the dividend" strategy.
