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A Bull Case for Caterpillar Stock

By Daniel Miller - Apr 20, 2013 at 8:00AM

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Cyclical industries provide an opportunity to buy valuable stocks at a discount during rough times.

Caterpillar (CAT 1.76%) has had a rough go of it lately, hovering just over its 52-week low of $78. The stock price is down 10% this year, and about 25% for the last 12 months. That said, Caterpillar finds itself with wide moat of competitive advantages in a cyclical industry. This, to me, is a diamond in the rough, presenting us an opportunity to buy in at a great price and await the global economic rebound to boost the stock price. The short-term headwinds it faces could be already priced into the stock -- it's trading well below its historic P/E ratio of 16 at around 9.5. Let's break it down for both short-term and long-term potential.

Short term
Caterpillar is going to face profitability headwinds in the short term and, if that's something you as an investor can't handle, Caterpillar stock isn't for you. Over the next several quarters, as the mining industry and global economy continues to slow, demand will follow for Caterpillar's equipment orders. We're likely to see the effects of that on the bottom line throughout 2013. I think the long-term potential of the company is great and, if you're a patient investor, this could be a great opportunity to snatch up a global industry leader at a cheap price.

Competitive advantage
When customers make a purchase, the most important factor is avoiding downtime, and that's where Caterpillars wide moat comes into play. It has an extensive national dealer network, and a wide-spread reputation for high quality. Its service network has allowed its market share to expand and keep customers coming back. It also enjoys a huge name-brand advantage, along with the sheer size of its company in an industry where both play a large role in success.

Long term
I mentioned the short-term issues that face Caterpillar internationally, but the long-term growth in these regions -- China, India, and Africa -- will be above average. With those markets continuing to increase spending, and stimulus on industrialization, it will be a boon to infrastructure building. With the infrastructure creation, there will be an increased demand for machinery and commodities. All will bode extremely well for Caterpillar, and will only strengthen its leading position globally.

Caterpillar's 2011 acquisition of Bucyrus -- a mining equipment manufacturer --means that almost half its operating profits are from the mining end market. The primary users of its equipment are from coal, oil, iron ore, gold, and copper, which would explain the short-term profit headwinds I mentioned. At some point, all of the previously mentioned commodities will rebound, and when that takes place, look for Caterpillar to enjoy the spoils on its bottom line.

Another thing in Caterpillar's favor is its ability, so far, to avoid pricing wars with competition. This is evident in its quickest growing market -- China -- where it battles rival Komatsu for the dominant position. Both compete throughout the region over service, technology, and reputation for quality, and have avoided a destructive price war. It will be something to keep an eye on if one grows a more dominant position, which may cause the other to react to try and gain lost ground.

Bottom line
Investing in its simplest form can be surmised in two pieces of well-known advice. One: Buy low, sell high. Two: Find great companies with an economic moat and hold on to them forever. Caterpillar offers a company that meets those two criteria. You're getting a global leader and excellently positioned company on the downside of a cyclical industry. You're getting a company that has built a competitive advantage through its service network and reputation for quality. Caterpillar stock may test, or even drop through, its 52-week lows; but it's not a matter of if -- but when -- the industry rebounds. At that point, Caterpillar's stock will soar along with it.

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