Ask any investor or hedge-fund manager what his favorite stock pairs are and Caterpillar (NYSE:CAT) and Deere & Company (NYSE:DE) are likely to feature near the top of the list. The two are oft discussed in the same breath as their investment propositions are believed to have had much in common during the last decade. However, on closer inspection the two stocks actually have notably different drivers. Let's take a look at them and, in doing so, assess what will guide their stock performance in 2015.
Caterpillar and Deere & Company, not quite a perfect pair
The chart above shows how both stocks underperformed the S&P 500 in the last five years, and how Deere has outperformed Caterpillar. More insight is gained by looking at a breakout of segmental profit for the two companies, starting with Deere.
The chart demonstrates that Deere is primarily an agricultural company while, whose growth prospects are largely dependent on a combination of farmers income and their propensity to spend on agricultural machinery -- historically the two things are closely correlated. In turn, farmers income Deere prospects are governed by the outlook for key crop prices such as corn, wheat and soybeans. The following article on Warren Buffett's position building in the company helps to explain the investment thesis for the stock.
In comparison, the following chart shows how Caterpillar generated profit during the last few years. You should note the significant fall in profitability in the Resource Industries segment -- a consequence of falling hard mining commodity prices. It's clear that the two companies have an industry overlap in construction, but it represents a relatively small part of Deere's profits. As for Caterpillar, interested readers can find a more in depth analysis of its current trading prospects in the article linked.
Specific end market drivers
In order to illustrate the point further, I've prepared a tabulated outline of each segment for the two companies (excluding their financial arms).
|Company Segment||Primary Driver||Primary Factor||Additional Factors|
|Deere--Ag and Turf||farmers income||crop prices||crop yields, weather, acreage planted|
|Deere--Construction and Forestry||global construction markets||global growth||U.S. construction spending|
|Caterpillar--Construction Industries||global construction markets||global growth||Emerging Market construction spending|
|mining and quarrying activity||mining commodity prices||Emerging Market growth|
|Caterpillar--Energy and Transportation||oil and gas, power generation, marine, industrial and rail||global growth||Energy prices, industrial, power and rail investment|
Putting aside the overlap in construction, the table above outlines how different the two companies' end market drivers are. With that said, why have they been traditionally seen as pairs?
In one word, the answer is China. The idea is that the emerging middle classes in China -- and to a lesser extent India, too -- are believed to be creating a long-term upward demand trend for both mining and agricultural commodities. In other words, both hard (base mining) and soft (agricultural) commodities have a common end-demand driver.
When middle classes emerge in developing countries -- particularly when accompanied by a shift toward urbanization -- the result is usually an increase in protein consumption. The oft-quoted factoid that it takes 7kg of grain to produce 1kg of meat is subject to debate, but the argument relates to the amount of grain needed, not that grain demand will increase disproportionately when people eat more protein. The end result of increased demand should be higher crop prices -- great news for Deere.
Similarly, the trend toward urbanization in developing countries is believed to create long-term demand for mining commodities, via infrastructure built out to support the growing urban population -- good news for Caterpillar's construction, resources and energy interests.
Four reasons why the theory doesn't work
First, although hard and soft commodity prices have moved seemingly in tandem during the last few years, there is no good reason why they should remain so.
In fact, a longer-term view shows some significant divergence.
Second, China actually imported record volumes of commodities last year, but it still wasn't enough to pull key commodity prices (hard and soft) out of their slump. Commodity end demand (hard or soft) isn't just about China.
Third, China's growth in industrial production is slowing anyway.
Fourth, the supply of crop prices is contingent upon weather conditions and their effect on crop yields, rather than purely economic factors.
Forget about pairing
All told, the two stocks do have much in common, but not enough to pair them together unconditionally. If you want to buy Deere or Caterpillar, or both, you will need to look at prospects for each company separately. They are not interchangeable, and anyone devising a pair-based investing strategy needs to consider this carefully.
Lee Samaha has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.