There are a couple companies that I’ve never written about that I regularly receive requests to cover–Caterpillar is one of them. To a lot of people, it seems like the perfect dividend growth stock. The company has a nice moat selling earthmoving equipment, as the fixed costs are so high that it is difficult for new companies to enter the field. Also, it tends to benefit from technological advancements because it can make more sophisticated equipments that tempts the customer base to buy the latest and greatest human-sized gadget.
The dividend has been excellent the past fifteen years–it has grown from $0.64 in 1999 to $3.08 this year. Other than paying out $0.70 in both 2001 and 2002, the dividend payment increased every year (perhaps most importantly during The Great Recession, when the 2008 payment of $1.62 was hiked to $1.68 in 2009). And since the early 1990s, the company has benefited from best-in-class management.
You would think, with all these benefits, it would be in every investor’s portfolio. It makes real stuff. The management team are good stewards of shareholder capital. The dividend goes up every year. It’s been around forever. There is a moat in terms of economies of scale.
So why doesn’t everyone it? Pull up a stock screener, and check out Caterpillar’s total returns since 1970 (the year in which most investment portals begin). You will see that Caterpillar returned just over 9% during that time frame. The S&P 500, meanwhile, returned just under 10%. If we did these 40+ year calculations last year, when Caterpillar’s results were more impressive and the stock price was a bit higher, you would see that it performed roughly in line with the S&P 500.
That calls to mind two questions: (1) What is it about Caterpillar’s core business model that gives it characteristics in line with that of the typical American business, and (2) does this mean you can just buy Caterpillar and collect a dividend that is double the S&P 500?
Let’s take the second one first. The answer is a tentative yes. Right now, the 4.2% dividend that you can get from Caterpillar stock is in line with the dividend you could get from Caterpillar during the market lows of 2009, and this moment represents the highest yield that you could receive from the company in the past 25 years.
But there is a catch: During general economic contractions or bad news for the firm, the stock price tends to double at twice the rate of the S&P 500. If the S&P 500 goes down 10%, Caterpillar goes down somewhere around 20%. If the S&P 500 goes down 35%, that means Caterpillar goes down somewhere in the neighborhood of 70%.
If you thought it was bad seeing your general stock portfolio go down around 30% or so in 2008-2009, that is absolutely nothing compared to a Caterpillar retiree sitting on a portfolio that consisted of nothing but Caterpillar stock. After hitting $87 per share in 2007, the price of the stock fell all the way to $21 in 2009. That is because Caterpillar’s earnings fell from $5.71 to $1.43. If you owned the stock in 2009, you knew that the company was not able to pay its dividend from profits–it had to borrow. If the economic conditions of 2009 repeated themselves for two or three years thereafter, a dividend cut would have been likely.
The current situation for the stock is yet another repeat of Caterpillar’s corporate history, though the results have been less dramatic so far. After earnings hit a cyclical high of $9.36 in 2012, Caterpillar is now on pace to generate $4.25 in profits over the next twelve months. That is why the stock has gone from $111 to $73.
So yes, a purchase of Caterpillar does give you double the dividend of the S&P 500, but you should know what you are getting yourself into–if you see the volatility as an opportunity to reinvest at low prices, things will work out for you if you are accustomed to thinking in terms of generations rather than quarterly news and annual stock price fluctuations.
Now, for the far more interesting question: What is it about Caterpillar’s business model that makes it so similar to the “typical stock” of the S&P 500? The answer is that the company’s cyclical highs do not last very long, and the years on end that agricultural machinery spends in the doldrums has a true negative effect on the company’s business years.
In the past fifteen years, only 2006, 2007, 2011, and 2012 could be classified as “fat years.” Before 2006, Caterpillar spent a lot of time making around $1.50 per share in profits as was quickly seeing its profits double and triple almost overnight during America’s housing boom. Then, after the economic crisis, the boom years of 2011 and 2011 brought profits of $7.81 and $9.36 respectively. Now, earnings are back down to the $4 range.
This is a process that has loosely repeated itself for the past 45 years. For every four years out fifteen, the company makes money hand over fist as patience appears rewarded and the stock price shoots through the roof (it’s not unusual for Caterpillar stock to double or triple in under a year during these periods). The other 11 out of 15 years are spent battening down the hatch–taking on debt, making tough capital expenditure decisions, and assuring investors that better days lay ahead.
There is a place for cyclical stocks in a portfolio–often, these are the companies that will be the most volatile in terms of price. You will regularly see 50% declines in the price of these companies. However, my interest in these companies does correlate to their ability to grow faster than the S&P 500 over the long haul–or pay out such hefty dividends that dividends + growth is better than what you’d expect to get from the S&P 500 over a very long time.
That’s why I like Emerson Electric, General Electric, Royal Dutch Shell, ExxonMobil, Chevron, and Aflac. The volatility that you experience is worth it in the end because it results in much greater net worth than what’d you get from holding a plain vanilla S&P 500 Index Fund.
Take Aflac, possibly the most misunderstood large company in the world. It lost almost 80% of its value during the recession, even though its profits and dividends were growing. It has delivered 17% annual returns since 1984, turning $10,000 into $1.4 million along the way. It grows its base, invests premium income, and has a conservative balance sheet. Seeing staggering price declines in the short run is worth it because you end up with a much greater net worth in the long run.
But Caterpillar does not offer that characteristic. The good years are not long and/or profitable enough to give you outsized wealth that beats the S&P 500 compared to the lean years, and that is why it merely tracks the S&P 500 in overall performance during 20, 30, and 40 year time frames. You get a higher dividend and a double dose of volatility for owning it compared to an index fund.
I think Caterpillar could make sense as a 45th stock added to a portfolio in the right circumstances. It definitely does not hold a spot on “These are the Top 10 Business Holdings I Am Going To Build and Hold Throughout The Rest of My Life” list. But you need to make a forecast about the overall economy to accompany this investment. If you believe that the overall economy is in an expansionary mode, it makes sense to hold Caterpillar for a few years.
But the problem with that is the strategy is difficult to execute. Even if you get the valuation right–correctly concluding that the $20 or $30 range was cheap in 2009, you would also need to pick a sale point. The peak time to exit was 2012 when the stock was over $110 per share and earnings were $9.39. That, I think, is the main difficulty with treating Caterpillar as a medium-term hold: How would you know that 2012-2013 was the ideal time to get out of the stock?
If you held the stock through 2015, you’d still be sitting on more than a double in your stock price, but at that rate, you could just do something like buy Johnson & Johnson which you could hold forever and not have to think about any timing issues because the business model perpetually expands outward–there is always a new drug or country to conquer that will increase overall earnings per share on a sustainable basis.
Charlie Munger said he doesn’t like businesses where the owner looks at a bunch of equipment and says, “Those are my profits right there.” Caterpillar requests constant reinvestment, as 10% of its assets churn over each year (compared to other cyclicals like General Electric where the churn is 3% in a typical year).
If someone wants an industrial, he can pick up GE, Emerson, Honeywell, Deere, United Technologies, or something like that. Those companies may be volatile, but the business has more “fat years” and the returns tend to exceed the S&P 500. Caterpillar isn’t a bad stock–if you hold it for twenty years, you will have more purchasing power than you do now–but it is not a great company from a growth perspective. The feast years just aren’t long enough.
When I think of Caterpillar, I’m reminded of an old professor who warned his students before picking up a book, “Be careful you want to sink your time into that one. If you are lucky, you will still only get to read 500 of them in a lifetime.”
I see parallel when I think about Caterpillar. There are 15,000 companies that are publicly traded in the world. You probably only have your sets sight on owning 25-50 of them. That means a company better have earnings per share growth that are quite high and have been sustained for 15+ years, or it must be of the highest caliber in the world.
Even though Caterpillar is a fine company, it doesn’t quite make the cut. There are so many companies to cover that have better long-term growth characteristics, and there are also enduring brands that offer much higher quality. Anytime I study Caterpillar, I think: “Someone who buys United Technologies and holds it forever without thinking about it is going to end up with so much more money and fewer heartburn, so why not just do that?”
Originally posted 2015-09-05 17:28:10.