2 Stocks Poised to Benefit from U.S. Recovery

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Anyone who has read my posts in the past knows that I generally expect a continued recovery in the U.S. economy. There are certain segments that will benefit from an improved domestic economy, like automotives, airlines, and entertainment companies. Going off a similar theory, I recently ran a screen on Fool.com to look for construction related companies that exhibit the following characteristics: positive revenue growth, 10%+ earnings growth, and at least a 2% yield. Two well-known names popped up, with both Caterpillar (NYSE: CAT) and Deere & Co. (NYSE: DE) making the cut. With strong brand names, each company benefits from repeat business. An improved domestic economy should continue the growth that both of these companies have experienced over the last few years.

Though I like both company's prospects, investors usually choose one stock to represent an industry. Keeping this in mind, I wanted to compare Caterpillar and Deere & Co. to see which one might be the more attractive investment today. First, let's look at each company's valuation and expected growth rate to see what analysts expect over the next few years. 

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>P/E on '12 Earnings</strong></p> </td> <td> <p><strong>Growth Rate</strong></p> </td> <td> <p><strong>PEG</strong></p> </td> </tr> <tr> <td> <p>Caterpillar</p> </td> <td> <p>9</p> </td> <td> <p>14.00%</p> </td> <td> <p>0.64</p> </td> </tr> <tr> <td> <p>Deere & Co.</p> </td> <td> <p>10.54</p> </td> <td> <p>11.00%</p> </td> <td> <p>0.96 </p> </td> </tr> </tbody> </table>

I can't say I'm tremendously surprised that both stocks sell for less than their expected growth rates. Many times, it takes investors a while to recognize that an economic recovery will continue, and this skepticism keeps them away from the shares. Assuming that my theory is right, and both companies continue to benefit from and improve domestic economy, Caterpillar looks like the better value, selling for a significant discount relative to its competitor. (Caterpillar – 2, Deere & Co – 1)

While each stock's valuation and expected growth tells us a little bit about the company, being able to trust this growth rate is another story. On a regular basis, I'll look at a company's past earnings performance to try and determine the likelihood of future growth. If a company is able to match or beat prior earnings expectations, it's reasonable to assume that analysts are not overestimating their growth potential in the future. Looking at each company's performance relative to estimates, Caterpillar has clearly outperformed over the last year. The company has actually beaten earnings estimates each of the last four quarters by almost 17% on average. Deere & Co. turned in just slightly less impressive results, beating estimates three times, but missing once. (Caterpillar – 2, Deere & Co – 1)

For many investors earnings growth is a guide, but free cash flow is how they measure the company's ability to reward shareholders. Free cash flow is more of a bottom line approach to what the company can use for dividends, share repurchases, and continued investment in the business. In order to compare companies of different size, I compare free cash flow to total sales during the most recent quarter. By this measure Caterpillar outperformed, but it's a close race. The company produced $0.03 of free cash flow per $1 of sales versus $0.023 at Deere & Co. The challenge in making this comparison was that Deere & Co. actually showed negative free cash flow during the current quarter and for this year. However, the company had a lot of asset and liability changes that are non-cash items. Adjusting for these changes, Deere & Co. did show positive free cash flow. I'm willing to give Deere & Co. the benefit of the doubt, given that the company has been free cash flow positive for the last few years. Even with these adjustments, Caterpillar still outperformed. (Caterpillar – 2, Deere & Co. - 1)

Last but not least, we need to take a look at each company's dividend and payout ratio to see which pays the more competitive dividend. Caterpillar pays a current yield of about 2.4%, and in its most recent quarter had a free cash flow payout ratio of just under 59%. Deere & Co. pays a yield of 2.25%, but even if we adjust their cash flow for the previously mentioned asset and liability changes, their current payout ratio is over 81%. Time will tell if this higher free cash flow payout ratio at Deere & Co. is normal. Last year the company's payout ratio was much lower at just less than 47%. However, for this test we have to go with what has happened recently, which makes Caterpillar our winner again. (Caterpillar – 2, Deere & Co. - 1)

Totaling up the scores, we find Caterpillar scored an 8 and Deere & Co. fell far behind with a score of just 4. This is a clean sweep by Caterpillar, and by two other measures this isn't really surprising. Caterpillar has a slightly higher operating margin at just over 15% versus Deere & Co. showing a current margin of 14.7%. While this difference is just a slight advantage, when it comes to the companies' balance sheets, there is a much larger difference. Caterpillar shows a debt to equity ratio of 1.71 versus the much more leveraged Deere & Co. with a ratio of 2.86. This relatively higher debt ratio helps explain why Deere & Co. has a lower operating margin and less relative free cash flow. Caterpillar is our clear winner. Investors looking to benefit from the continued improvement in the economy, would be well served to do more research on this construction giant.

Interested in Additional Analysis?

Caterpillar is the market share leader in an industry in which size matters, and its quality products, extensive service network, and unparalleled brand strength combine to give it solid competitive advantages. Read all about Caterpillar's strengths and weaknesses in the Fool’s brand new report. Just click here to access it now.

MHenage has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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