1 To Buy, 2 To Sell To Construct A Winning Portfolio
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Whenever there is a question about a slowdown in the economy, some of the first stocks to take a hit are construction related companies. This makes sense because these companies get such a big lift from new construction and development. However, I think at least in one case the market is betting against a highly successful company. In the construction industry there are three different companies I've identified as opportunities, but for different reasons.
It's one thing if the overall market is down and you can easily identify multiple companies selling at a discount to their 52 week high. Where I've found good opportunities in the past is, when the market overall is doing okay, yet one sector gets left behind. This is the situation with the construction industry, and in particular companies like, Caterpillar (NYSE: CAT), Deere (NYSE: DE), and CNH Global (NYSE: CNH). While both Caterpillar and CNH are selling for a near 20% or more discount to their 52 week highs, Deere & Co is down just over 5%. I would make the argument that the market is mispricing these opportunities, and that could present a chance to profit for investors.
Construction companies benefit when the economy picks up steam because their goods and services are in higher demand. Most companies have to take on significant debt to finance their cost of goods sold, but if they use this leverage wisely it can lead to superior returns. The challenge for any company that takes on debt is not taking on too much. This is my big worry when it comes to Deere. Deere has an iconic brand name and gets business from both the construction and farming segments of the market. Some investors might look at Deere as an opportunity at about 10 times next year's EPS projections, but I see trouble. It is true that analysts are calling for 10% EPS growth in the next few years for Deere, but in this company's case, EPS growth doesn't mean cash flow growth.
In fact, in the last three years, Deere grew its net income by over 64% in total, yet operating cash flow dropped 100%. In addition, Deere shows negative average free cash flow in the last four quarters. The biggest worry has to be Deere's balance sheet. It's not unusual to see a debt-to-equity ratio of over 1 for construction companies, but Deere's ratio currently sits at 3.28. With more than three times as much debt as equity, any hiccup in the company's operations could be a problem. The fact that the company's dividend of 2.17% is covered by a negative payout ratio isn't too reassuring either. I would recommend investors look for an exit from Deere's shares until the company shores up their balance sheet, and solves their free cash flow issues.
A Global Laggard:
CNH Global is an agricultural and construction company based in Amsterdam, Netherlands. Unfortunately for investors, CNH shares some of Deere's characteristics, but without the same growth, and without the yield. CNH is selling for a relatively cheap P/E ratio based on next year's estimates at about 8.5 times earnings. However, unlike Deere which is expected to see 10% growth, CNH is expected to grow by about 8.6%. If the company offered a higher yield, investors might overlook this lower growth rate, but CNH pays no yield at the current time. In addition, CNH shares Deere's affinity for net income growth at the expense of operating cash flow growth. In the last three years, CNH's net income growth has been impressive. The company has increased net income from a loss of almost $200 million to a profit of $939 million in the last three years. However, during this same timeframe the company's operating cash flow has dropped by 55%. While CNH's balance sheet is significantly stronger than Deere's with a debt-to-equity ratio of 1.4, the fact that the company lags in so many other areas makes this a stock to avoid.
A Leader Being Treated Like A Laggard:
Investors looking for a play on the construction sector should look first to Caterpillar. The company offers several traits that its competition can't claim. First, Caterpillar pays the best yield of the three with a current payout of about 2.36%. Second, Caterpillar is selling for about 10 times next year's earnings, but analysts expect superior EPS growth of about 14% in the next few years. Third, in the last three years, Caterpillar has been able to grow both its net income and operating cash flow. Net income has increased 450%, while operating cash flow increased about 8% in total from 2009 to 2011. This increase in operating cash flow might not sound great, until you consider their competition saw their cash flow cut by 50% or more in the same timeframe. In addition, while Deere struggles with much higher debt, and CNH has less debt and less growth, Caterpillar has a good blend of a strong balance sheet and good expected growth. According to the company's last quarterly financials, their debt-to-equity ratio is 1.48. It's true that Caterpillar has struggled to maintain positive free cash flow in the last few quarters, but next year could be a different story. If 2013 is another year of global recovery, Caterpillar's superior brand and worldwide reach should serve the company well. The fact that the stock is down more than 20% from its 52 week high is just another reason to put CAT on your Watchlist.
On the surface these three companies look similar, but as you can tell there are some major differences once you dig into the numbers. With an over 2% yield, the best expected growth rate of the three, and a relatively strong balance sheet, Caterpillar looks like the stock to watch in this industry. Investors in Deere and CNH should compare their companies to Caterpillar and ask themselves why they believe these stocks are better investments. From what I can see, the other two come up short in light of Caterpillar's attributes.
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. Is this post wrong? Click here. Think you can do better? Join us and write your own!