Is Jim Chanos Right to Short Caterpillar?

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When a world-famous investor known for successfully short-selling stocks takes aim at a Dow Jones Industrial Average component, the market takes notice. That’s exactly what happened when Jim Chanos, founder of Kynikos Associates, announced he was short heavy machinery maker Caterpillar (NYSE: CAT).

Chanos must be smiling in the wake of Caterpillar’s results, which were overwhelmingly disappointing. As a result, should investors follow the noted short-seller and rush for the exits? Or does the blue-chip stock represent a compelling value?

In the wrong business at the wrong time?

That’s what Chanos had to say about Caterpillar when he first announced his short position. In his estimation, Caterpillar is too heavily focused on the mining industry and booming construction in China, which he believes are both exhibiting demand far above historical norms.

Investors need to give credit where credit is due, and at least for one quarter, Chanos was right on the money. In all, Caterpillar reported second-quarter profit of $1.45 per share, down from $2.54 the year prior. That represents a whopping 43% decline in profits. Not surprisingly, Caterpillar’s EPS badly missed analyst estimates.

Revenues weren’t anything to brag about, either: Caterpillar’s sales dropped 16% year over year, which also missed expectations.

Broad industry problems

Caterpillar isn’t the only heavy machinery stock facing hard times. Industry peer Deere & Company (NYSE: DE) has seen its stock drop from $95 per share earlier this year to its current level of $82 per share, despite a record-setting second quarter.

Worldwide net sales increased 9% during both the second quarter and over the first six months of the year, as opposed to 2012.

Net income clocked in at $2.76 per share, representing 5.7% quarterly growth year over year. Earnings per share over the first half of the year were $4.41, growing 13% from the same period the year prior.

Going forward, Deere’s outlook is as cloudy as Caterpillar’s, which may explain its poor share price performance. Deere advised investors that the slow global economic recovery, combined with inclement weather, will take a toll on the company’s full year results. Deere said it expected worldwide sales of construction equipment to fall 5% this fiscal year.

Smaller competitor Joy Global (NYSE: JOY) has had its fair share of troubles. The $5 billion company by market capitalization reported its first-half sales and diluted earnings per share dropped 6% and nearly 10%, respectively, year over year.

Joy Global is seeing the same weakness in mining activity as its competitors, which is having a pronounced effect on its outlook. Management isn’t painting a bright picture for itself this year. The company recently stated that its capital expenditure analysis for mining equipment customers is down 40% to 50%. In addition, the prospect list of major projects that Joy Global tracks has declined by about 30% from 2012 levels.

How should Fools proceed?

I thought Caterpillar Chief Executive Officer Doug Oberhelman took an appropriate stance in the wake of the company’s disappointing earnings. I respect corporate leaders who acknowledge mistakes and pledge to work focus more diligently on righting the ship, and that’s exactly what Oberhelman did.

He admitted the company is hurting from the slowdown in global mining activities. At the same time, he noted that as the global population continues to grow, demand for minerals and energy will only grow in tandem.

There’s no escaping the fact that Caterpillar’s quarter was a rough one. That being said, Caterpillar may be cheap enough that the stock looks like a bargain for long-term investors who are willing to wait for the turnaround.

Caterpillar management guides investors to expect $6.50 per share in 2013 earnings. At its recent price, shares exchange hands for about 12 times this year’s earnings.

If you believe Caterpillar’s earnings are at or near a bottom, then the current valuation is actually even better than it seems. I’d be inclined to agree with that sentiment. North America is performing very well, China’s rumored slowdown has not yet materialized, and global mining activity should pick up sooner or later.

When you consider the fact that Caterpillar recently upped its dividend by 15%, clearly the company is optimistic about its own future. At a nearly 3% yield, investors are being paid to wait for Caterpillar to turn itself around. All in all, Caterpillar looks like a great buy for investors with a long-term horizon.

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Robert Ciura 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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