Make Sure to Buy the Right Stocks in Construction

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

After Cummins gave weak guidance during its earnings call, construction firms have been on a sizable decline. However, there are several stocks that are well positioned to gain from a global increase in infrastructure spending. As business activity and trade picks up, there will be greater demand for travel and construction. Accordingly, the next few years look bright for the sector. With that said, there are stocks that are overvalued based on strong past results that have no bearing on the future.

Caterpillar (NYSE: CAT) & Deere (NYSE: DE): Both Undervalued, Well Positioned For Long-Term

After underperforming Deere by more than 2,100 basis points over the last six months for a return of -18.2%, Caterpillar shares look particularly compelling. The company trades at a respective 9.5x and 8.3x past and forward earnings. This is in dramatic contrast to the historical 5 year average PE multiple of 16.9x. Free cash flow trends have been admittedly weak, with $2.3 billion for the TTM ending 2Q 2012 down from $4.6 billion two years ago. However, this is just due to a weak economy, not operational problems.

Analysts currently forecast the company to still grow EPS by 14% annually over the next 5 years. Assuming expectations are met, 2016 EPS will come out to $15.05. At a 15x multiple, this translates to a future stock value of $225.75. Discounting backwards by 10% yields a present value of $140.17, which implies that the stock is roughly 40% undervalued. With a beta of 1.9, the stock is also well positioned to close this gap quickly when the economy moves towards full employment. It is at the bottom of the business cycle and irrationally not pricing up the long-term secular trends. I am particularly bullish on China, where I believe the market has become overly concerned about signs of deceleration there. My belief that the market was over reacting was confirmed when China recently announced large expenditures on infrastructure.

In addition to offering a sizable margin of safety, Caterpillar has nearly a two-decade long history of boosting dividend distributions. This further limits downside, should the economy head into a double dip recession. The IMF recently warned about a frightening likelihood that global macro activity could slow beyond original anticipations. However, Deere is most likely to suffer most from this downfall, given that it engages in the very competitive agriculture industry.

Moreover, Deere is forecasted for "only" high single-digit annual EPS growth over the next 5 years. At a respective 10.9x and 9.9x past and forward earnings, Deere is still cheap and worthy of an investment. It can issue debt fairly cheaply to increase scale through growth opportunities. Meanwhile, supply problems from last quarter have been taken care of, and net debt is not nearly as bad as retail investors make out, since it comes from the finance segment.

Manitowoc (NYSE: MTW): Don't Buy Into The Bull Run

After soaring 85.7%, Manitowoc is near its 52-week high and inflated at a current PE multiple of 21.5x. The dividend yield is insignificant and EPS has been on a 29.9% annual decline over the past 5 years. Despite this past weakness, analysts somehow expect a 15% annual gain over the next 5. In my view, this sets the bar way to high and will result in negative "surprise earnings" that will leave shareholders holding the bag.

Debt-to-equity is also extremely disconcerting at 4x - especially since a lot of it is long-term and will complicate future financing. Second quarter performance was also solid, with earnings per share 28% above consensus, as the top line grew 6% despite a challenging environment.

Going forward, however, I am not confident about the company's investment in food-service products alongside construction equipment. These two entirely different markets challenge investor's ability to allocate risk. Accordingly, a breakup may be in the works - although I wouldn't hold my breath, given how much of a bull run the stock has been on of late.


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