Getting Bullish On These Construction Stocks

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Construction equipment companies have gone through considerable volatility over the last year. From slowing growth in China to record farmer incomes, tailwinds have cascaded with headwinds and, in the process, created an uncertain economic environment. The positive news is that this uncertainty provides an opportunity for you, the investor, to scoop up shares in the more undervalued producers. Below, I review 3 stocks in this industry and offer my take on their position.

What To Look At For Caterpillar (NYSE: CAT)

At only 9.3x past earnings and a 2.3% dividend yield, Caterpillar is a cheap stock with considerable value. It generates a 13% return on invested capital and is forecasted for 16.7% annual EPS growth over the next 5 years, which is around 600 bps greater than the industry average. The immediate short-term, however, has clouded this positive outlook. In the third quarter, although EPS of $2.54 was ahead of consensus by 31 cents, revenue of $16.45 billion was $450 million below expectations--an announcement that sent shares falling 1.4% recently. Caterpillar has itself forecasted for low or negative growth in 2013, but this is sharply contrasted by the positive "attitude change" in China.

There are several factors to look at before investing in Caterpillar. Faster delivery times has caused dealers to find themselves with excess inventory and in the position of needing to cut order rates. Management's call for no economic improvement until no earlier than 2H13 still seems incredibly bearish. Brazil is providing a meaningful tailwind, and Chinese dealer outlook is improving despite the presidential transition. This improved outlook is being driven by greater levels of building permits and major government infrastructure investments. China is looking to moderate stimulus spending more this year, which means greater control and redirection of resources to this priority. 

Meanwhile, steady inventory reductions have been made in this emerging market to fight back against margin pressure. Investors should note that the company has not bee too aggressive in cutting inventories here, because it believes it will need the large capacity to supply the demand increase resulting from a recovery. Growth is accelerating to 8.5% in China, so it will be a juggling act between lowering inventory and ensuring the needed capacity is in place.

Deere (NYSE: DE) Vs. Joy Global (NYSE: JOY)

Deere and Joy are the agricultural and the mining versions of Caterpillar, respectively, and, as such, are fundamentally positioned for different tailwinds. Joy produces mining equipment for the natural resources sector and is down 30% over the last 6 months. Deere, which is up 12.9% over the same time period, primarily produces agricultural machinery for loggers, farmers, excavators, you name it. Will Deere continue to outperform?

Deere has two top billionaires that are backing the company: Bill Gates and Warren Buffett. The latter is the largest owner in the stock while Gates effectively controls 5.8% of the business. They are bullish on the stock for several good reasons. Despite the drought, domestic farmers have seen profits balloon to a record $122.2 billion. And while return on invested capital is 300 bps below the industry average at 10.4%, value is still being created and will outweigh peer levels in light of the 19.8% annual 5-year EPS growth rate, which is 970 bps greater than the industry average. At only 9.8x forward earnings and a recovery in progress--shares are near a 52-week high.

It trades at just 9x past earnings and is forecasted for 12.8% annual EPS growth over the next 5 years. Assuming expectations are met (and they are in-line with recent performance), 2016 EPS will come out to $9.67. At a multiple of 13x, this translates to a future stock value of $125.71 for an average annual return of 21%. Discounting backwards by 10% yields a present value of $78.06, which means the stock offers a 23.7% margin of safety. The expansion of multiples will likely cause Joy to outperform Deere.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Joy Global. 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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