Give me a high-quality dividend growth stock at an attractive valuation and I’m usually going to buy it, assuming I have the capital available and room in the portfolio for it. Give me an even cheaper price (with unchanged long-term fundamentals) shortly thereafter, and I’m likely to scoop up additional shares as fast as I can. Averaging down is practically my middle name.
As such, I decided to start the month of August by immediately averaging down on a recently initiated position in a company that I’ve watched over the last few years somewhat passively.
Why the sudden interest?
Well, it’s basically available at one of the lowest possible prices you could have grabbed it at over the last five years, even while earnings and guidance both remain strong. And the yield is almost twice its five-year average.
Let’s check it out!
I purchased 15 shares of Caterpillar Inc. (CAT) on 8/3/15 for $77.31 per share.
Caterpillar Inc. is the world’s largest manufacturer of heavy construction and mining equipment, and also manufactures diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives.
The company operates in the following five primary segments: Energy & Transportation (39% of fiscal year 2014 sales), Construction Industries (35%), Resource Industries (16%), Financial Products (6%), and All Other (3%).
Approximately 62% of FY 2014 revenue was generated outside the United States.
They have a network of 177 dealers – 129 of which are located outside the US. These dealers, which are mostly independently owned and operated, serve more than 180 countries and 3,500 outlets.
Solid Q2 And Accelerated Buyback
I just recently analyzed the company and its stock after initiating my position, so I won’t do that again. Instead, I’ll quickly go over a couple important points.
The company recently released its Q2 fiscal year 2015 results and, in my opinion, they were pretty solid. Earnings per share guidance for the year remained unchanged, which stands at $4.70 to $5.00 for the full year.
Revenue guidance was reduced slightly not out of unexpected challenges in the core business, but due to the strong dollar possibly impacting revenue a bit more than initially anticipated. This is, however, not an uncommon problem among all global businesses right now.
Quarterly EPS was down approximately 26% year-over-year, reflecting the cyclical nature of the business and more or less in line with the stock’s price change YOY. But you have to remember something. When you buy stock in a company like Caterpillar after earnings have dropped significantly due to where it’s at in the business cycle, you’re locking in a low purchase price even though it’s highly unlikely lower EPS will be extrapolated out forever.
So while the company’s EPS isn’t locked in, your purchase price on the stock is. You get to take advantage of those cycles over the short term by locking in an attractive long-term investment. Obviously, buying this stock at over $110 in 2012 when earnings were at their highest point over the last 10 years isn’t smart because you’re locking in your purchase price on all-time high earnings, knowing this is a cyclical business and earnings will at some point fall again. Conversely, locking in when earnings are low, knowing they won’t be low forever, is probably not a bad idea.
And shareholders are also locking in a very appealing yield right now. CAT yields 3.98% here. That’s attractive in both absolute and relative terms (the five-year average yield is 2.2%). Outside of the financial crisis, that’s as high a yield on this stock as you could have possibly snagged over the last 10 years. So I think CAT is paying current buyers a rather handsome rate to wait out the cycle and buy while the stock is cheap.
All this talk about the cyclical business makes it all the more impressive that the company has managed to increase its dividend for the past 22 consecutive years. You have to be fiscally responsible and prepared to manage the business through the ups and downs to be able to do something like that. It’s one thing to increase your dividend year in and year out for a couple decades while running a consumer products company with fairly secular growth, but it’s even more impressive when you’re able to do that while running a heavy machinery company.
In that regard, we can see just how prudent management is right now, in real-time. The company sees that the stock is attractively valued and has decided to take advantage of that by announcing the acceleration of share buybacks.
They’re buying back $1.5 billion worth of common stock (about 3.2% of the market cap of the company), which is three times the amount of money the company spent on buybacks during the first two quarters of the year. I feel that’s being opportunistic, and it appears to be a good use of shareholders’ capital. If CAT is good enough for me as an individual investor down here at $77/share, I then also think it’s good for the company (and me as a shareholder due to accretive nature of the repurchase).
The company is heavily exposed to a number of cyclical industries, making its very business model highly cyclical.
Since the company is extremely global with most of its sales occurring abroad, it faces currency risks.
Its global dominance has been challenged in China, as the company trails market leader Komatsu Ltd. (KMTUY).
Caterpillar also faces acquisition and integration risks. Poorly timed acquisition of Bucyrus International, Inc. in 2011 and the write-down of assets related to ERA Mining Machinery Limited highlight this risk.
Any slowdown in the global economy could adversely affect the company due to its exposure to economically sensitive industries.
The stock’s P/E ratio is 13.26 right now, which is similar to the P/E ratio the stock sported when I initiated my purchase. Falling EPS was met with a falling stock price, but I’m willing to bet that CAT will be earning much more profit on a per-share basis over the short term and long term. That in turn should drive growing dividends.
I valued shares using a dividend discount model analysis with a 10% discount rate and a 6.5% long-term dividend growth rate. I think that growth rate is fair when looking at the long-term track record for underlying operational growth and dividend growth, as well as the moderate payout ratio and potential for growth moving forward. Both the long-term and short-term numbers for dividend growth seem to indicate I’m including a margin of safety there. The DDM analysis gives me a fair value of $93.72.
As I stated before, the company is pretty much unrivaled in terms of scale, diversification, network, and brand.
The near term appears challenging, but that’s exactly when I like to pounce on a high-quality dividend growth stock. I don’t want to buy when everything is cheery and everyone is in love with a stock (like my example of CAT in 2012). I want to buy a slice of a great company when everyone hates it and they’re selling. That means maximum value, maximum yield, and minimum risk (assuming the fundamentals haven’t permanently deteriorated).
This purchase adds $46.20 to my annual dividend income, based on the current $0.77 quarterly dividend.
I’m going to include current valuation opinions from other analysts below, which I use to concentrate my reasonable valuation estimate:
Morningstar rates CAT as a 3-star stock, with a fair value estimate of $79.00.
S&P Capital IQ rates CAT as a 3/5 star “hold”, with a fair value calculation of $78.40.
I’ll update my Freedom Fund in early August to reflect this recent purchase.
Full Disclosure: Long CAT.
What do you think of CAT here? Like the stock? Excited about the accelerated buyback?
Thanks for reading.
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