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Take Advantage of the Selloff in Caterpillar Stock — But Not Yet

Will Healy

Caterpillar Inc. (NYSE:CAT) faces a crossroads. Its recovery from the slump in the energy industry faces a huge potential interruption as a trade war with China escalates. CAT stock has fallen by more than 20% since January partially because of trade war threats. A full-scale trade war would likely take the stock down further.

However, Caterpillar has also played a critical role in the worldwide construction and energy industries for decades. Between general population growth and the constant need to upgrade and replace infrastructure, Caterpillar fulfills a need that never goes away. Due to this need, trade war fears are working to create a lucrative buying opportunity in a company that plays a critical role in world economic growth.

CAT Stock in a Slump After Two Years of Strong Growth

On the surface, the drop in CAT stock seems nonsensical. Since bottoming out in 2016, the company has surged back and now enjoys double-digit profit growth. Analysts estimate average annual profit growth at 23.31% per year over the next five years.

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The performance of CAT stock has told a different story recently. Between January 2016 and January 2018, CAT stock nearly tripled in value. The stock price moved from just below $60 per share to this year’s 52-week high of $173.24 per share. Since that time, the stock has fallen. CAT fell victim to the market slump that hit most stocks starting in January.

However, the stock has also fallen victim to an increasingly heightened trade war with China. Caterpillar equipment has played a critical role in construction projects across the emerging China market.

Caterpillar already manufacturers equipment in China. This China-made Caterpillar equipment goes to destinations as far away as Africa and Eastern Europe. Despite competition from the likes of Komatsu (OTCMKTS:KMTUY), General Electric (NYSE:GE) and Honeywell (NYSE:HON) on some projects, Caterpillar has developed niches where other Western companies and Chinese equipment companies fail to compete.

Still, if a trade war curtails Caterpillar’s activities in China or other major growth regions in Asia, such a move could devastate CAT stock. The 23.31% average growth rate will come way down if a trade war hurts CAT sales. Besides construction, the energy industry serves as the other large revenue driver for CAT. The 2014-16 energy price slump took CAT stock down by close to 50%. I expect a full-scale trade war can have a similar effect on the stock. For that reason, I would urge investors not to buy at this point.

Stay Mindful of the Coming Buying Opportunity

However, I think investors also need to look for a buying opportunity here. The stock trades at a forward price-to-earnings (PE) ratio of just under 13. The average annual PE ratio has ranged from 7.9 during the financial crisis to over 108 as profits began to recover from the energy price slump. Hence, the multiple stands near historic lows.

A trade war almost certainly makes it cheaper. However, an end to that trade war will send the stock surging back towards the $173 per share high. I stand by a previous assertion that the so-called “trade war” is a negotiating tactic. While the market and CAT stock could face more pain, I believe this uncertainty will only persist for a short time.

Moreover, revenue lost from the decline of the energy industry has begun to surge back. Losing business in Asia hurts immensely. Still, I expect such losses to be temporary. Moreover, the country’s need to upgrade its infrastructure can serve as another strong revenue source in the near term.

Investors should also note that this year’s dividend increase marked the 24th consecutive year that Caterpillar raised its dividend. The dividend will rise from 78 cents per quarter to 86 cents. Assuming the company raises its dividend next year, CAT stock will achieve dividend aristocrat status. This benefits dividend-oriented shareholders immensely. Under this circumstances, the stock’s value hinges on maintaining these dividend increases. Hence long-term investors who buy now should enjoy increasing cash flows for years to come.

The Bottom Line on CAT Stock

Trade war fears have hurt CAT stock. However, they have also given investors a chance to buy into one of the world’s most important companies at a low valuation.

Trade wars, whether real or perceived, will hurt CAT stock as a substantial share of its revenue depends on the rise of Asia’s developing economies. However, the company’s peers have failed to compete in many areas which should maintain some Asia presence no matter how long the trade war persists.

Moreover, the energy industry in the U.S. continues to recover. CAT stock will also benefit as the U.S. focuses increasingly on infrastructure. The stock could fall further if the trade war worsens. However, falling valuations and a bright, long-term future bode well for Caterpillar. Investors will know more about the effects when Caterpillar reports earnings on July 30th.  If the market sees a near-term end to the trade war, or if the PE falls below ten, investors should start buying CAT stock.

As of this writing, Will Healy did not hold a position in any of the aforementioned stocks. You can follow Will on Twitter at @HealyWriting.

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