Why Caterpillar Stock Crashed In June; What Is The Outlook?

This post was originally published on this site

Mihail Minin

Introduction

I always like to begin my articles by revisiting any past coverage I’ve had on a stock so readers can see how my previous expectations turned out. In Caterpillar’s (NYSE:CAT) case, I was surprised to find all four of my previous articles have been bearish. And this one will be no exception. However, I want to make it clear at the outset that I typically only cover stocks that I would consider buying myself if the price was right. I have relatively high quality standards, and just because I have been consistently bearish on a stock doesn’t mean there is anything wrong with the business. In fact, I like Caterpillar’s business a lot, and if the stock ever hits a good price, I’ll be a buyer. But the price needs to be right. I like to have the potential for market-beating returns and a margin of safety, and if I pay too much for a stock I’m less likely to achieve those goals. So, let’s start by reviewing CAT’s performance since my previous bearish articles, and then I’ll examine when I would be willing to buy the stock.

Caterpillar stock will always have a special place in my heart as a stock writer because it was the first article I wrote specifically about the dangers of investing in deep cyclical stocks near their peaks, late in the economic cycle. My January 15th, 2018 article “How Far Could Caterpillar Fall?“, in many respects started my investment writing career. It’s interesting to reread my process at the time, nearly five years later, but my “optimistic” scenario for CAT’s stock price back in early 2018 was pretty close to spot on.

Then let’s say that after these three years of gains, the economy turns down and Caterpillar loses 45% of its value, which is very typical for Caterpillar historically. That would put Caterpillar’s price at $140.25 per share. If we assume the drop will be similar in nature to those of the past it will take 12-18 months to bottom, so one would be 4-5 years into their investment from today and be sitting on significant losses. And it still may take another year or two from this point just to get back to even if history is any guide. So, in a pretty optimistic scenario, a Caterpillar owner here at $170 per share may be looking at a 5-6 year investment breaking even.

Here we are 4.5 years later and CAT is sitting at $178 per share. Here are the total returns compared to the S&P 500 since the article came out:

Data by YCharts

CAT was underwater for about three years. It did indeed fall -45%, and has underperformed the index the entire period. Overall, it was a pretty good warning article.

I also, continued to warn investors that CAT stock could fall farther, even after the stock had dropped a lot. So let’s take a look at that article as well. It was written one year later, on January 19th, 2019 and titled “Understanding Caterpillar, The Cycle, And Why It Fell“. While I rated CAT stock a “Sell” I was reasonably constructive in the article and shared two potential entry points for the stock.

For investors in cash waiting to buy CAT with a margin of safety, I would aim for about a $94 entry point on my first position (1% portfolio size). And for investors still holding CAT, I shared my numbers, and I think there is still more risk to the downside, but it’s a lot less than last January. You can judge for yourself based on the numbers.

CAT would eventually hit that first $94 buy price in March of 2020, but, given what was going on at the time, I was only personally using my “deep recession” buy prices, so I didn’t buy the stock because it didn’t fall enough for a deep recession. All things considered, CAT stock has still underperformed the index since that January 2019 article was written, even though it has produced decent absolute returns.

Data by YCharts

And this brings us to my most recent CAT article, earlier this year, when I thought we were probably near a peak for CAT stock again, and I issued a fresh bearish warning on the stock on February 1st, 2022 “How To Capitalize On Caterpillar’s Future Price Decline“.

Data by YCharts

Since that article CAT is down about -12%, which is similar to the S&P 500, but the decline since June has been breathtaking fast. Overall, I think I have produced good articles on CAT despite being pretty bearish most of the time. In this article I want to warn investors again, specifically about using earnings and P/E ratios to value cyclical stocks when they are falling rapidly off their peaks, as CAT is doing now. In my opinion, the next few months will be one of the most dangerous times to buy Caterpillar stock because it’s likely to look like a tremendous value when it isn’t.

Categorizing a “Deep Cyclical” Stock

When I analyze any stock the first action I take is to see how much history the stock has as a publicly traded company. After that, provided they have enough of a history, I check to see how much their historical annual earnings per share have fluctuated over the years. This helps me determine whether a stock is a “deep cyclical” or not.

FAST Graphs

In the FAST Graph above, the dark green shaded area represents earnings per share. I have circled the years in which earnings per share growth was negative. While Caterpillar’s overall earnings trend is up over the past 20 years, there have been seven of those years where EPS growth was negative. I consider declines in EPS growth of -50% or more “deeply cyclical”, and CAT’s were deeper than that in the Great Recession in 2009 and also in the industrial recession in 2015/6. During COVID, they fell about -40%, but quickly recovered. In many respects CAT is an ideal cyclical stock to invest in. Overall, it’s not too dangerous because earnings typically bounce back within a few years, and, during the past two decades, they have never gone totally negative. However, the price can often sell off deeply, which gives investors a chance to buy the stock at a decent price every now and then. This can allow investors who know what they are doing to get outsized returns over 2-5 years without taking on excessive risk.

However, the catch is that investors who want market-beating returns, have to buy at the right price, and often CAT can look attractive based on earnings when the stock price still has a lot of downside. This can cause many investors to buy at a price that is too high to produce really great returns, and that is not ideal.

FAST Graphs

In the FAST Graph above, I highlighted some particularly enticing historical P/E ratios for Caterpillar. All of them are much lower than the P/E ratio of 15.22 where the stock trades today. With businesses that are less cyclical, low P/E ratios often correspond to superior medium and long-term returns. However, the opposite is often true with more cyclical businesses like Caterpillar. Below are the total returns from the data points highlighted in the FAST Graph above compared to the S&P 500.

Data by YCharts

The first entry point was from September of 2008. This entry point produced average returns on both an absolute and relative basis compared to the index, but with considerably more volatility.

Data by YCharts

The second entry point in November of 2012 produced good absolute returns, but significantly underperformed the index and also experienced a lot more volatility.

Data by YCharts

And the third entry point from April of 2019, produced mediocre absolute returns and underperformed the S&P 500 index.

I’m sure there are going to be some investors out there who would be happy with a 10% CAGR over the past 15 years, and they perhaps don’t mind that they would have also had much deeper drawdowns than simply owning the index. I am not one of those investors, though. And, if we are being honest, I don’t think most of the investors who were buying Caterpillar stock when its P/E looked “cheap” during these times were aiming for below market or average returns.

Personally, I aim for medium-term returns in 15-20% CAGR range at the portfolio level, and when I invest in a deep cyclical stock like Caterpillar, I typically aim for a 100% return within five years or better. Since I never count on a cyclical stock trading any higher than its previous cyclical high, that means I usually need to buy a deep cyclical at least -50% off its cyclical high, so that if it takes a full five years to recover, then I’m still in my 15-20% CAGR return range.

Usually the pushback I get from readers regarding my goals and buy prices is that the market will never give me the prices I’m looking for. And for some stocks that is absolutely true. They never end up trading at prices that I can confidently predict good medium-term returns from. But that’s okay, as long as there are other stocks that do hit my buy prices. So, while Caterpillar hasn’t fallen enough for me to buy during the past five years, there are other industrial stocks that have. During the March 2020 crash, I bought two industrial stocks in my marketplace service, The Cyclical Investor’s Club, that were deep cyclicals and had similar characteristics as Caterpillar. One was Kennametal (KMT), and the other was Astec Industries (ASTE). I bought them both on 3/16/20, and I have already taken profits in both of them since they reached my return goals. Here is how they performed during their respective holding periods compared to both SPY and CAT if purchased and sold on the same dates.

Data by YCharts

Little-known Astec Industries actually produced better returns than the well-known Caterpillar during my holding period and in just over a year I made +150% return.

Data by YCharts

In Kennametal’s case, I would have been better off buying Caterpillar than KMT, but I still got a double in 15 months, and most importantly the market gave me the opportunity I was looking for with KMT while CAT just missed my buy price in March 2020. What is important to compare, here, is that anyone who bought CAT stock in 2018 and 2019 severely underperformed an investor who bought CAT or similar stocks like KMT and ASTE when they were actually deep in a downcycle. And downcycles, while they are all different, regularly occur with these stocks, so it’s almost always worth waiting for them before one buys.

CAT’s historical price patterns

Because CAT’s earnings are deeply cyclical it causes the P/E ratio often used by investors as a valuation tool to not be very accurate predicting medium and long-term returns. In order to deal with this problem when it comes to cyclical stocks I use historical price patterns instead of earnings as a guide for when to potentially buy a stock. Once we control for a few additional factors, we can then examine the stock’s historical drawdowns and make a rough estimate of what we might expect during a future drawdown.

Data by YCharts

Above is a long-term price drawdown chart for CAT. Below is a breakdown of the deeper drawdowns to give us an idea of CAT’s general patterns over the long-term.

~Year ~Time Until Bottom ~Duration ~Depth
1973 12 months 2 years -48%
1981 14 months 6 years -60%
1987 6 months 5 years -48%
1999 17 months 5 years -53%
2007 18 months 4 years -74%
2014* 16 months 3 years -50%
2018 26 months 3 years -46%
2022 13 months** ? -30%**

*2014 was not a full recovery to the 2012 highs, but it was very close.

**So far this downturn.

Every cycle is a little different so examining past downturns is really just a way to get us in the right ballpark so we have an above average chance at achieving above-average returns after we buy the stock. If we examine the last three recessions and downcycles since 1999, we can see that the typical downcycle usually causes Caterpillar’s stock price to fall about -50% off its highs. During the 2018-2020 downcycle, CAT stock only fell about -46% off its highs, which is why I missed buying it during that downcycle. That’s okay. The estimate was still pretty good and if the Federal Reserve would have acted a day later issuing its “whatever it takes message” in March of 2020, then CAT probably would have fallen below that -50% level the next day, and I would have picked it up.

So, when I look at this history, it’s pretty easy for me to establish a buy price that is about -50% off CAT’s recent highs, which works out to $123.35. The stock price still needs to fall about -30% more to reach that level. Importantly, if we look at 2008’s drawdown, we can see that CAT fell much deeper during a worse recession and that even if we buy CAT’s stock -50% off its highs, it could still fall another -50% after that if the next recession is a very bad one. I typically don’t like to buy stocks at prices I know they have a reasonable chance to still fall more than -50%, so buying CAT at any higher price, isn’t worth it to me. Even though my base case right now is for a mild recession and not a severe recession, things can change, and I like to be prepared for the worst.

I have an additional series of tests that I run cyclical stocks through before I actually purchase them, and if I do end up buying CAT at some point, I’ll share that process in a new article. (I generally don’t get too much pushback when it comes to CAT being a quality business so I don’t think it will be too controversial to declare CAT “high quality” enough to buy during a downturn.)

So why the big drop in price in June?

While there are a lot of stocks in this market that are overpriced because of temporary government stimulus, I don’t think Caterpillar is one of them. CAT’s earnings and stock price actually got hit pretty hard during the pandemic. So, if the market was left to its own devices in 2022 and 2023, I think CAT’s stock price probably could have continued to rally, or, at least not sold off like it did. There are two factors at play that I think have caused the recent sell-off. The first is that the Federal Reserve has gotten extremely hawkish and is hiking interest rates at an extraordinarily fast rate with the express purpose of slowing down the economy. These actions typically precede and contribute to recessions, and, as we have seen from the historical data, recessions are particularly hard on CAT’s earnings. Market professionals are very aware of this historical pattern, so when they see gigantic interest rate hikes from the Fed, they sell deep cyclical stocks like Caterpillar. It’s really that simple.

In my February 1st, 2022 article I warned investors this was the likely outcome:

I judge that we are currently in the early stages of the Late Cycle. This stage is usually characterized by the Federal Reserve tightening monetary policy, high asset prices, and relatively low unemployment rates. We certainly have high asset prices and low unemployment rates, however, if the Fed is only tightening slowly, as they started to do in 2015, then it can take two or three years to move from Mid-Cycle to Late Cycle which is what happened back then. Now the Fed appears to want to tighten faster, and the government, so far, is on track to withdraw financial support from the economy as well. If both of these actions stay on track, then I think we will have a shortened Late Cycle period, and probably have some sort of recession in 2023.

There are two counter-cyclical things that could occur, though, that might stretch out the Late Cycle period. First, the Fed or the Federal government could change their mind later this year regarding tightening, or they could continue stimulus. Secondly, we could see parts of the service economy that have been suppressed because of COVID fully reopen. Some combination of these two factors could potentially extend the Late Cycle into 2023. So, I’m not making an all-or-nothing call here, but the odds right now are that when it comes to the stock market, the Fed and government will likely act too late to save highly cyclical stocks, if they decide to act at all.

We have seen parts of the service economy doing well this summer, but there is no sign the Federal government will issue more stimulus and the Fed has only gotten more hawkish since February. I think it took the market a little while to really believe the Fed would put us into a recession, but when they started hiking by 75 basis points at a meeting in June, the market knew it had better sell deep cyclical stocks while it still could, and that’s likely what drove CAT’s price down. The market is forward looking, and it might not get the timing exactly right, but usually within a couple of years the recession comes, and CAT’s stock price falls deeply. June’s price action was indicative of that expectation.

Will CAT stock rise again?

CAT stock has historically recovered very well from past drawdowns. While I’m personally aiming to buy after a -50% drawdown, if an investor wanted to be a little more aggressive to increase their chances of buying the stock during the current downturn, below I calculated the how an investor would have done historically if they bought after a -45% decline off the highs.

The table below shows the results one would have had if they invested after a -45% decline in price during CAT’s previous downturns. The returns in the table do not include dividends. I annualized the returns and then compared them to the S&P 500 if bought and sold on the same dates, annualized. The goal is to see if historically buying after a -45% decline would be an alpha-producing strategy, so the last column is the alpha produced by the investment annualized relative to the S&P 500. All the percentages should be treated as estimates and are based on the approximate months held. If one buys after an ~45% decline and sells after the stock makes a full recovery, it produces an ~80% simple return, so that is the simple return for each of the investments in the table below.

Year the Decline Began Purchase Date Sell Date Months Held Annualized Gains S&P 500 Annualized Gains Alpha to the S&P 500 Annualized
1973 9/30/74 10/21/75 13 73.85% 39.25% 34.60%
1982 5/19/82 9/24/87 64 15.00% 33.43% -18.43%
1987 10/9/90 5/27/93 31 30.97% 18.69% 12.28%
1999 2/11/00 7/18/03 41 23.41% -8.31% 31.72%
2007 10/8/08 12/1/10 26 36.92% 10.36% 26.56%
2014 1/13/16 7/25/17 18 53.33% 20.70% 32.63%
2018 3/12/20 10/16/20 7 137.14% 68.52% 68.62%

During every deep drawdown over the past 50 years except one, in 1982, buying CAT stock when it was -45% off its highs would have produced market-beating returns in addition to great absolute terms as well. While there is never any guarantee that history will repeat, the odds are dramatically in an investor’s favor who uses history as a guide and assumes that eventually Caterpillar stock will recover. It’s unlikely we will stop needing the products CAT produces during the next decade. Even during CAT’s worst recovery period in the early 1980s it still returned annualized gains of 15%, which isn’t too bad on an absolute basis. But, in order to produce these returns, the stock needs to be purchased at the right price.

Is CAT a buy, sell, or hold?

From my perspective, CAT is still a sell here because it likely still has at least another -30% downside, but obviously it would have been better to sell back in February after my first warning article. If an investor really loves their CAT stock and is worried they won’t be able to buy it back at a lower price, then CAT is fine to hold as long as poor-to-mediocre returns over the next three years is acceptable to them. Personally, I’m not the type of investor who trims positions or takes half positions, but this is the type of situation where if an investor is really attached to the stock, they could sell half and then attempt to buy back at a lower price to both help ease the pain of the potential drawdown, and also to lower one’s cost basis.

One thing I feel confident about over the medium-term is that even though it is off its highs a bit already, there is much more downside risk with this stock than there is potential upside given where the price is, and where we are in the economic cycle.