On Thursday, Robert W. Baird analyst Mircea Dobre upgraded Caterpillar (NYSE:CAT) to an “outperform,” and simultaneously upped his price target on CAT stock to $191, roughly 25% above the stock’s current price.
It’s a reasonable call. Although the heavy equipment maker’s stock has been tossed around by the tariff war, the company’s sales jumped 23% year-over-year for the three months ending in August. The company’s average monthly revenue growth so far in 2018 has been an impressive 28%.
A closer look at Dobre’s optimism, however, bodes even better for Caterpillar stock than just the upgrade and upped price target do. Dobre is stoked about the machinery industry in general, which can play a surprisingly significant role in the bigger-picture success of CAT stock.
Sector Catalysts for CAT Stock
According to Baird,“The near-term picture is still robust as demand remains solid, (and) pricing is coming through to support [second-half 2019] margins with raw materials plateauing.”
While Dobre concedes some of the company’s markets are already at full capacity, he also believes that more than 60% of its markets are “at or below mid-cycle levels.”
It’s interesting to note that while Baird was suggesting CAT stock was an opportunity, the firm also upgraded Manitowoc Company (NYSE:MTW) and Sun Hydraulics (NASDAQ:SNHY) — a couple of other machinery/industrial names, perhaps making the call as much about the industrial sector as it was about CAT stock.
That matters, perhaps more than most investors realize.
Although the estimated figures vary somewhat, it’s believed that a particular stock’s industry accounts for about 37% of that stock’s price performance. Another 12% of a stock’s performance can be chalked up to the strength or weakness of its broader sector.
In other words, picking the right sector and industry is half the battle for investors.
It’s this sector-based and industry-based influence that may have held down CAT stock for the better part of this year, while other areas and the broad market were performing well. It’s also this influence that has recently shoved CAT stock and its peers into a higher gear.
The graphic below is telling. The industrial sector, machinery stocks, and CAT stock in particular have all trailed the S&P 500 year-to-date. They’ve all closed the gap in a big way since July, establishing some momentum that’s understandably starting to turn heads. In this light, Baird’s target doesn’t seem far-fetched at all.
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Fundamental Support
Dobre was bullish enough to make bets on several names in the sector, although Robert W. Baird has hardly been the only firm to suggest that machinery stocks are attractive right now. Melius Research explained in late August that machinery stocks were valued at a “far wider than normal” discount compared to the S&P 500’s valuation.
Melius Research’s Rob Wertheimer specifically notes that, “Thus far, execution has been far more consistent and far better than we or the market imagined, despite the curveballs thrown in from tariffs.” Wertheimer specifically mentioned Caterpillar and engine-maker Cummins (NYSE:CMI), though it was the strong second-quarter report from Deere & Company (NYSE:DE) that bolstered his bullishness on the group as a whole.
The optimism of analysts is not misplaced. The S&P 500 Industrial Index’s earnings trend, earnings projection, and price-earnings ratio are indeed more attractive than the market is giving the group credit for.
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The green arrow on the chart above marks the sector’s second-quarter earnings per share; everything to the right of the arrow is an estimate. Given that the sector’s Q2 bottom line was better than expected, though, it’s not unreasonable to assume that analysts’ so-so earnings outlook actually underestimates the level of earnings growth the S&P 500 Industrial Index’s constituents will generate for the next year and a half.
Either way, Wertheimer is exactly right about the group’s valuation. Thanks to unmerited weakness earlier in the year, the sector’s trailing price-earnings ratio of 18.7 is well below the market average.
The Outlook for CAT Stock
Just for the record, the 12% gain CAT has generated since the end of last month has left it vulnerable to some profit-taking. Right now isn’t exactly the best time to wade into a position, as a small pullback by Caterpillar stock appears likely.
A healthy pullback in Caterpillar stock would create a buying opportunity, though, for a myriad of reasons. Not the least of those reasons is that the sector and the machinery industry themselves are well-positioned for gains.
Caterpillar stock wouldn’t even have to do that much of its own heavy lifting to forge its way to higher highs in the foreseeable future.
Baird’s Dobre definitely has the right idea when it comes to CAT stock.
As of this writing, James Brumley held a position in Cummins. You can follow him on Twitter, at @jbrumley.
