Shares of Caterpillar (NYSE:CAT) have been under pressure over the past few weeks. After making a new recent high at $133 on Sept. 12, CAT stock had fallen nearly 10% before recovering the past two days. Some of the selling was warranted given the ongoing U.S.-China trade war, tariff turmoil and slowing economic growth. But that selling has now gotten overdone. It’s time to be a buyer of CAT stock on any dip.
The latest leg down in CAT stock was sparked by a downgrade on Sept. 12 by Wells Fargo. In a note to clients, Andrew Casey lowered his rating on CAT from “buy” to “hold.” He also dropped his price target from $150 to $143. He cited demand for construction equipment as the main rationale for his less rosy outlook.
Since that downgrade, Caterpillar stock has fallen over 12 points even though the price target was lowered by only 7. This means there is actually more upside in CAT stock now than prior to the Wells Fargo downgrade. While $143 may be a bit optimistic as a price target, a move back towards $130 is certainly more than realistic.
CAT now carries a trailing price-to-earnings multiple of just 11.3, nearing the cheapest valuation of the past 10 years. The forward P/E is under 10 with a PEG ratio of just 0.7. Caterpillar is at by far the cheapest comparative valuation to the overall market in the last decade. Other traditional fundamental metrics, such as price/sales, price/book, and price/free cash flow, paint a similar picture. Value investors will likely begin to take notice and start to accumulate CAT stock on any further weakness.
CAT Stock Technical Chart
Caterpillar stock reached extremely oversold levels on a technical basis before strengthening. The five-day relative strength index dipped below 20 while moving average convergence/divergence broke through -1. Bollinger Band Percent B printed at a negative reading. Prior instances when these indicators aligned at such extremes marked significant lows in CAT. There is major horizontal support at the $112 area.
Caterpillar stock is trading at a big discount to the 100-day moving average which has been a prelude to a pop in the past. CAT, normally highly correlated to the S&P 500, has been a huge underperformer over the last six months. I expect this correlation to revert and for Caterpillar stock to be a relative market outperformer in the coming weeks.
Earnings are due before the market opens on Oct. 23. Expectations are for $2.89 in earnings per share on $13.5 billion in revenues. Given the trough valuation multiples, simply meeting earnings expectations would likely result in a multiple expansion. It will likely take a decent miss to take CAT stock down appreciably from current levels. I think probabilities favor an upside move post-earnings for CAT.
The Bottom Line on Caterpillar Stock
CAT stock sports a very attractive 3.4% dividend yield, over twice the 10-year Treasury yield of 1.5%. The payout ratio is just 35.4% — meaning the dividend is extremely safe. Income-oriented investors may want to consider buying Caterpillar stock on any weakness. Selling a Jan $125 covered call at $5 would bring in an additional 4% in option premium (12.6% annualized) while still allowing for some upside appreciation. It also targets the $130 area as an exit point.
Option players may want to position for some upside with a bullish call spread. The Jan $120/$125 call spread is priced at $2.40. Maximum risk on the trade is $240 per spread with maximum gain of $260 per spread. Potential return on risk is 108%.
As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a free trial of the Delta Desk Research Report can email Tim at timbiggam@gmail.com.
