Core Concepts: Machinery Peaks and Troughs

At this point, Caterpillar's operating metrics meet or even exceed the record levels achieved during the 1997-98 peak. By itself, this doesn't make Caterpillar an automatic sell. But equity holders in Caterpillar should recognize that risk has escalated in a material way. The probability that the company can sustain current operating performance over the long term is exceedingly small.

A Comeback for Cummins

It's not easy taking advantage of investors' linear bias because it often requires buying in the midst of a maelstrom. For example, at the end of 2001, Cummins was an operating mess. Sales growth and margins were lousy, well below historical norms. Returns on capital were below the cost of capital. Amid all the negativity surrounding the stock, I highlighted Cummins at $38 per share in a December 2001 RealMoney column:

I think operating and net profit margins can get to 9% and 3.5%, respectively, in the next cycle ... suggesting the company has $7 a share in annual earnings power. For fiscal year 2002, consensus estimates expect the company to earn 69 cents a share. If you believe, as I do, that you have to buy companies when they're down and out, in front of better times, then it's time to consider this company.

In 2004, Cummins earned $7.39 per share and achieved margins that were near my estimates. Operating performance continued to improve through 2006, with margins and other operating measures reaching record levels. The stock recently traded at $138 per share.

It looks like a nice story in retrospect, but reality is much more difficult. About 10 months after my column appeared, the stock traded at $19 per share, down 50%. Even a few months later, the stock was still down a hefty 40%, at $21 per share.

Cummins Here's a seven-year chart

This is the stuff of value investing. Just because you nail a story doesn't mean the market will immediately reward you with a stock price that mirrors value. Stock prices eventually migrate to value, but it can often take a year or more.

Patience is the watchword that is bandied about when stock prices deviate from value for extended periods of time. But patience doesn't occur in a vacuum. It's borne out of conviction. If you are convinced that the stock you're buying is selling at 50 cents on the dollar, you won't short-circuit the trade just because the market is taking a long time to recognize value.

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At time of publication, Alsin and/or ACM had no positions in the stocks mentioned, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor, and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback; click here to send him an email.