Caterpillar Investors Waiting for 'Buy' Signal

BOSTON (TheStreet) -- Caterpillar (CAT) has generated massive sales of construction equipment across the world, acquisitions are boosting earnings and profit margins are at their peak. The company's stock has surged 64% in the past year.

And yet Oliver Pursche, manager of the GMG Defensive Beta Fund ( MPDAX), which counts Caterpillar as one of its largest holdings, isn't increasing his position in the industrial giant, which will release first-quarter earnings results Friday. At least, not yet.

For a stock that has jumped 20% already this year, his view shouldn't be all that surprising to Caterpillar bulls.

"The stock has done phenomenally well over the last couple of years," Pursche said Wednesday from his office in Suffern, N.Y. "But we would rate this stock as a 'hold' based on valuation. We are still bullish on it. But as a result of that strong price appreciation, we would look for very strong, bullish forward-looking statements from Caterpillar in order for us to determine that we want to add to the position."

Caterpillar is expected to report first-quarter earnings of $1.31 a share on revenue of about $11.7 billion before the opening bell Friday. That compares to 36 cents a share and sales of $8.3 billion a year earlier.

Pursche maintains a focus on large-cap multinationals, which are growing businesses aggressively in emerging markets and demonstrate strong free cash flow. Caterpillar fits these requirements perfectly, making it the second-largest equity position in the GMG Defensive Beta Fund, according to Morningstar. Pursche has about $500 million in assets under management at his firm and about $20 million in the fund.

"We strongly believe in global infrastructure expansion and rebuilding, and Caterpillar is in a terrific space for that," Pursche says. "We think there will be continued wealth growth in emerging market nations, which is going to drive further demand in housing and road infrastructure. Specific to Caterpillar, they've done a very good job at managing their business, cutting some of their operating costs."

Pursche says he doubts anything the company says in its earnings release or subsequent conference call will persuade him to dump shares. Instead, he's looking to CEO Douglas Oberhelman to speak about Caterpillar's move into emerging markets.

Already, Caterpillar has pursued an acquisition strategy to move into markets where it hasn't had much penetration. Late last year, the company bought mining-equipment manufacturer Bucyrus ( BUCY) for $8.6 billion to gain more exposure to Asian markets. Pursche is looking for a similarly aggressive stance from the company on other markets, like Latin America.

"We expect bullish statements on their outlook, which is absolutely critical," Pursche says. "In terms of wanting to add to the position, we want to hear more about their growth plans, particularly in Latin America. They have a good handle on Asia and they're doing very well in that region. Latin America is where we think they can give some more insight."
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Other mutual fund managers share that bullish outlook. One portfolio manager, who requested anonymity for compliance reasons, offered his view that Caterpillar is a "great company with very rosy long-term prospects, no question." This manager does not own the stock, though, as the company's mining-equipment business does not align with the fund's socially responsible investing mandate.

With expectations high that Caterpillar stands to benefit greatly from Japan's rebuilding following the catastrophic earthquake and tsunami, the company's outlook will be weighed heavily as many other industrial companies have already reported strong results for the first three months of 2011, with many boosting their full-year guidance.

Shares of engine manufacturer Cummins ( CMI) hit an all-time high earlier this week after the company beat analysts' expectations for the first quarter while also hiking its guidance. The story was the same at Illinois Tool Works ( ITW).

Pursche, though, says investors should not get lost in the quarter-to-quarter noise from Caterpillar. "We're looking 12 to 18 months ahead. We think it's very difficult to have visibility beyond that," he says. "We have to think that they'll beat, but whether they're a penny above or below doesn't make much of a difference. It's not as significant."

Instead, Pursche will look for confirmation of Caterpillar's growth in several financial metrics. One that immediately stands out is Caterpillar's price-to-earnings (P/E) ratio of 13.3 based on next year's earnings estimates, which is below the P/E ratio of the market. That indicates shares of Caterpillar are trading at a discount to the market and are potentially undervalued.

Among peers like Deere ( DE), CNH Global ( CNH), Cummins and Illinois Tool Works, Caterpillar trades near the group average P/E ratio based on the current year's earnings, according to Bloomberg.

But Caterpillar's free cash flow, book value, net profit margins and operating margins are all just as critical to Pursche. "When we see an environment where operating margins and net profit margins are growing at a fairly solid pace, along with earnings and free cash flow growing, it's a strong indication that they're managing the business well," he says.

The trend that impresses Pursche though most, even with a blip in 2009 due to the economic meltdown, is that Caterpillar has continuously improved its book value per share and cash flow per share. "The cash flow per share is rising sharply," he says. "In 2010, it was just below $8 in terms of cash flow per share. Estimates are that it will be closer to $10 in 2011 and $12 in 2012."

Lastly, Pursche says that investors looking for a similar company to Caterpillar would be wise to follow farming-equipment maker Deere. Pursche notes that Deer has been growing their businesses in Asia as well as Latin America, similar to Caterpillar. "Deere is a slightly different business, focusing on agriculture and farming rather than earth moving. But again, it's a company we like a lot also," he adds.

-- Written by Robert Holmes in Boston.

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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