Why CAT Looks Like a 'Dog'

NEW YORK (TheStreet) -- If you drink water from the same fountain as legendary investor David Tepper (who you can read about in Business Insider) by all means load up on shares of Caterpillar ( CAT).

However, if you are a traditional investor who is accumulating equities to build wealth over a long-term horizon, perhaps you would be wise to understand the asymmetry that exists in realistic upside and downside scenarios for CAT common shares. Check out this article in BusinessWeek. for more on that.

In my view, the traded value of CAT common shares depends much more on how successful central banks are in keeping benchmark interest rates suppressed than on whether CAT management succeeds in growing revenues, net income, and "free cash flow."

De-Constructing the Bull Case for Owning Shares of Caterpillar

At headline level, investors who own CAT common shares expect to profit as a growth trajectory takes firmer shape globally and especially in rising economies.

One of 30 components in the Dow-Jones Industrial Average since May 1991, CAT seems to be a solid, globally accepted brand that should prosper even through the cloudy future as it has done for decades since 1925. The equipment it manufactures and sells moves and powers the world.

If you do not already own CAT common shares, is this a good time to jump on board? CAT Chart CAT data by YCharts

Technical analysis might suggest that there is little downside in CAT and realistic hope for regaining three-digit pricing based on levels attained in the recent past.

Furthermore, CAT prides itself on paying a stream of cash dividends that has risen consistently for years. The last four quarterly dividends totaled $2.08 per share and management likely will soon boost the quarterly dividend even higher.

With a current yield around 2.4 % and likely headed upward, why not sock some dead cash into purring CAT shares?

A Structural Case Against Owning CAT Now

Extraordinary measures taken by major governments and central banks have artificially supported economic activity and simply deferred the inevitable day of reckoning when global capacity will be "right-sized" closer to intrinsic ("unfinanced") demand for the suite of products and services offered by CAT.

In simple terms, the profile presented today by CAT combines defects seen in common shares of General Motors ( GM) with defects seen in common shares of General Electric ( GE).

How could we possibly believe that GM, GE, or CAT are potential value traps?

Like GM, CAT sells many of its products to dealers so management is one step removed from understanding true "end-use" demand. Like GE, CAT has a financial services business that has grown over many years to represent a substantial proportion of the company's tangible assets. Like GM and GE, CAT's end-use customers require access to debt-financing to purchase or lease equipment.

In the downside scenario that seems reasonable -- where nominal interest rates will be pushed upward -- CAT's end-use customers will likely be hurt just as CAT itself suffers.

Taking a Long-Term View

Technical analysts may argue that looking back over years at available data simply muddies the waters. In a sense, these analysts are correct. However, their conclusion actually supports the surprising 30,000-feet view, the stock's movement since 1999.

In that year, companies like CAT, GM and GE were basking then in the glow of a long tear upward as they fretted about what may happen with "Y2K." Unlike Internet start-ups, these behemoths had solid brick-and-mortar footprints, commanding global market position and robust competitive advantages.

Subsequently, as companies like Google ( GOOG) and Facebook ( FB) emerged out of university dorm rooms, "legacy" companies like CAT, GM and GE approached or hit the wall between September 2008 and June 2009.

Before 1999, analysts accorded intangible value to companies with "assembled workforces." In 2013, some see large pools of employees and retirees as daunting liabilities. Companies are taking every opportunity they can find to trim employment costs in the U.S. and in other high-cost nations with slow-growth populations.

To jump into the water with CAT common shares, you should first study macro-economic data carefully for each of the major markets where CAT's end-use customers reside. We accept that this type of data has many limitations but, given that, we feel it argues against a realistic growth case.

Next, you should examine accounting conventions used to produce balance sheets and other financial information for the world's largest and most active central banks. In our view, some of these Central Banks have painted themselves into a corner -- even they cannot find enough solvent counterparties to hedge against an inevitable return to more "normal" nominal interest rates.

Last, when Financial Crisis Version 2.0 is about to become inescapable reality (as this report on Bloomberg hints, for instance), you better hope you can adapt quickly to the new conditions.

When the bear market does roar back in, common shares of CAT (along with GE and GM) will be crushed harder than they were between 2008 and 2009.

At the outside, we are talking months before hibernation is over. But who knows -- watching the way things move in murky geo-political waters and hyper-active domestic politics, the bears could return to town sooner than most expect.

At the time of publication, the author had no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage. Charles Ortel is managing director of Newport Value Partners LLC, which provides independent investment research to professional investors.

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