By James Anderson
Ah, the good old days. Back in the fourth quarter -- when growth stocks and technology shares in particular began to look like a boxer past his prime -- heavy-machinery stocks came alive, like a young George Foreman. Over the past three months, Caterpillar (CAT ) has produced a 38.0% total return. Deere (DE ) has taken off on a 24.5% run during the same period. And hyrdaulic-components maker Parker Hannifin (PH ) has delivered a gain of 32.2%.
After all that, equipment makers are still trading at a substantial discount to the broad market. At a close of $41.75 on Jan. 25, Caterpillar is trading at a mere 12.4 times its consensus 2001 earnings estimate of $3.37 a share, as compiled by Zacks Investment Research. Ingersoll-Rand is even cheaper, trading at a mere 9.6 times targeted 2001 earnings of $4.08 a share as of its Jan. 18 close of $39.25. By comparison, the S&P 500 is currently priced at 25.5 times projected 2001 profits, even after a 9% drop last year.
MIRED IN MULTIPLES.
So, it all adds up to a bunch of bargain stocks worth a gander, right? Think again. Wall Street's true feeling about heavy equipment is still rather lukewarm. Analysts attribute the recent streak of good fortune to sector rotation, a fancy way of saying investors have embarked on something of a bottom-fishing expedition. Right about the time that growth shares -- and technology companies in particular -- began to sputter, rusty Old Economy sectors such as machinery started to look inviting. If for no other reason, that was because the group was mired at depressed price-to-earnings multiples of 10 or lower at a time when the S&P 500 still fetched close to 30 times projected profits.
The problem is, long-term, heavy-machine makers have lots of issues to sort out. Start with the brave new world of U.S. agriculture. Free-market farm reform has yet to raise incomes out on the prairie. Bumper soy, wheat, and corn crops over the past four years are sure to keep the grain market glutted. Prices have dropped through the floor, and the U.S. Agriculture Dept. estimates that farm subsidies will account for about 50% of the agriculture industry's estimated $45 billion in net income this year.
If that isn't enough to make farmers wary, the fact that Congress is due to give agriculture handouts a close look in the new year isn't likely to perk up capital outlays down on the farm. That spells rough going ahead for companies such as John Deere and CNH Global, which both generate 55% or more of their revenues from agricultural equipment.
At the same time, construction, a market that has been good for heavy equipment, could be topping out. That's because the strong economic growth that kept crews hoisting girders and stacking bricks looks to be slowing. What's even more disheartening, Salomon Smith Barney's David Raso says the market for construction equipment has been headed downward since last year, and unit sales in the U.S. could tail off 7% to 8% in 2000. Furthermore, Raso thinks the percentage decline could reach "double digits" in 2001. "The valuations [of these stocks] are great, but you can't get around the fact that the industry's fundamentals are uninspiring," he says.
The outlook for 2001 isn't all bad, however. The heavy-equipment industry's big names can be thankful for a weaker dollar. "In this market, I'm steering toward companies with large operations overseas, the ones that stand to benefit when exports get cheaper," says Legg Mason analyst Barry Bannister.
Now that the U.S. currency is retreating from its 2000 highs, Caterpillar and Deere, two companies that reap around 50% of their sales abroad, should have better luck there. For other players in the machinery group, a diversified product line will help in the year ahead. Caterpillar, which gathers 12% of its revenue from power-generation turbines, stands to benefit from a boom in electric-plant construction. A hand in equipment for aerospace should work to Parker Hannifin's advantage.
If you're steering toward diversified-machinery stocks, your best bet might be the company whose bright yellow earth-moving gear is known the world over. Caterpillar certainly has been a favorite of the Street over the past decade. From 1991 to 1999, it outperformed the S&P 500 with an average annual rise of 20%. Mushrooming construction activity had the world at Cat's door. Now that builders' orders are starting to tail off, Caterpillar could still cash in on a couple of new trends. Rising demand and electricity squeezes have put the company's smaller generators, where Cat gets 12% of its revenues, in hot demand.
A cheaper dollar will not only boost Cat's top line but should expand the company's margins as well. And it has launched a campaign to cut its annual costs by $1 billion. Currently, 10 of the 16 analysts who follow the stock rate it a strong buy or buy, according to Zacks. And consensus estimates look for the company's earnings to grow an average 11.9% annually over the next five years. Legg Mason's Bannister says the stock could reach a 12-month price target of $55.
For a value play on the group, look no further than Ingersoll-Rand. The company's price took a drubbing in 2000, falling 22.7%. The Street worried much of the year that Ingersoll's Thermo-King transport-refrigeration business or its Bobcat industrial-equipment arm would get walloped by a slowdown in construction and trucking. Investors may have been too hasty in exiting, however, since the company's aggressive restructuring efforts could pay dividends.
HIGH FAIR VALUE.
By Wall Street's calculations, Ingersoll's earnings growth could climb from 9.1% in the year ahead to 12.1% annually over the next five years. Zacks reports that 11 of the 15 analysts who follow Ingersoll-Rand rate the company a strong buy or buy. Standard & Poor's analyst Robert Friedman says the stock's fair value is as high as $60.
It isn't an exact fit, but Fidelity Select Industrial Equipment (FSCGX ) is the closest thing you'll find to a sector fund for the diversified-machinery group. As of the end of August (the latest data available to Morningstar), the Fidelity fund had a sizable weighting in several heavy-equipment makers, including 4.4% of its assets in Ingersoll-Rand, a 3.9% stake in Caterpillar, and 1.9% invested in Parker Hannifin. The fund had a rocky go of it last year, dropping 4.2%. But over the past three years, it has averaged an annual total return of 9.9%, and so far in 2001, it has delivered investors 0.7%. If the sector's naysayers are correct, investors might not see much better returns anytime soon.
Anderson teaches journalism at the City University of New York. Follow his twice-monthly Sector Scope column, only on BW Online