3 Reasons Caterpillar Could Be The Best Dividend Stock To Own Over The Next 5 Years (NYSE:CAT) (2024)

(Source: imgflip)

Income investors love dividend aristocrats and for good reason. These are the bluest of blue chips, with 25+ consecutive years of dividend growth to their credit. This indicates strong business models, good competitive advantages (moats) and conservative and dividend friendly corporate cultures.

Which explains why the aristocrats have historically outperformed the S&P 500, and with lower volatility and superior risk-adjusted returns to boot.

Dividend Aristocrat and Kings Total Returns Since 1993

(Source: Portfolio Visualizer) portfolio 1 = dividend aristocrats, portfolio 2 = dividend kings

But the downside to such impressive track records is that the aristocrats and kings are currently richly priced.

• Average dividend aristocrat yields 2.6% and is 10% historically overvalued
• Average dividend king yields 2.2% and is 20% historically overvalued

But as I like to say, no matter what the broader market is doing, something great is always on sale. Today this means economically sensitive aristocrats like construction/industrial equipment maker Caterpillar (NYSE:CAT).

Caterpillar Total Returns Since 1986

(Source: Portfolio Visualizer) portfolio 1 = CAT

Despite its cyclical business model Caterpillar has managed to outperform the S&P 500 by 2.1% CAGR over the past 33 years. Its overall volatility during that time was 41% less than the market's, and its average rolling returns have beaten the S&P 500's over every time period.

Today recession risks are near 10-year highs (33% to 55% estimates from economists and banks). Trade war fears have resulted in even the highest quality industrials trading at significant discounts to historical fair value.

This creates a potentially attractive buying opportunity for long-term income growth investors to buy Caterpillar today, at a 32% discount to fair value, and potentially lock in 17% to 31% CAGR total returns over the next five years. The upper end of that realistic return range is the highest of any company on the Dividend Kings' 150 company master valuation/total return potential list.

No one can know whether or not we'll get a recession and when. But here are three reasons why Caterpillar is the best dividend growth stock you can buy today (as long as you plan for inevitable gutwrenching volatility).

Reason One: A Very Safe And Growing Dividend, Even During Recessions

Caterpillar's 3.5% yield is attractive compared to the S&P 500's 1.9% and high-yield ETFs like the Vanguard High Dividend Yield ETF (VYM), which yields 3.1% after expenses.

But an attractive yield is worthless unless it can be maintained through all economic and industry conditions (such as economic and industrial recessions).

Caterpillar earns a 5/5 dividend safety score courtesy of increasingly stable cash flow (more on this in reason two), a safe payout ratio, and rock-solid balance sheet. These are the factors that have allowed it to become a dividend aristocrat, with 26 consecutive years of dividend growth.

(Sources: Gurufocus, F.A.S.T Graphs, S&P, Morningstar)

Caterpillar's adjusted EPS payout ratio is a safe 30%, and its TTM FCF payout ratio is 46%. Over the past 10 years, CAT's EPS payout ratio has averaged 51%, far above today's levels. This provides plenty of safety buffer should we indeed get a recession in 2020 or 2021 (about 42% probability based on current economic and bond market data).

(Source: F.A.S.T Graphs)

I've place recessions and industrial recessions in black boxes, which shows that, while Caterpillar's dividend growth slows to token amounts during downturns, the operating earnings cash flow payout ratio hasn't been negative in 20 years. During which time the company has grown the dividend at 9.1%, or roughly 50% faster than the S&P 500.

Caterpillar's management is guiding for "at least" high single-digit dividend hikes in 2020, 2021 and 2022, following 2019's 20% hike.

(Source: investor presentation)

Guidance is not a promise, just a plan, and a recession could scuttle those plans for 7% to 9% dividend hikes over the next three years.

But even if EPS and FCF were to evaporate or turn briefly negative (such as a protracted and severe recession), the company could maintain the dividend thanks to its ability to borrow safe amounts of very low-cost debt.

The balance sheet is a fortress, with net debt to EBITDA a very low 1.0, and sky-high interest coverage ratio. That explains why the company enjoys a strong "A" credit rating from S&P and why it's effective borrowing cost is just 1.1% (thanks to overseas borrowing), compared to 2.6% for the US treasury in July.

That's also 13.5 times lower than its returns on invested capital of 14.9%, indicating that what debt Caterpillar does have is being put to good use, driving long-term cash flow and dividend growth.

But a safe dividend is just part one of Caterpillar's long-term thesis. The second part is excellent growth potential, created by an epic boom in global infrastructure spending.

Reason Two: Excellent Long-Term Growth Prospects Courtesy Of Massive Global Secular Trends And The Best Management Team In The Industry

Caterpillar was founded in 1925 and has spent nearly 100 years building itself into the world's largest industrial equipment maker. It now operates in 193 countries and territories, which is just one reason it's poised to profit from a massive global infrastructure boom in the coming decades.

(Source: BIP investor presentation)

By 2035 alone nearly $70 trillion in infrastructure spending will be needed, and by 2040 the G-20 estimates the total will be closer to $94 trillion (over the next 50 years estimates run as high as $200+ trillion).

That's because Caterpillar is a wide moat giant, that makes construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives.

Caterpillar has several competitive advantages, one of which is its vertically integrated nature, effectively making it a one-stop-shop for all its customer's needs

• it has its own financing arm
• it offers insurance on its equipment
• high margin services and aftermarket parts to maintain equipment and keep it in good operational condition (boosting long-term profitability for clients)

(Source: Ycharts)

The company's R&D spending averages about 4% in recent years, which the company is focusing on automation and telematics. Its focused R&D budget is why Caterpillar has over 20,000 patents to support its pricing power and defend its wide moat.

Caterpillar's premium equipment is designed to minimize long-term operating costs which can run four times the cost of initial purchase. CAT's world-class products have been known to operate for over 130,000 hours, or up to 20 years and counting.

While Chinese firms (four major rivals) have attempted to steal market share in recent years with prices 25% below that of CAT, ultimately servicing these has proven difficult, due to poor distribution networks being unable to service less reliable machinery.

Caterpillar's other competitive advantages include a network of 168 global distributors who know how to sell premium industrial equipment to some of the world's largest energy/industrial/construction firms. Morningstar estimates that to recreate CAT's dealer and distribution network would cost over $20 billion, financial resources few companies in this industry have.

These dealers are also very good at marketing the company's aftermarket parts and service contracts which made up $14 billion in sales in 2016 (36% of company sales), That's the business management wants to double to $28 billion over the next seven years.

(Source: investor presentation)

The company's installed base numbers about 2 million pieces of equipment, 850,000 of which are connected with telematics, likely makes this goal achievable. What's more, aftermarket parts and services are necessary to keep the machinery running, meaning it should create more stable cash flow over time, further increasing dividend safety.

This is a key reason management's growth plans call for doubling high margin service revenue by 2024, which is expected to generate $4 to $8 billion in FCF that year alone. For context, in 2013, CAT generated record free cash flow of just over $6 billion This means that the least volatile part of its revenue is expected to generate record amounts of FCF all on its own within the next seven years.

(Source: Ycharts)

Caterpillar's other competitive advantages include an excellent management team. Morningstar's Scott Pope considers it "the best-run company in the heavy equipment market", a sentiment I agree with. That management team is led by CEO Jim Umpleby, who has been in the top spot for about 2.5 years but has been with Caterpillar in numerous roles for decades.

Management plans to improve adjusted operating margins from its historical 7% to 15% to 10% to 21%, across the economic cycle (including recessions). That's courtesy of immense economies of scale and a great track record of cost-cutting ($1.8 billion cost reduction plan is on track). Higher margin service revenue is also a linchpin in that plan for consistently higher profitability.

The company has $10 billion buyback authorization in place to opportunistically repurchase undervalued shares during it's many, many short-term crashes (see risk section). This ability to repurchase shares at highly accretive levels is just another way that Caterpillar is able to deliver some of the best growth rates of any aristocrat over time.

And today, as long as you are comfortable with current recession risks, and avoid oversized positions (keep some powder dry to buy more), Caterpillar is offering literally the best future return potential of not just any aristocrat, but any blue-chip I know of, period.

Reason Three: Great Valuation Means Excellent Total Return Potential...Even If We Get A Mild Trade War Recession

My new valuation approach is based on my fellow Dividend King Chuck Carnevale's (SA's valuation guru and founder of F.A.S.T Graphs) 50 years of experience in asset management. His approach is inspired by Ben Graham (father of value investing, and Buffett's mentor) who famously pointed out that over the long-term the market correctly "weighs the substance of a company".

What I do is look at 10 historical valuation metrics, the time frames corresponding to periods when a company's fundamentals and growth rates were similar to what's expected in the future. Then I apply that year's expected results (consensus earnings, cash flow) and dividends to the multiples real investors risking real money paid for the company.

Caterpillar's 2019 Fair Values Based On:

• 5-year average yield: $170
• 10-year median yield: $170
• 25-year average yield: $162
• 10-year average PE ratio: $215
• 10-year average P/Operating Cash Flow: $127
• 10-year average price/free cash flow: $214
• 10-year average price/EBITDA: $146
• 10-year average price/EBIT: $198
• 10-year average Enterprise Value/EBITDA (factors in debt): $146
• Average Historical Fair Value: $172
• Current Price: $117
• Discount To Historical Fair Value: 32%
• Quality: 10/11 (SWAN stock and a dividend aristocrat to boot)
• Recommendation: Very Strong Buy

Like with many cyclical companies (and tech stocks), the range of fair values can be wide. It's impossible to determine precisely what the intrinsic value of a company is but I can say with high confidence that Caterpillar's fair value is between $127 and $215 today. The average of these values, $172, is a reasonable approximation (Morningstar's fair value estimate is a nearly identical $169).

This average historical fair value is what I then apply each company's quality score to determine its buy classification. While it's not a mistake to buy a quality company at fair value (what I call "reasonable buys") to earn a good/strong and very strong buy rating I need to see a margin of safety commensurate with a companies quality and risk profile.

Dividend Sensei Quality-Based Valuation Classifications

Based on Caterpillar's quality score of 10/11, here are its classifications

• reasonable buy at $172
• good buy at $163
• strong buy at $146
• very strong buy at $129

At $117, a figure that's below every single historical fair value metric and 32% below my estimate of its current true worth, I consider Caterpillar a very strong buy.

That's because it is currently offering the best total return potential, not just of any dividend aristocrat, but any blue chip dividend stock I know of, period.

(Source: F.A.S.T Graphs)

The company's growth over time can be volatile, depending on the economic cycle. However, 7% to 15% is a reasonable growth range, that the company's growth runway, strong fundamentals, and skilled management is likely to be able to deliver. According to FactSet Research, the current 5-year CAGR analyst EPS consensus is 14.1%, which lines up well with the company's growth rate of the past 10 years.

(Source: F.A.S.T Graphs)

Over the past decade, when CAT's fundamentals and growth was similar to what it's likely to keep delivering, its average PE was 17.5. To estimate a realistic total return potential range I use Chuck Carnevale's and Ben Graham's 15.0 rule of thumb and the lower 7% growth range, which factors in a possible trade war recession.

(Source: F.A.S.T Graphs)

The upper range of realistic returns factors in 15% growth and the PE returning to its historical 17.5, which would be justified by steadily more stable cash flow from its rapidly growing high margin services and aftermarket parts business.

(Source: F.A.S.T Graphs)

I round up and down to the nearest whole numbers to estimate 17% to 31% CAGR five-year total return potential. Note the low end of that range, which means doubling your investment within five years, is factoring in a trade war recession. A trade war that has been going on for nearly 20 months now and which analysts are also factoring in, yet still expect 14% CAGR EPS and FCF/share growth (and which supports management's 7% to 9% dividend hike guidance through 2021).

On my 150 company master valuation/total return potential list (exclusive to Dividend Kings), there is no company with higher return potential than Caterpillar.

For anyone comfortable with its risk profile, this level 10 SWAN aristocrat offers the potential for returns to rival the best investors in history, at least over the next five years.

Risks To Keep In Mind

There are three kinds of risk all investors need to keep in mind.

• fundamental risk (Buffett's definition of risk): permanent impairment of cash flow from business model breaking, can result in dividend cuts and permanent loss of capital (up to 100%)
• valuation risk: overpaying for a company to such an extent that even if growth rates are as expected your total returns will be insufficient to achieve your financial goals
• volatility risk: poor planning/asset allocation forces you to be seller of a great company (bought at a good to great price) during a market downturn, resulting in permanent loss even if your facts and reasoning are right

Caterpillar's fundamental risks are tied to its leading global role as the world's biggest seller of industrial equipment. Specifically, 53% of 2018 sales were generated outside of North America. Last year North American sales grew an impressive 20%, but Asia/Pacific sales boomed 28%, indicating that overtime Caterpillar's foreign exchange risk might increase.

(Source: Ycharts)

While currency risk tends to cancel out over time, for many years a strong dollar can result in growth headwinds (its equipment becomes more expensive in local currencies). Today the US's stronger economic growth relative to developed countries (and much higher interest rates) is keeping the dollar at very high levels relative to other major currencies.

This trend may persist for several more years, potentially resulting in Caterpillar missing growth expectations.

The company will have to effectively deal with various foreign rivals both large and small, including several Chinese firms that could reduce its market share should their reliability and parts distribution networks ever improve sufficiently.

And of course, we can't forget that industrial equipment sales are cyclical and economically/trade war sensitive.

(Sources: F.A.S.T Graphs, FactSet Research)

According to FactSet Research, the analyst consensus for CAT's EPS growth in the coming years looks like this

• 2019: 6%
• 2020: 6%
• 2021: 2%

Those are much slower growth rates than in recent years, and might prove unrealistic should the US or global economy fall into a recession. And even if the world and US economies avoid a recession, the industrial/manufacturing sectors are likely to contract.

(Source: Bloomberg)Since the trade war began in early 2018 global manufacturing has slowed significantly and is now in a mild recession. That's both in emerging markets like China (about 10% of CAT's sales), but also in developed countries like the G-7.

(Source: FactSet Research)

In the last three months, US manufacturing and industrial production have ground to a halt, and the most recent trends indicate a mild industrial recession is likely in the US.

The good news is that industrial/manufacturing represents 25% of US GDP (down from 65% in the 1950s), so we're likely to see a 2016 like growth scare. Back then the second-worst oil crash in over 50 years (77% peak decline in crude prices) caused industrial production in the US to fall 5%. If the same thing happens this time, Caterpillar may be in for some painful slow or even negative growth.

The good news is that following recessions companies have to catch up on equipment orders which typically results in rapid growth rates, that allow Caterpillar to achieve high single or low double-digit earnings, cash flow and dividend growth over time.

• 2003: 36% EPS growth (and 84% in 2004)
• 2010: 90% EPS growth (and 78% in 2011)
• 2017: 101% EPS growth (and 63% in 2018, though boosted by tax cuts)

And as I explained in section one, it's unlikely that a future recession will cause Caterpillar to break its dividend growth streak, much less cut the payout.

But this is where the other two kinds of risk, valuation, and volatility come in. Paying $117 for Caterpillar means you have little risk of overpaying for this level 10/11 quality dividend aristocrat. However, like any stock, much less economically sensitive cyclical industrial ones, Caterpillar can be wildly volatile at times.

I present the following historical volatility data not to scare you out of buying CAT now, but merely to warn you of what kind of short-term paper losses you must be willing to stomach to own this blue-chip. This is why it's always a good idea to buy in chunks, rather than go all into any company in one fell swoop.

Even deeply undervalued top quality names can fall much further if market fear gets bad enough (stocks tend to overshoot to the upside and downside).

(Source: Portfolio Visualizer) portfolio 1 = CAT

If we do get a recession (42% probability right now), Caterpillar is likely to decline more than the broader market.

(Source: Portfolio Visualizer) portfolio 1 = CAT

Caterpillar's low historical volatility tends to occur during good times, but during times of high market fear it falls harder and faster than the broader market.

That includes numerous one-month corrections over the past 33 years.

• July 1986: -10.1% (market 5.7%)
• September 1986: -24.1% (market -8.3%)
• October 1987: -32.1% (market -21.7%)
• August 1988: -10.6% (market -3.4%)
• June 1990: -21.5% (market -0.7%)
• August 1990: -12.0% (market -9.0%)
• March 1991: -12.4% (market 2.4%)
• November 1991: -14.1% (market -4.0%)
• June 1992: -11.0% (market -1.5%)
• August 1992: -12.7% (market -2.1%)
• August 1995: -15.3% (market 4.2%)
• August 1998: -13.4% (market -14.5%)
• May 1999: -14.8% (market -2.4%)
• November 1999: -16.2% (market 2.0%)
• February 2000: -17.4% (market -1.9%)
• June 2000: -11.4% (market 2.5%)
• September 2000: -15.6% (market -5.3%)
• September 2001: -10.4% (market -8.1%)
• September 2002: -14.7% (market -10.9%)
• October 2005: -10.1% (market -1.7%)
• June 2008: -10.7% (market -8.4%)
• September 2008: -15.7% (market -8.9%)
• October 2008: -35.3% (market -16.8%)
• January 2009: -30.2% (market -8.4%)
• February 2009: -20.2% (market -10.7%)
• May 2010: -10.8% (market -8.0%)
• September 2011: -18.9% (market -7.0%)
• May 2012: -14.7% (market -6.0%)
• January 2015: -11.9% (market -3.0%)
• September 2015: -14.5% (market -2.5%)
• June 2018: -10.7% (market 0.6%)
• October 2018: -19.9% (market -6.9%)
• May 2019: -14.1% (market -6.4%)

As Joshua Brown (aka "The Reformned Broker") said during 2016's correction "volatility isn't risk, it's the source of future returns." Caterpillar has always offered plenty of opportunistic buying opportunities and will continue to do so in the future. .

But anyone who owns this company has to be prepared for such short-term crashes, either to buy more or ride out the short-term periods of hysteria.

(Source: Portfolio Visualizer) portfolio 1 = CAT

Buying Caterpillar when it's overpriced can result in periods of 5.6 years of paper losses. Today it's not overpriced, but whether or not it falls significantly lower will depend on the broader economy, our twitter happy President, and famously fickle short-term market sentiment.

For my own retirement portfolio (where I keep 100% of my life savings) I made one small initial $2,000 purchase of Caterpillar, with the knowledge that it might crash further, in which case I'll buy more.

For the Dividend Kings' Deep Value Portfolio, we've bought CAT four times, during the recent trade war freakout/recession scare (due to yield curve inversion).

Dividend Kings' Deep Value Portfolio, Caterpillar Buys

(Source: F.A.S.T Graphs)

Those DK buys were $500 each because that portfolio is designed to fearlessly buy quality companies, both cyclical and defensive, via a massive cash stockpile (the portfolio launched with 90% cash).

My point is that anyone considering Caterpillar must realize that SWAN status (which it most certainly has) only applies to its fundamentals and dividend safety. It does NOT mean "can't fall hard and fast at times". As you've just seen owning Caterpillar means riding out (or ideally profiting) from short-term crashes which occur frequently.

All my recommendations should only be made for the stock portion of a diversified and properly constructed portfolio.

One that uses the right asset allocation for your individual needs. If your portfolio's volatility is costing you sleep during corrections, you are overweight in equities and at risk of costly emotion-driven errors, such as panic selling Caterpillar during one of its many, many sharp declines.

Bottom Line: Recession Fears Are Creating A Great Buying Opportunity In One Of The Fastest Growing Dividend Aristocrats

Don't get me wrong, I'm not saying that Caterpillar is guaranteed to soar over the coming year (historical fair value isn't a 12-month price target). The risks of a recession in 2020 or 2021 are very real, and should an economic downturn occur, the company's cash flow and earnings would almost certainly decline.

The share price would likely fall significantly further, which is why it's important to keep sufficient dry powder to buy it at potentially lower prices. That being said, currently recession risk is about 42%, meaning a 58% probability that we avoid a bear market, and CAT achieves its expected strong growth.

Even if the longest economic expansion in history does end, today's 3.5% yield would almost certainly remain safe (less than 1% probability of a dividend cut). What's more, it's likely to keep growing steadily, which is ultimately what income growth investors care about.

No one knows what the next turn in the trade war drama will be. Bulls make valid claims about Trump needing a deal by the election, while bears are correct in countering that a deal appears a low probability event by the end of next year (20% probability according to Moody's).

Ultimately my job isn't to market time, and guess the precise bottom for this, or any safe income stock. All I can do is point out a fundamentally excellent dividend growth blue chip that's trading at a significant discount to historical fair value, and that's offering the best long-term total return potential of any company I know of.

As long as you understand how volatile this company can be, and incorporate that into your overall investing plan (diversification, asset management, and buying more during recessions), CAT is likely to generate substantial income and capital gains for you in the coming years.

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