This note was originally published at 8am on October 25, 2012 for Hedgeye subscribers.
“You can boil down what we're thinking about 2013 to a short statement, and that goes both for economic environment and sales, and that statement is steady-as-she-goes, not much change from 2012.”
– Michael DeWalt, Caterpillar, 10/22/12
This morning, Hedgeye ran a proprietary P/E screen to identify a couple of bargains. JDS Uniphase (JDSU) is trading at only 3x its 2000 EPS. Lennar (LEN) is at only 4.5x its 2005 EPS. Multiples were much higher when those earnings were reported, so today these names are on a big sale. OK…probably not. However, those “bargains” highlight the problem with using the peak margins and a simplistic framework to value companies.
The Industrials sector is loaded with mini-bubbles. Capital equipment goes through replacement cycles, driving sales and margins to very high levels only to have them drop-off following the boom. Our favorite cycle is shipbuilding. After World War II, war tonnage was converted to commercial use. Ships only last for about 30 years, so there was a replacement boom in the mid-1970s. Tonnage deliveries were nearly three times higher in 1975, at the peak of the boom, than they were in 1980, after the bust. The industry just had another replacement cycle with deliveries peaking in 2011. The group looks like a promising short today and should be a great long around 2035. Mark your calendar.
We joke that mining is the world’s second oldest profession and that there is a reason the iron-age was called the iron-age. Mining is a highly mature industry with long-term cyclical growth slightly below global GDP growth. It should not boom. When it does, you know something interesting is going on.
Mining capital spending is an obvious bubble. For example, global iron ore output went from ~1 billion tons in 2005 to ~3 billion tons last year. Capital spending above depreciation at the eight largest miners went from about $10 billion in 2004 to $56 billion in 2011. And 2004 was a fantastic year for mining capital spending.
Today, Caterpillar is best defined as a manufacturer of mining and resource-related capital equipment. Among its largest customers are BHP, Rio Tinto, and Vale. Typical of companies caught up in a boom, CAT has made overpriced acquisitions and added excess capacity to meet peak demand, in our view. Investors who hold CAT through the down-cycle may end up paying for management’s investment errors in addition to their own. Buying CAT today is similar to buying Lennar in 2005 or JDSU in 2000. The peak $9.20/share or so that CAT will likely earn in 2012 may prove just as irrelevant for valuation as any other bubble-driven profit.
The Hedgeye Industrials team hates P/Es. Extreme profit cyclicality leaves multiples useless in the Industrials sector. We prefer to build DCFs to estimate (wide) valuation ranges. We forecast reasonable longer-term growth rates, margins, capital needs, and other factors, making assumptions explicit. November 5th, we are presenting on the Express & Courier Services industry, including Fedex. Fedex may grow at 2% or 6%, but it isn’t going to grow at 15% in the long-run. Similarly, global iron ore production is not going to keep tripling every 5 years. To value CAT by extrapolating recent trends in mining capital investment would be to assume the surface of the earth ends up covered in ferrous rocks. A normal peak multiple applied to recent profits implicitly makes that assumption.
To note that there is a bubble in many commodities is different from explaining why. The narratives that drive bubbles tend to be very persuasive and contain much truth. The internet will revolutionize commerce. Check. Home prices rise over time and will be supported by the government. Check. A rising middle class in the developing world will need more appliances and cars. Check. Narratives allow investors to feel better about applying absurdly simplistic valuation ratios to companies serving highly complex markets.
We’ll throw out a narrative to explain the commodity bubble to allow CAT short sellers to feel better. We suspect that the commodity bubble has been driven by world’s second largest economy pegging its currency to the world’s largest economy while the world’s largest economy engages in highly simulative and largely experimental monetary policy. The peg contributes to inflation in China, which drives savers in China to protect real wealth by investing in property and other hard assets. Maybe check. Maybe not.
Narratives aside, our view on CAT is straight-forward. Don’t be the investor who buys a cyclical at a multi-decade peak in margins. We may well come back to CAT when it hits our proprietary P/E screen in a few years.
Our immediate-term risk ranges for Gold, Oil (Brent), US Dollar, EUR/USD, UST 10yr Yield, and the SP500 are now $1699-1733, $106.63-110.71, $79.69-80.25, $1.29-1.31, 1.71-1.89%, and 1401-1419, respectively.
Jay Van Sciver, CFA
Managing Director Industrials