Sunday, October 14, 2012

Caterpillar versus Deere Which Stock to Buy?

I'd like to share with you an approach to looking at stocks which most investors are unlikely to have looked at before. It's the sort analysis that a friend of mine used to use a lot in trading at his hedge fund. He was a math PhD, a quant, someone who believed that mathematical relationships would express the ultimate reality that fundamentals based guys like me were 'fumbling' about trying to analyze.

I'm going to take you over to the dark side of the force and look at a pair of stocks purely from the kind of perspective that my quant friend might do. In this article I will focus on Caterpillar Inc (NYSE: CAT) and Deere & Company (NYSE: DE) and look at some of the mathematical relationships between them.

I confess I have long been fascinated by the pair. They have a one year correlation of over 84% and are frequently mentioned together when people discuss the sector. In addition, other stocks in the sector like CNH Global NV (NYSE: CNH) and to a lesser extent Kubota (NYSE: KUB) are also correlated. This analysis equally applies to where their prospects are headed. In fact it says a lot about where the market is headed in general.

Deere and Caterpillar Analysis

Despite the high correlation they do have some key differences. Deere is much more exposed to farming and agriculture whilst Caterpillar has a far larger exposure to mining and construction. In other words, Caterpillar can be seen as a much more cyclical stock.

This is borne out if we look at how revenue growth and decline works across the cycle

We can clearly see that the downturns and upswings are far greater for Caterpillar than Deere. Also note how they both give a beautiful depiction of the growth cycle and with emerging markets in particular. This is borne out when we just look at revenue generation for the two companies.

They tend to move together.

Deere and Caterpillar and What the Market is Pricing in

I want to return to a key point I made earlier.  If Deere's earnings are less cyclical than Caterpillar's than when the market is pricing in an economic slowdown surely the relative evaluation of Deere should get stronger?

In addition, a chart of the relative revenue generation should show Deere getting stronger in the slowdown. Now if only someone took the time to map these charts out!

Funnily enough, I have!

It's an unusual chart so let me explain that the 'Red/Brown Line' represents Caterpillar Revenue/Deere Revenue (when the line goes up it represents Cat getting relatively stronger and therefore a stronger current economy). In other words the more cyclical business (Cat) is generating relatively more revenues.

Whereas the 'Blue Line' represents Caterpillar Stock Price/Deere Stock Price (when the line goes up Cat is getting stronger signaling the market predicting a stronger future growth ) represents what the market is anticipating for future growth.

Of course if the market is any good at predicting what will happen then their lines should be the same shape with the blue line slightly ahead of the brown line.  By and large that is what we see but there is one interesting instance where it does not. I'm going to highlight a few periods

In early 2008 despite current data (brown line going up-revenues) trending up, the evaluation movements were favoring Deere (blue line going down). This is an indication that the market was starting to price in a heavy cyclical slowdown and very bearish. Clearly the market got it right!

The period from 2009 until mid 2011, saw the market pretty gradually pricing in a cyclical recovery which was then borne out in the relative revenue movements.

From late 2011 we see a lot of turbulence moving into declines predicted (blue line) in 2012, so again the market got it right.

So Where are we Now and What Does it Mean?

We appear to have a mini-summer rally in the blue line. I'm perfectly aware that this is partly a reflection of the 'risk-on' mode that the market has been in recently.  In a sense, what this is telling us is that the market is getting a bit more optimistic about the outlook despite it not being shown up in the revenue numbers yet. For the record, I don't happen to share the conclusions of this analysis but it takes two to make a market and I'm willing to admit that I may be wrong.

As for what the charts and the math are saying to you -in a weird paraphrasing of the immortal words that Kate Bush once said to Peter Gabriel-  it is 'don't give up, you still have us, don't give up'.  Despite the earnings downgrades the market appears to be sanguine about a cyclical slowdown and the relative evaluation of Cat/Deere hasn't declined anything like it did in 2008.

And the last point is the key.

If you are a fundamentals based investor like me, then everytime you sit down and start looking at a cyclical stock there is one nagging thought that goes on in your head. It runs like this 'this stock looks cheap but what if we run into a 2008-like scenario and an earnings collapse in cyclicals?'.

At which point my quant friend might whip out a chart like this and tell you that that collapse isn't going to happen, so go ahead and buy your cheap cyclical.