Streetwise
Lauren Rudd
Sunday, May 11,
2008
Uncertainty Yields Bargains
The uncertainty over the direction and health of the economy
will reign supreme in the minds of many during the months ahead. It will also
result in some bargains on Wall Street as share prices are subjected to the
scrutiny of Wall Street’s prognosticators and the inescapable consequences of
reduced earnings.
Caught in the mandibles of rising energy costs and lower
economic activity, corporate salvation can only come through increased
productivity. Although the recent announcement by the Labor Department had
productivity rising at an annual rate of 2.2 percent in the first quarter,
future increases of that magnitude are likely to be in jeopardy as companies
look to cut expenditures in the face of reduced revenues.
Unfortunately, every time there is either an announcement or a
forecast of lower earnings it not only spawns the expected decline in a
company’s share price but you can look forward to hearing the shrill cries of
discontent from a cadre of spectators, all of whom are of the nervous and
twitchy variety. Interestingly, it is these same people who cast a look of
disdain on long-term investing, enjoying only their brief moment of glory as
they espouse the dangers of investing on Wall Street.
Consider the wisdom found in Ecclesiastes 11:1-12, “Cast your
bread upon the waters...for you do not know which will succeed, whether this or
that, or whether both will do equally well.” Here the world of commerce is
depicted as an ocean capable of increasing your wealth...if you undertake the
risk of casting your investment dollars upon its waters and have the patience to
wait for the associated returns.
Therefore, you want to ignore the rhetoric of uninformed
bystanders and instead use any pullback in stock prices as an opportunity to
strengthen your portfolio. The key is to look for companies that are the leaders
in their respective fields, able to successfully withstand a somewhat higher
cost of doing business and whose sales are relatively immune to economic
fluctuations. Moreover, you might want to consider companies that will benefit
from the seemingly insatiable demand for raw materials.
An excellent example is Caterpillar. For fiscal 2007,
Caterpillar reported its fifth consecutive year of record sales and its fourth
consecutive year of record earnings. Sales rose 8 percent to $44.958 billion and
earnings per share came in at $5.37, up 4 percent from 2006. The earnings number
reflected higher price realization and higher sales volume, which was offset to
some degree by higher core operating costs.
At the conclusion of its first-quarter in 2008, Caterpillar’s
earnings were a record $1.45 per share, an 18 percent increase over the same
period a year ago.
Revenues of $11.796 billion were also a first-quarter record
and 18 percent higher than the company’s first-quarter revenues a year ago.
Meanwhile, revenues derived from outside North America represented 58 percent of
total revenues in the first quarter, up from 53 percent of the total a year ago.
Caterpillar appears headed for another record year with
revenues increasing 5 to 10 percent and earnings per share increasing 5 to 15
percent when compared to 2007, despite further weakening of demand in North
America.
Looking at the intrinsic value of the shares, a discounted
earnings approach, using a discount rate of 15 percent, yields an intrinsic
value of $97 per share. The discounted free cash flow to the firm model produces
an intrinsic value of $120 per share.
However, I am reducing my 2008 earnings estimate to $6.10 per share from my
estimate a year ago of $6.67, although I am leaving my 12 month share price
target of $93 unchanged. With the shares recently trading at $82.22, you have a
potential capital gain of 13 percent, plus a dividend yield of 1.75 percent.
