Is Caterpillar a Buffett Stock?

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As the world's third-richest person and most celebrated investor, Warren Buffett attracts a lot of attention. Thousands try to glean what they can from his thinking processes and track his investments.

We can't know for sure whether Buffett is about to buy Caterpillar (NYS: CAT) -- he hasn't specifically mentioned anything about it to me -- but we can discover whether it's the sort of stock that might interest him. Answering that question could also reveal whether it's a stock that should interest us.

In his most recent 10-K, Buffett lays out the qualities he looks for in an investment. In addition to adequate size, proven management, and a reasonable valuation, he demands:

  1. Consistent earnings power.
  2. Good returns on equity with limited or no debt.
  3. Management in place.
  4. Simple, non-techno-mumbo-jumbo businesses.

Does Caterpillar meet Buffett's standards?

1. Earnings power
Buffett is famous for betting on a sure thing. For that reason, he likes to see companies with demonstrated earnings stability.

Let's examine Caterpillar's earnings and free cash flow history:

anImage

Source: S&P Capital IQ.

Demand for construction equipment is highly economically sensitive, so it's no surprise that Caterpillar's earnings have fluctuated somewhat over the past several years. Still, it's impressive that the company has managed to stay profitable over that time frame.

2. Return on equity and debt
Return on equity is a great metric for measuring both management's effectiveness and the strength of a company's competitive advantage or disadvantage -- a classic Buffett consideration. When considering return on equity, it's important to make sure a company doesn't have an enormous debt-to-equity ratio, because that will skew your calculations and make the company look much more efficient than it is.

Since competitive strength is a comparison between peers, and various industries have different levels of profitability and require different levels of debt, it helps to use an industry context.

Company

Debt-to-Equity Ratio

Return on Equity

5-Year Average Return on Equity

Caterpillar258%40%34%
Deere (NYS: DE) 414%42%29%
Manitowoc (NYS: MTW) 399%5%(8%)
Illinois Tool Works (NYS: ITW) 40%21%18%

Source: S&P Capital IQ.

Caterpillar generates an enormous return on equity. That's in large part due to the company's huge debt-to-equity ratio, which inflates its returns. Deere provides a similar, and perhaps more extreme, example of this phenomenon. So long as these two companies can successfully manage their debt burdens, it might make sense to operate with that kind of leverage. Crane and tractor manufacturing is a capital-intensive line of work, after all.

But it's important to remember that these debt burdens could magnify their already substantial economic sensitivity. And so, despite the fact that its return on equity clocks in at about half that of Caterpillar and Deere, Illinois Tool Works arguably scores the highest in this department, since its debt-to-equity ratio is so much smaller than the rest of its peers.

While it still lags the others by a significant margin, Manitowoc may be starting to find its footing in some areas. It has a significant food-service division whose operating margins have basically doubled over the past half-decade. Overall sales were up 40% in its most recent quarter, and its cranes have received some recognition as well.

3. Management
CEO Doug Oberheelman has only been at the job since 2010, but he has had decades of experience in various other top positions in the company.

4. Business
Cranes, tractors, and food-service equipment aren't particularly susceptible to technological disruption, though, again, demand for all Caterpillar as well as its peers can be fairly cyclical.

The Foolish conclusion
So, is Caterpillar a Buffett stock? It's a mixed picture. The company operates in a straightforward industry, it has managed to hang on to earnings despite the economic downturn, it does generate significant returns on equity, and its CEO has had a great deal of experience in other roles. However, it doesn't particularly exhibit the quintessential characteristics of a Buffett investment: consistent earnings, high returns on equity with limited debt, and tenured management. However, if you're interested in a stock that our top analysts and chief investment officer picked to beat the market, you can check out The Motley Fool's Top Stock for 2012. I invite you to download this special report, which is available free for a limited time.

At the time this article was published Ilan Moscovitzdoesn't own shares of any company mentioned.Motley Fool newsletter serviceshave recommended buying shares of Illinois Tool Works. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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