Can Caterpillar Overcome a Weak Economy to Thrive Again in 2014?

It's been just more than four and a half years since the Dow Jones Industrial Averagebottomed out in the spring of 2009. Since the index's lowest ebb, its overseers have replaced six components, and the Dow has surged from below 7,000 points to more than 16,000 points for the first time in its history. Different components will push the Dow more forcefully from one year to the next, but those with share prices that merit heavier weighting in the index's value calculations will always produce outsize movements. Caterpillar has been one of the best-performing of the heavier-weighted Dow stocks (those in the top 15 by weighting) since the market bottomed out:

CAT Total Return Price data by YCharts.

However, Caterpillar's clear advantage over many of its Dow peers has vanished in 2013, and it has actually become the worst performer among this same group of stocks:

CAT Total Return Price data by YCharts.

This mediocrity could point to a big swing higher as shareholders catch on to Caterpillar's hidden potential, but it could also be a big red flag warning investors of future weaknesses. Which is more likely? One way to find out is to drill down to the fundamentals.

The year ahead: by the numbers
The cause of Caterpillar's huge initial surge and recent leveling-off can be seen in the company's earnings over the past few years, which demonstrate quite clearly the impact of a once-in-a-generation global recession on the fortunes of a heavy-industry manufacturer. Caterpillar's fortunes have historically risen and fallen with the worldwide mining, forestry, and construction industries, and the post-recession period was kind to those sectors ... for a while:

Sources: Morningstar and company press releases.
* 2013 EPS result and growth rate are based on Caterpillar's latest (from Q3) estimates.

Caterpillar's weak full-year guidance, last updated along with the release of its third-quarter report, sent shares tumbling in October, but analysts had already been anticipating weakness on the bottom line -- a current average of 19 analysts pegs Caterpillar's 2013 earnings at the same level as the company's own projections. This leaves room for an upside surprise, but given Caterpillar's recent history, this might not be likely. The company has missed earnings estimates in each of its past four quarters, and all but one of these disappointments came in at least 13% weaker than expected.

The question is: can Caterpillar come back from this bust? Analysts expect a rather tepid 6% earnings-per-share growth rate for the coming year, which is weaker than what they project for competitor Joy Global (a 12% growth rate), and is significantly weaker than expectations for the more specialized Terex (a 36% growth rate) and Manitowoc (a 19% growth rate). However, analysts are at least more optimistic for Caterpillar than they are for the prospects of chief American competitor Deere , the only major heavy-machinery maker in this group to sport a negative earnings projection -- analysts expect the farm-focused Deere to generate 8% lower profits in 2014 than it did this year.

Despite these mediocre expectations, Caterpillar boasts a valuation that's higher than all those competitors but Manitowoc and the much-elevated Terex. This is likely among the benefits of being the industry leader: investors are just willing to give you more slack if you're slackening. Deere, by contrast, has a single-digit P/E ratio at the moment:

CAT P/E Ratio (TTM) data by YCharts.

But this chart masks a rather worrying aspect of Caterpillar's past-year performance. It's lost so little of its market cap because its P/E has nearly doubled in the past year, a surge that only just falls short of Terex's valuation growth. None of the other three companies come close in terms of sheer P/E expansion this year:

CAT P/E Ratio (TTM) data by YCharts.

This is both a positive and a negative for Caterpillar, but 2014 will likely show which is stronger. On the one hand, it does confirm the general strength of Caterpillar's business and brand with the investing public, which has largely ignored fundamental weaknesses to support the company's share price. On the other hand, Caterpillar's P/E ratio has not risen for an entire year since 2009, when the company was decimated by the financial crisis and saw its gains ride largely on the hopes of a future return to normalcy.

A return to normalcy in 2014 might look like growth back toward Caterpillar's record 2012 results, but Caterpillar itself expects to better 2013's results by no more than roughly 5% on the top or bottom lines. Since the company's own guidance has already looked too optimistic several times this year, investors may have little reason to expect 2014 to look much like 2010, when Caterpillar's valuation began falling back to a more modest level even as profit soared.

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The article Can Caterpillar Overcome a Weak Economy to Thrive Again in 2014? originally appeared on Fool.com.

Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter @TMFBiggles for more insight into markets, history, and technology.The Motley Fool recommends Chevron, Johnson & Johnson, and McDonald's. The Motley Fool owns shares of Johnson & Johnson, McDonald's, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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