Patience Needs Nine Lives With Industrial Stocks

Wall Street loves symbols, and since 1992 Caterpillar Inc. has become one of the best-recognized symbols of American manufacturing’s resurgence.

Which makes it that much tougher for many investors to swallow Cat’s announcement late Monday that earnings in the current quarter will fall below year-ago results. Demand for its heavy machinery has weakened, Cat admitted, ensuring a halt to a three-year earnings streak that has stunned most analysts with its intensity.

The news slashed Cat’s stock price to $58.875 on Tuesday, down $6.50 for the day. Many other industrial stocks suffered collateral damage.

In some ways, the only surprise here is that this should be a surprise. With virtually every indicator confirming a slower U.S. economy this year, and much the same story overseas, it was only a matter of time before reality caught up with industrial companies like Cat.

The only explanation for Cat’s stock reaching a record $75.25 in July, then, was that some investors totally placed their trust in the “long-cycle” idea: That is, even if industrial companies’ sales temporarily weaken, the need for greater capital spending by governments and businesses worldwide is so strong that it assures a secular sales (and earnings) uptrend for industrial leaders through the late 1990s.

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Investors who still believe the secular industrial story see no reason to sell stocks like Cat now. Quite the contrary, they view selloffs as opportunities to buy. “We added to our position in the stock” on Tuesday, said Jim Walline, equity chief at investment firm Lutheran Brotherhood Research Corp. in Minneapolis.

The dramatic improvement in American manufacturers’ global competitiveness since 1992 isn’t about to suddenly disappear, Walline argues. Companies like Cat are deeply motivated to preserve the gains they’ve made in quality, productivity and market share, he says.

The only question, then, is the ebb and flow of demand. If you concur with the economic soft-landing scenario, this year’s weakness will give way to stronger growth next year, leading to an earnings rebound for industrial firms and another leg up for their stocks. “We still see substantial capital spending ahead,” Walline says.

The nightmare scenario for stocks like Cat, of course, is that the long-cycle bulls are wrong and that the early-’90s pent-up demand for earthmovers, tractors, diesel engines and many other capital goods has largely been satisfied.

Consider what happened to Cat when the last sales cycle peaked, in 1988. Between that year and 1992, the company’s annual sales were basically flat. Earnings, meanwhile, collapsed under the weight of competitive pressures. The stock price crumbled from a peak of $37.43 in 1987 to a low of $18.88 in 1991.

“I think the jury is still out on the long-cycle idea,” says Tom McManus, stock strategist at Morgan Stanley & Co. in New York. But even if the long-cycle bulls are correct, he says, the big question is how many investors are psychologically prepared to ride out even a relatively brief period of weakness in industrial companies’ earnings.

For many companies the problem won’t be an outright decline in earnings, but simply slower growth, McManus says. Yet investors hardly seem to be in a forgiving mood these days when confronted with any earnings disappointment.

The dive in Cat’s stock makes the point: Most analysts still expect the company to report higher earnings in 1996 than in 1995. But the overall numbers are coming down. Smith Barney Inc. analysts on Tuesday cut their 1995 earnings estimate for Cat from $5.80 a share to $5.25, and their 1996 estimate from $6.45 to $5.90.

Industrial stocks like Cat may begin to look like bargains as their prices come down. But McManus warns that, when earnings doubts are rising, history shows that the stocks can get beaten up far worse than eager buyers might suspect--especially when so many money managers have loaded up with the shares.

Think about the auto stocks in 1994. GM peaked at $65.38 early in ’94 and fell to $36.13 before bottoming, a 45% decline. It’s at $47.25 now. Caterpillar, so far, is off 22% from its July high.

With many big investors increasingly turning back toward utilities and brand-name consumer stocks like Nike and Procter & Gamble -- companies more likely to show stable earnings growth ahead--McManus argues that the danger right now is in buying industrial shares too early. The trend isn’t their friend.

To stick with stocks like Cat and other industrial names today, you must believe in the long cycle, and you must be willing to be very patient. “A lot of secular investment plays can be good for 10 years or so,” says Tom Medcalf, a fund manager with IDS Advisory in Minneapolis. But at some midway point, “they can take a breather,” he says.

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Caterpillar’s Climb

Shares of machinery giant Caterpillar rose sharply between 1992 and July of this year, ridingan earnings boom. But on Monday the company indicated that that boom is deflating, at least temporarily.

Caterpillar stock, high price each quarter and latest on NYSE TUES. $58.88

Note: prices adjusted for stock split.