Caterpillar CAT) has a lot more long-term upside potential, but we sold 100% of our Caterpillar shares this morning for a gain of +110% after owning them for 19 months. Before describing the 5 better income-producing investments, we review why we sold our shares of Caterpillar. Our 5 better options than Caterpillar for income-seeking investors are organized from least to most risky, but they’re all attractive, in our view. Keep in mind, this article is about attractive income opportunities, but not necessarily the highest income opportunities. As we’ve written in the past, we loathe “yield chasing,” and it’s one of our 7 Deadly Sins of Long-Term Investing.
Why We Sold Caterpillar
We sold our shares of Caterpillar because its valuation has been driven too high. Specifically, a lot of the optimism surrounding the “Trump Rally’s” economic growth and tax reform expectations (possible overseas cash repatriation, lower corporate tax rates, protectionism in general) are already baked into the price. Caterpillar is no longer a “Dog of the Dow,” it has the highest short interest of any Dow component, the upcoming upgrade cycle will only go so far, and we’ve held it over a year allowing us to recognize the lower long-term capital gain rate. For your reference, you can read an excerpt from our original members-only buy thesis report on January 8, 2016, here:
Caterpillar (CAT) stock has fallen 43% since July of 2014, and it has a large 4.9% dividend yield. Additionally, the company has plenty of cash to continue its track record of dividend increases, and the stock also offers significant opportunity for capital appreciation. Despite dramatic declines in Caterpillar’s mining business, significant weakness in energy, a strong US dollar, and a declining outlook from management, CAT is still worth more than its current market price. Further, the company has ample financial wherewithal to weather intermediate-term challenges, and we believe Caterpillar will eventually revert to moderate growth making now an exceptional buying opportunity for long-term dividend investors as well as those seeking capital appreciation.
And you can also read our earlier public write up on Caterpillar here:
Simply put, we believe Caterpillar is one of the great American industrial companies, but its valuation has gotten too far ahead of itself given the risks such as valuation, tax irregularities (the IRS executed a search warrant in March over tax irregularities), overseas competition (e.g. Kamatsu), stagnant commodity prices, and currency realities (the marginal benefits of this year’s weaker dollar are priced in), and its relatively high cost of capital.
For a little more color on valuation, here is a look at Caterpillar’s lofty EV to EBITDA ratio.
And Caterpillar’s declining margins.
And here is the big (price-driven) decline in Caterpillar’s dividend yield.
We suspect Caterpillar has significant very long-term price appreciation potential, but the price is ahead of itself. Given our +110% 19-month total return, and the fact that the dividend yield was nearl 5% when we bought it and it’s under 2.5% now, we freeing up this cash to move it to other opportunities that are more attractive for us.
5 Better Options for Income Seekers
Our 5 better options than Caterpillar for income-seeking investors are organized from least to most risky, but they’re all attractive, in our view. Without further ado, here is the list.
1. Verizon (VZ), Yield: 4.8%
Unlike Caterpillar, Verizon is a Dog of the Dow based on its current yield. If you don’t know, the “Dogs of the Dow” strategy proposes that an investor annually select for investment the ten Dow Jones Industrial Average (DJIA) stocks whose dividend is the highest fraction of their price. Here is a look at the current components of the Dow sorted by dividend yield.
The Dogs of the Dow is a contrarian strategy whereby investors choose companies that are often out favor, and as you saw in the above table, Verizon’s stock has delivered negative returns over the last year whereas the overall Dow Jones Industrials Average has been positive. Granted the Dogs of the Dow strategy is passive in nature considering it can be implemented without looking much further than dividend yields (proponents of the strategy argue that blue-chip companies don’t alter their dividend to reflect trading conditions and, therefore, the dividend is a measure of the average worth of the company). However, it worth considering a few of Verizon’s “fundamentals.”
For starters, Verizon is the nation’s largest network, it generates lots of free cash flow, and despite growing competition (as competitor networks catch up in quality, and compete more on price) Verizon is not going away. Communications networks are the lifeblood of businesses and retail consumers, and with the ever expanding sophistication and demands of network users, especially the eventual arrival of 5G, Verizon’s importance will remain strong considering its vast network and economies of scale. Further still, many of the weaker communications company’s (e.g. Frontier, CenturyLink, Windstream) may eventually go the way of the dodo bird thereby creating opportunities to pick up marginal customers and marginal assets at fire sale prices.
Further still, in addition to executing on the fundamentals, Verizon is taking steps to evolve for the future.
Another thing to consider about Verizon, simply from an investment allocation standpoint is that it is a “large value” stock, a category that has been underperforming “large growth” stocks lately, as shown in the following table.
However, over the long-term, value stocks tend to outperform growth stocks, and this phenomenon will eventually resume, in our view. No one knows exactly when, but large value stocks will eventually overtake large growth stocks, and now is a particularly attractive time to consider large value stocks from a contrarian standpoint.
We've written detailed reports about Verizon many times in the past; and based on its current price and dividend safety, Verizon is worth considering if you are a lower-risk income-seeking investor.
2. Kimberly Clark (KMB), Yield: 3.3%
Kimberly Clark is not a Dog of the Dow (it’s not a member of the Dow) but it is similar in the sense that it is a steady blue chip company with a relatively attractive dividend yield and it’s trading at an attractive contrarian price, in our view.
A lot of you may be scoffing that we’d even consider purchasing a boring “paper-making” company like Kimberly Clark, but our thesis is clear. This profitable business is NOT going away, the price is cheap, and the dividend is big, growing and safe. Here is a look at some of this company’s products
For further perspective, here is a look at Kimberly Clark’s current and forward price-to-earnings ratios
The fact that they’re similar is an indication of low growth expectations, and the fact that they’ve declined is an indication of decreasing optimism about the company. Many contrarians like these low valuation multiples especially considering this is a low beta company with a very steady business (it’s a safer bet that consumers will keep using Kimberly Clark products no matter what happens to the market than say Rolls Royces or some other luxury item).
Also, as we mentioned earlier, large value stocks (such as Kimberly Clark) have been out of favor compared to the rest of the market, and over the long-term this is generally not the case (value stocks tend to significantly outperform growth stocks over market cycles).
Another important consideration for Kimberly Clark is the consistent share repurchase. This is an attractive way to return cash to shareholders and it helps keeps the total returns stronger than this company's low but steady growth would suggest. Here’s a looks at Kimberly Clark’s long-term earnings per share versus shares outstanding (it’s a very steady, growing, profitable business).
Also worth noting, Kimberly Clark has increased its dividend for 45 consecutive years. If you are an income-seeking contrarian investor, Kimberly Clark is an attractive blue chip, with a steady growing yield, and it is currently trading at an attractive price, in our view.
3. Ventas (VTR), Yield: 4.8%
Ventas is a well-managed, attractive dividend-paying (+4.8% yield) healthcare REIT that is currently trading at a compelling price. We recently reviewed ten attractive qualities about Ventas in this article:
As an overview of that article, we like Ventas because of its powerful demographic tailwinds, high private pay revenue sources, low beta, business and operator diversification, valuation, management, financial strength and dividend safety, to name a few.
Also worth noting, Ventas is a real estate investment trust (“REIT”) and that whole group has been underperforming the rest of the market over the last year as investors have been fearful (overly fearful in or view) about the possibility of sharply rising interest rates, and REITs have been out of favor as investors have preferred growth stocks as we discussed earlier. If you are looking for an attractive income opportunity, Ventas is worth considering.
4. Simon Property Group (SPG), Yield: 4.5%
(Selling Put Options for Income)
Simon Property Group is another attractive dividend paying REIT that has been particularly out of favor recently. SPG owns shopping mall real estate, and that industry has gotten crushed over the last year as many investors fear online retailers (such as Amazon) will put all "brick and mortar" stores out of business. And while we believe this may be true for some brick and mortar retailers, it is not true for Simon Property Group considering its highly attractive property locations and its very strong (and continuously record-breaking) financial position. Simon Property Group was our investment idea of the month earlier this year, and you can view that video here.
However, instead of purchasing shares of SPG outright, there've been plenty of opportunities to take advantage of the high fear and negativity by selling put options for the premium income. Specifically, when fear is high, the income available for selling puts is higher than usual. As members know, we've written about this strategy of generating income by selling put options on SPG. And if the shares do get put to you, you can be happy to purchase shares of this very high quality big-dividend payer at an even lower price. If you are an income-seeking investor, selling puts on SPG is a very attractive opportunity given the current market environment.
5. Triton International (TRTN), Yield: 5.4%
(Selling Put Options for Income)
Triton International is the world's largest lessor of intermodal containers (large, standardized steel boxes used to transport freight by ship, rail or truck). And Triton currently presents a very attractive opportunity to generate income by selling put options.
For some background Triton was formed a little over one year ago when Triton Limited and TAL International combined in an all stock merger. The company now enjoys significant economies of scale versus its competitors (as shown in the following chart) and an attractive growing industry.
Also worth noting, Triton doesn’t run the same risk of being put out of business by online retailers like Amazon because even online sales require intermodal shipping and transportation services, such as those provided by Triton.
As an indication of market conditions, Triton’s stock price is up significantly since started trading, but has pulled back recently as shown in the following chart.
One of the things we like about the business is than the contracts tend to be somewhat long-term which gives some stability and visibility into future revenues.
From a valuation standpoint, we consider Triton to be a growth at a reasonable price opportunity. For example, the following tables show its price-to-forward earnings and EV to EVITDA ratios relative to peers.
One risk Triton faces is the threat of customer default (such as the Hanjin bankruptcy, which represented 3% of Triton’s fleet). However, Triton maintains a high container utilization rate (over 96%). Another risk for investors is the dividend may appear unsustainable (too high) given the company’s high capital expenditures. However the company has been spending on future growth which makes the dividend payout more palatable.
Attractively, the yield for selling put options on Triton is compelling as shown in the following table.
For example, you can generate $0.25 in premium income for selling the November $25 strike price puts which expire in about a month and a half and they are 25% out of the money. This premium amount equates to approximately 8% extra income on an annualized basis. Similarly, the October puts with a $30 strike price offer even more attractive premium income if you’re comfortable with the possibility of owning the shares. As we mentioned earlier, this is the most risky of the income ideas in this article, but it is still very attractive nonetheless if you are comfortable with these risks. We have not implemented this trade, but if you are a more aggressive income-focused investor it may be worth considering.
Despite our decision to sell Caterpillar, we believe the company still has significant long-term price appreciation potential. However, considering a variety of factors (as described in this article), and given its diminished divided yield (it was nearly 5% when we bought it, and it’s now under 2.5%) we believe there are more attractive income opportunities available that will fit better into our investment portfolio. We haven’t yet replaced our shares of Caterpillar, but we likely will within the next few trading days (we don’t like to be out of the market), and we’ll share that information with Blue Harbinger members as soon as it is available. Stay tuned.