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It’s Time To Dig In To Caterpillar (Buy Caterpillar on Weakness)

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Caterpillar (CAT) shares have had a terrible go of it in 2015, falling from 105 in December to just 65 today. Shares dropped more than 6% Thursday on a disappointing corporate update from Caterpillar.

Buy Caterpillar on Weakness

The company cut its revenue guidance for both this year and next, citing difficulties in its various operating segments. The company announced up to 10,000 layoffs coming by 2018. In all, it was a very negative report, showing the global slowdown has hit the company harder than analysts had speculated.

With Thursday’s drop, Caterpillar has fallen below the 2011 European panic lows, and now trades back where it did five years ago.

For many companies, that would be a great indicator of value 5 year lows for a giant global behemoth. In Caterpillar’s case, a 5-year low isn’t necessarily a sign of great value. Its industry, construction, is ruthlessly cyclical, going from bust to boom and back to utter despair frequently.

Caterpillar shares shot up between 2009 and 2011 as the global economy exited the financial crisis, metals prices soared, and the global emerging market started to demand more and more equipment with which to build vast amounts of infrastructure.

Gold prices peaked in mid-2011, and with that, one of the pillars of the Caterpillar boom was toppled. The meteoric rise in the precious metal mining industry came turned to a bust. The gold mining industry, as represented by the GDX ETF is down more than 80% from its peak, and mining industry capital expenditures have been slashed to the bone. Result: Far fewer Caterpillar sales.

Other mining sectors took longer to cave-in, but they’ve pretty much all given way now. Copper started to drop hard last year. The coal industry has collapsed, buried by heavy regulations from the current administration. And now the iron ore price has yielded under the weight of the slowing global economy.

Caterpillar also sells lots of equipment into the oil and natural gas extraction industry. Naturally, these sales have slowed dramatically since last fall when the price of oil began to implode.
Some segments have held up better. Homebuilding is fairly strong in many areas of the world, particularly in the United States, and as such, sales in the construction sector have remained stable.

But overall, it’s been a dark year for Caterpillar. Revenues are dropping, and earnings are slipping with them. Adding insult to injury, the company’s highest-margin products are in the oil & gas space which has been hit hardest in 2015.

Another problem comes with the strength of the US dollar, which is making the company’s products more expensive versus foreign competition, in particular the Japanese firm Komatsu. Falling sales combined with increased competition isn’t a good mix.

So, if there’s so many negatives, then why is this the time to buy Caterpillar? Good question. Remember, first and foremost, that Caterpillar is a hyper-cyclical stock that is supposed to behave exactly like this. The stock soars in good times and plunges in bad ones; this action is precisely why we have an opportunity now.

At the current $65 share price, the company yields a mouth-watering 4.7%. For a storied mega-cap corporation, that’s a great dividend.

And the company is aggressively buying back shares. With the company reducing the outstanding share count at very favorable prices, it adds dramatic earning power to Caterpillar’s shares on the next upturn.

The company has a very strong balance sheet and a solid A credit rating. It is built to withstand these sorts of downturns. Buyers today get paid nearly 5% a year to wait for the cyclical upturn, all the while, the company is buying back shares rapidly.

Caterpillar shareholders who bought in the 2001 doldrums would make 400% on their money by 2007. Anyone who bought the 2009 low saw their shares go from $25 to $110 in under 2 years.
Given that the global economy has grown substantially since Caterpillar’s last peak in 2011 and that Caterpillar is reducing its share count smartly, it will be easy for Caterpillar to surpass the 2011 high and reach $120 or $130 on the next cyclical upturn, doubling a current investment.

There’s no guarantee that $65 is the bottom, cyclical stocks can go lower than you’d expect, but five years from now, it’s almost certain shares will be much higher than here.

Norway’s Central Bank Cuts Interest Rate From 1% to 0.75%

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Today Norway’s Central Bank, Norges Bank, surprised the markets by cutting its main interest rate from 1% to 0.75%. As a result, the Norwegian crown (NOK) declined sharply with more than 2% against major currencies. Against the USD it was traded at a 13year low. The Central Bank cited continued low prices and its effect on the Norwegian economy as a concern. This is a major setback in Norway’s traditional reputation as a safe haven.

NOK weakness

Traditionally, the NOK, the Swedish crown (SEK) and of course the Swiss franc (CHF) are considered as (Europe’s) safe havens. Historically, the NOK was higher valued compared to the SEK, but more or less were highly correlated. Today, the NOK/SEK dived below parity (see chart) and the trend is clearly unfavorable for the NOK.

The strength of the NOK was always explained by its strong commodity exports. The Norwegian economy was able to weather rainy days due to stable income from oil exports. The government could implement anticyclical measures by using its income from oil revenues. However, now with oil prices lower for an extended period of time, this is no longer possible. In addition, investments in the oil sector are less attractive with the current oil price. The supplying industry is therefore severely hit, dragging down the economy as a whole.

Further rate cuts unwanted

The rate cut is surprising, since underlying price factors do not support a more expansive monetary policy. In particular housing prices are a concern. Also consumer prices are rising due to a depreciation of the NOK. The Norges Bank states that a weaker currency may benefit exports, but academic literature shows us we can doubt this line of reasoning. On the other hand, further cuts might be possible since unemployment is rising and wage pressure is not to be expected. The Norges Bank said in its statement that the key policy rate may be reduced further in the coming year. This added to the pressure on the NOK today.

Safe haven elsewhere

The likelihood of further rate cuts makes the NOK unattractive. Although financial markets are currently experiencing enhanced levels of uncertainty, it is unlikely that the NOK will be seen as a safe haven as it used to be in the past. Norway’s neighbor, Sweden might be a better place. The Swedish Riksbank’s main policy rate is already at a negative interest rate of 0.35%, further cuts are less likely. Sweden is also experiencing rapid rising housing prices and further cuts may lead to a housing bubble. For investors looking for a safe have, negative interest rates are not a problem as long as the currency is increasing in value. Traditionally, the Swiss currency is also considered as a safe haven, but the Swiss National Bank (SNB) could cause some headwind for investors. Governor Jordan repeatedly stated that the SNB considers the CHF overvalued and may intervene in the currency market. However, despite negative interest rates between -1.25% and -0.25%, international investors are finding the CHF these days of increased market volatility, albeit modestly. Another traditional safe haven, the Japanese Yen (JPY) is the clear winner.

Where to go?

The current developments in safe haven currencies are somewhat confusing. Especially since all safe havens also have very low interest rates. Fleeing to these currencies is in some cases costing money due to negative interest rates. This all may lead to increased volatility, since there is no one-fits all solution for this problem. Markets will react more heavily than normal on policy decisions and macroeconomic data. Maybe a good reminder that there is no such thing as a 100% safe investment after all…

What does the ‘massaging’ of ISIS intelligence portend?

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President Barack Obama’s statement made back in January 2014 that the group we now know as ISIS was the “JV team,” meaning junior varsity, has certainly come back to haunt him. ISIS has turned out to be an even more potent threat to civilization that Al Qaeda ever dreamed of being. The development has trampled on the narrative that the president and his supporters have promulgated of the terrorists being on the run in the wake of the execution of Osama bin Laden.

Why would the president say such a thing? The Daily Beast recently reported on how a group of 50 intelligence analysts attached to the United States military’s Central Command complained about how reports on the growing strength of ISIS and the persistent threat posed by Al Qaeda were “massaged” by senior Obama administration officials.

In short, the intelligence reports used to brief President Obama and other high-ranking officials were altered to make it seem as if the terror threat in Syria and Iraq was diminishing, not increasing. The altered reports were made to reflect the administration line that its policies were winding down the war on terror.

Reality, naturally, intervened as ISIS expanded its dominion, committing unspeakable atrocities and threatening the peace of civilization. Apparently blindsided, the Obama administration has reacted against the threat in a desultory and haphazard manner.

Faulty intelligence usually leads to catastrophe. Lack of intelligence on the activities and intentions of Al Qaeda led to the United States being surprised on 9/11 when thousands of Americans were murdered when airliners they were passengers in were deliberately flown into the World Trade Center, the Pentagon, and a field in Pennsylvania. Dubious intelligence on the existence of weapons of mass destruction in Iraq informed the invasion of that country, the consequences of which redound to this day.

But the news that intelligence was deliberately modified for political reasons is a new and disquieting development. To be sure, politics has often affected the interpretation and dissemination of intelligence in subtle ways. But the situation that the rebel analysts are reporting on seems to be the first instance recorded of intelligence being systematically altered to create an impression that does not align with objective reality.

The question arises, as it often does with scandals of this sort, what did the president know and when did he know it? Did President Obama let it be known that he did not want to hear about anything that he would find inconvenient, like a stronger than expected terrorist strength in the Middle East? Or did his people known instinctively that the president would not welcome bad news?

What does that portend for other trouble spots? Who is going to be brave enough to tell the president that Iran is on the verge of a nuclear bomb, despite the agreement? What will happen if Vladimir Putin is seen to be preparing a move against the Baltic States? Will the president choose to hear of it or will he decide to hope things will blow up, pun intended, after he leaves the Oval Office? The future of world peace depends on the answer.

Buyback Levels Support Current Share Prices?

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Earlier this week, FactSet reported that share repurchases for S&P500 companies amounted USD 134.4 billion during the second quarter of 2015. The buybacks decreased 6.9% compared to the first quarter. With the Federal Reserve postponing a rate hike last week, buyback levels may continue to be strong in the second half of the year, even helped by new issuance of debt. But can they support share prices?

Shareholder’s friend

Buyback programs are an easy way to increase earnings per share (EPS), since the outstanding number of shares is reduced. Many activist shareholders are therefore pushing managing boards to either distribute cash to shareholders by increasing dividends or by increasing EPS through buybacks. It is also believed that since buybacks increase demand in shares of a company, the share prices will benefit substantially (more on that later). The current environment of low interest rates makes it for a number of companies interesting to even issue debt to fund buyback programs. As traditional corporate finance teaches us: cost of equity is higher than cost of debt. In addition, for some major companies the interest rate paid is lower than the dividend payment obligation.

IT on top

During the second quarter, the information technology (IT) sector was the leader in buyback programs. The sector spent a total of USD 35.9bn in Q2, with Apple being the sector (and overall) leader with USD 10bn of repurchases. During the last twelve months, buybacks by the tech giant amounted USD 41.6 bn, with dividend payments totaling USD 11.4bn.

One noteworthy development is that companies spent more on buybacks than that they generated in free cash flow (FCF). FactSet noticed that the buybacks to FCF ratio exceeded 100% for the first time since October 2009. On a trailing twelve month basis, the ratio hit a level of 108%. The main reason is a decline in FCF. One might wonder if there’s still room left for further expansion of buyback programs or dividend increases.

Failing to support

As mentioned earlier, the standard line of reasoning is that buybacks should support the share price of the repurchasing company. However, during 2015 this was not the case. If we look at the S&P 500 and compare the index to the S&P 500 Buyback Index, which tracks the performance of the 100 stocks with the highest buyback ratios, we see a structural underperformance. In the graph below, the SPDR ETFs of both indexes are compared.

One might wonder what the underlying reason for this development might be. One possible explanation could be that investors are worrying that the continuing process of increasing buybacks financed by new issuance of debt, is deteriorating the financial strength of the companies. The equity part is shrinking compared to the debt position and thus balance sheets are showing a less prudent picture. In an expanding economy, this should be no issue when the company stays profitable and sees it revenues increase. However, in Q2 the S&P500 as a whole disappointed in revenues. In addition, when interest rates are low, investors are less worried about debt positions but with a potential rate hike getting closer, debt may be monitored more closely.

Aggressive buybacks no longer effective

With buyback programs high for an extended period of time, the inflection point of lower effectiveness of this financial strategy is getting nearer. As the chart above shows, we might already have crossed that point. Companies should focus more on a sound balance sheet and investments in R&D instead of giving shareholders presents. The time may come when debt will again be an issue and the importance of earning real money returns.

Volkswagen Fraud… Time To Invest In VLKAY?

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Invest In Volkswagen (VLKAY) After The Scandal?

Shares of Volkswagen (VLKAY) have gotten absolutely trounced this week. Volkswagen is famous in stock market lore for its infamous 2008 short squeeze, which sent shares up more than 170% in two days, briefly making it the largest company in the world.

Now Volkswagen is enjoying a similarly shocking collision, this time in the opposite direction. Shares dropped 20% both Monday and again Tuesday, taking more than $10 billion off the company’s valuation. Shares are up about 7% in early Wednesday trading, but it’s still been a heck of a drop. German shares have gotten pounded as well, taking that country’s index into official bear market territory.

At fault is the news that the company was deliberately cheating on emissions testing for its vehicles. The company admitted than in 11 million vehicles, it had installed software that would intentionally reduce emissions when the car was being tested, thus allowing it to spew vast amounts of contaminates the rest of the time.

This isn’t the first time Volkswagen has run into trouble either. Just a couple months ago, the company was sued by an Italian group for overstating the fuel efficiency of its vehicles. One has to ask if there is some cultural problem at Volkswagen that is leading the company to repeatedly break the rules.

It’s one thing to try something in a gray area and push the limits of competitiveness. But outright cheating and committing fraud is not just bad ethics, it also hurts shareholders. The company is deeply imperiling its valuable brand for a short-term profit.

Consumers are very picky about the vehicle they buy and drive. It’s not an area where you can afford to be seen as cutting corners or unethical.

The immediate reaction among analysts has mostly been of the buy the dip, it’ll blow over variety. We’re skeptical. When you type Volkswagen into Google search now, the auto complete starts offering such conclusions as: Volkswagen cheat and Volkswagen fraud. The amount of negative advertising that will stick to the brand could be immense.

And that’s to say nothing of the financial costs as well. Forget your forward earnings estimates, the company’s US sales will be minimal for the foreseeable future. The cost of a recall will be huge, who knows just how big.

The company also faces potential fines of more than $10 billion in the United States. We’ll see if other countries try to take regulatory action against the company as well.
Keep in mind that there is a distinct political aspect to the story. Volkswagen has been making great advantage of the plunging Euro, recently surpassing Toyota (TM) to become the world’s largest seller of automobiles.

With the domestic automotive industry in the United States facing difficulties from the increasingly strong U.S. dollar, wouldn’t it be, you could say, convenient timing for a major scandal to hit one of the sector’s major players?

Election season is in full swing, and with protectionist left-wingers like Bernie Sanders getting major play in the primary, to speak nothing of Trump and his nationalistic tendencies, its not a good time to be a European competitor cutting corners. The dogs have been unleashed, and they are out for blood.

The one factor that may play out to Volkswagen’s favor is that it appears other manufacturers may be cheating on the emissions tests for diesel vehicles as well. If Volkswagen can suggest that this is an everybody does it we just had the misfortune of getting caught event, then perhaps it will blow over more quickly.

However, Volkswagen just hired the lawyers that BP p.l.c. (BP) used following their catastrophic oil spill. It appears they’re aware of the gravity of the situation they’ve gotten themselves into.
And despite the drastic drop in shares, Volkswagen still doesn’t appear all that cheap compared to peers, even assuming its earnings won’t be hit by the scandal. For example, Volkswagen still trades at a Price/Sales ratio greater than that of General Motors (GM). GM, by comparison, faces no major scandal, fines, regulatory problems, etc.

Furthermore, the auto industry faces a difficult market with emerging economies such as China and Brazil struggling so mightily. Sales in the United States have been very strong, bolstering the industry, but the global macroeconomic winds are difficult. As such, it seems premature to take a long-term investment in Volkswagen at these levels.