Markets
DE

Investment Strategies: Caterpillar Inc. vs. Deere & Company

CAT Chart

Ask any investor or hedge-fund manager what his favorite stock pairs are and Caterpillar and Deere & Company are likely to feature near the top of the list. The two are oft discussed in the same breath as their investment propositions are believed to have had much in common during the last decade. However, on closer inspection the two stocks actually have notably different drivers. Let's take a look at them and, in doing so, assess what will guide their stock performance in 2015.

CAT data by YCharts

Caterpillar and Deere & Company, not quite a perfect pair

The chart above shows how both stocks underperformed the S&P 500 in the last five years, and how Deere has outperformed Caterpillar. More insight is gained by looking at a breakout of segmental profit for the two companies, starting with Deere.

Source: Deere & Company Presentations

The chart demonstrates that Deere is primarily an agricultural company while, whose growth prospects are largely dependent on a combination of farmers income and their propensity to spend on agricultural machinery -- historically the two things are closely correlated. In turn, farmers income Deere prospects are governed by the outlook for key crop prices such as corn, wheat and soybeans. The following article on Warren Buffett's position building in the company helps to explain the investment thesis for the stock.

In comparison, the following chart shows how Caterpillar generated profit during the last few years. You should note the significant fall in profitability in the Resource Industries segment -- a consequence of falling hard mining commodity prices. It's clear that the two companies have an industry overlap in construction, but it represents a relatively small part of Deere's profits. As for Caterpillar, interested readers can find a more in depth analysis of its current trading prospects in the article linked.

Source: Caterpillar Presentations

Specific end market drivers

In order to illustrate the point further, I've prepared a tabulated outline of each segment for the two companies (excluding their financial arms).

Company Segment Primary Driver Primary Factor Additional Factors
Deere--Ag and Turf farmers income crop prices crop yields, weather, acreage planted
Deere--Construction and Forestry global construction markets global growth U.S. construction spending
Caterpillar--Construction Industries global construction markets global growth Emerging Market construction spending
Caterpillar--Resource Industries mining and quarrying activity mining commodity prices Emerging Market growth
Caterpillar--Energy and Transportation oil and gas, power generation, marine, industrial and rail global growth Energy prices, industrial, power and rail investment

Source: Caterpillar 10k filing, Deere & Company 10k filing

Putting aside the overlap in construction, the table above outlines how different the two companies' end market drivers are. With that said, why have they been traditionally seen as pairs?

In one word, the answer is China. The idea is that the emerging middle classes in China -- and to a lesser extent India, too -- are believed to be creating a long-term upward demand trend for both mining and agricultural commodities. In other words, both hard (base mining) and soft (agricultural) commodities have a common end-demand driver.

When middle classes emerge in developing countries -- particularly when accompanied by a shift toward urbanization -- the result is usually an increase in protein consumption. The oft-quoted factoid that it takes 7kg of grain to produce 1kg of meat is subject to debate , but the argument relates to the amount of grain needed, not that grain demand will increase disproportionately when people eat more protein. The end result of increased demand should be higher crop prices -- great news for Deere.

Similarly, the trend toward urbanization in developing countries is believed to create long-term demand for mining commodities, via infrastructure built out to support the growing urban population -- good news for Caterpillar's construction, resources and energy interests.

Four reasons why the theory doesn't work

First, although hard and soft commodity prices have moved seemingly in tandem during the last few years, there is no good reason why they should remain so.

U.S. Corn Farm Price Received data by YCharts

In fact, a longer-term view shows some significant divergence.

U.S. Corn Farm Price Received data by YCharts

Second, China actually imported record volumes of commodities last year, but it still wasn't enough to pull key commodity prices (hard and soft) out of their slump. Commodity end demand (hard or soft) isn't just about China.

Third, China's growth in industrial production is slowing anyway.

Source: Tradingeconomics.com website

Fourth, the supply of crop prices is contingent upon weather conditions and their effect on crop yields , rather than purely economic factors.

Forget about pairing

All told, the two stocks do have much in common, but not enough to pair them together unconditionally. If you want to buy Deere or Caterpillar, or both, you will need to look at prospects for each company separately. They are not interchangeable, and anyone devising a pair-based investing strategy needs to consider this carefully.

This $19 trillion industry could destroy the Internet

One bleeding-edge technology is about to put the World Wide Web to bed. And if you act right away, it could make you wildly rich. Experts are calling it the single largest business opportunity in the history of capitalism... The Economist is calling it "transformative"... But you'll probably just call it "how I made my millions." Don't be too late to the party -- click here for one stock to own when the Web goes dark.

The article Investment Strategies: Caterpillar Inc. vs. Deere & Company originally appeared on Fool.com.

Lee Samaha has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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 .

Copyright © 1995 - 2015 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

In This Story

DE CAT

Other Topics

Stocks

Latest Markets Videos

    The Motley Fool

    Founded in 1993 in Alexandria, VA., by brothers David and Tom Gardner, The Motley Fool is a multimedia financial-services company dedicated to building the world's greatest investment community. Reaching millions of people each month through its website, books, newspaper column, radio show, television appearances, and subscription newsletter services, The Motley Fool champions shareholder values and advocates tirelessly for the individual investor. The company's name was taken from Shakespeare, whose wise fools both instructed and amused, and could speak the truth to the king -- without getting their heads lopped off.

    Learn More