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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Is This The Mining Equipment Sector’s Last Act?

Is This The Mining Equipment Sector’s Last Act?

Amid all of the stock market volatility in recent weeks an enormous amount of attention has been focused on the energy sector and the daily volatility in that group. And with the price of oil swinging wildly, that attention makes sense. But there is another sector that has been buffeted just as badly that seems to be flying below the radar of many investors despite some stupendous opportunities; the mining and construction equipment sector.

The fact is that construction is actually fairly robust at this point, and while the potential of the Fed raising interest rates in the future may weigh on the outlook for housing sales somewhat, the larger problem in the industry is a lack of housing supply rather than a Fed rate hike. The office construction market looks similarly robust. Despite this strength in commercial markets, however, makers of backhoes, bulldozers, excavators, and a variety of other types of construction equipment have all been hit by dizzying drops in the recent market turmoil. Related: Petrobras Scandal Reaches Far And Wide: Are Investors At Risk?

The outlook for mining is largely responsible. Worries over a lack of demand from China and the EU have crushed miners and equipment markets alike. This fall is coming despite optimism about a better 2016 from company executives. And certainly there are reasons to worry about the short-term in both China and the EU. Both economies seem mired in perennial problems revolving around economic growth and are showing an inability to come up with lasting durable solutions. At the same time though, the U.S. economic outlook is reasonably strong and the world’s biggest economy is continuing to grow at a rate roughly in-line with its long-term historical average.

That is the quandary for investors – how important are China and the EU to equipment makers relative to the U.S? The answer the markets are promoting right now is ‘very important’. Most mining equipment stocks are being priced as though they will never grow earnings again. High growth stories like Terex (TEX) are now sporting P/E ratios around 12X, while bellwethers like CAT and John Deere (DE) are trading around the same level. And specialty mining equipment maker Joy Global (JOY) is being priced like it’s one step from bankruptcy with a P/E ratio of less than 7X. Related: Oil Majors Sacrifice Production To Protect Dividends

From the point of view of a long-term investor, none of this makes sense. In the short term, European and Chinese demand may be lackluster, but it’s inconceivable that over the long-term there won’t continue to be a substantial and growing need for all sorts of heavy machinery to do everything from build houses and office buildings to mine coal, gold, and copper.

Analyst earnings predictions have certainly come down on all of these stocks, but even using forward EPS numbers, the stocks still look cheap. Take CAT for instance. Analysts are forecasting the company will earn around $4.75 a share for the full year 2016.  Related: How Russia’s Oil Companies Are Defying Sanctions and Low Oil Prices

Nonetheless, even if analysts are correct, that still gives CAT a P/E ratio of around 15X 2016 numbers. The average P/E over time has been about 15X. Thus Caterpillar’s valuation right now only makes sense if an investor believes that not only is 2016 going to be worse than 2015, but that things will stay that bad indefinitely. If an investor thought Caterpillar’s earnings in the future would rebound, then the stock should warrant an above average P/E ratio for those future earnings.

The point is that investors are being irrational and short-sighted regarding heavy equipment stocks today. The reality is that the world has continually needed more and more capital equipment over time, and from growth stories like TEX to diversified giants like DE, the markets are pricing these firms as if they are businesses entering secular decline rather than companies experiencing a temporary demand shock associated with a normal economic slowdown. Long-term investors should sense an opportunity and behave accordingly.

By Michael McDonald of Oilprice.com

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  • gtatar@shaw.ca on September 28 2015 said:
    Good Article.

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