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Thursday, January 30, 2014 - 13:00

Why Bill Gates Loves This Buyback Machine -- And You Should Too

Thursday, January 30, 2014 - 1:00pm

To apply a shopworn phrase to the bull market of 2013: "A rising tide lifted all boats."

Or at least many of them.

Investors gravitated toward almost any company that was delivering decent quarterly results, making it ever harder to spot deep value. Companies that stumbled through a series of challenging quarters, however, stayed in investors' doghouse.

Yet as the world's top investors will tell you, real profits are made in the unloved stocks, not the loved ones. That was clearly logic in place for Bill Gates and his investment firm: While most investors were shunning heavy equipment maker Caterpillar (NYSE: CAT), Gates and his team were loading up.

Though Gates likely sees many virtues for Caterpillar, it's the company's financial firepower that may have held the greatest appeal. As I noted back in September, "Caterpillar's cash flow is so robust that its dividend was hiked at a double-digit pace in 2012 and again in 2013, even as the company is in the midst of a $7.5 billion share buyback program."

Fast-forward to January, and Gates is looking wiser than most. Caterpillar just topped earnings per share (EPS) forecasts by more than 20%, leading to fresh surge in the stock. This laggard has become a leader: While the S&P 500 has moved sideways since Nov. 15, perhaps signaling an end to the era of a "rising tide lifts all boats" market, CAT is up more than 10%.

Equally important, Caterpillar has just made a fresh commitment to its buyback strategy, implying further gains ahead.

As you know, share buybacks are simply another way companies enrich their investors. My colleague Nathan Slaughter is a huge fan of companies with substantial stock buyback programs, which he often says are indicative of management's confidence in their own company. That's not to mention the obvious benefits to shareholders, who often see the value of their shares climb as a result.

When combined with dividends and debt paydown, buybacks form what Nathan calls a "Total Yield" strategy, which according to our research, beats the market (and traditional dividend-only investing) hands-down.

As I noted, Caterpillar was in the midst of a $7.5 billion share buyback program. There's still another $1.7 billion to go on that plan. The moment that plan is completed, CAT will launch a $10 billion share buyback, bringing the grand total of these two plans to $17.5 billion. That's more than 25% of the company's entire market value.

Flickr/Gagetdude
Caterpillar's construction and power systems divisions are poised for a good year, while the mining equipment division is likely to face another challenging year.

CAT's dividend is also getting more attention. Between 2009 and 2011, CAT's dividend rose just 4% annually. The payout rose 9% in 2012 (to $1.96 a share) and 14% in 2013, and is on pace to rise at a similar pace this year, to around $2.60 a share.

Analysts at Merrill Lynch see the dividend rising to $3.45 a share by 2016, or roughly twice what the company offered in 2010. That works out to be a prospective 3.7% dividend yield, which when combined with the buyback yield, pushes the Total Yield to nearly 30%.

Another plus for Total Yield: Caterpillar paid off more than $2 billion in long-term debt in 2013. Another pillar of the Total Yield strategy, debt paydowns like this allow companies to spend less of their free cash flow on servicing debt -- and more on rewarding their investors.

Brightening Prospects
It's understandable why Gates and his firm have been steadily amassing what is now an $11.6 billion stake in this company: Business is just fine, despite the implications of a lagging stock chart in the summer of 2013. The company's backlog stands at a hefty $18 billion, which should keep its factories humming.

To be sure, not all of CAT's cylinders are firing in unison: The company's construction and power systems divisions are poised for a good year, while the mining equipment division is likely to face another challenging year. Total sales are likely to be flat in 2014 at around $52.5 billion.

Yet simply looking at that sales figure can be misleading. CAT has a long history of revising guidance in the same direction. The company has been reining in analysts' expectations since the first quarter of 2012. That's when its mining equipment division hit a sales pocket, and its other divisions lost some momentum.

The fourth quarter of 2013 marked a shift: Management had no need to lower forward guidance, and if history is any guide, it will be followed by a reiteration or raising of guidance in the quarters to come. Translation: CAT is slowly seeing a shift from headwinds to tailwinds.

So what would help push this stock back through the $100 mark? "On a 12- to 18-month basis, the eventual pickup in mining truck replacement demand would be the ultimate catalyst," note analysts at Merrill Lynch, who ultimately see shares rising to $115 as that catalyst plays out. That's 25% upside from current levels.

You could argue that CAT would actually benefit by seeing shares remain in the low $90s. Those massive share buybacks would go even further in shrinking the share count. Gates likely takes another view: That massive buyback will likely help this stock hold its ground if the market action gets rough in 2014.

Risks to Consider: CAT remains very sensitive to global economic activity, and any fresh economic weakness in China and elsewhere may lead management to once again lower guidance.

Action to Take --> This is a classic example where sales growth is deceiving. Caterpillar still faces challenges in its various end markets, which is keeping a lid on growth. But the company's cash flow is so robust that shareholders will be rewarded anyway. There's no need to assess this stock in the context of how the company will fare in coming quarters. Instead, focus on how the company's excellent Total Yield strategy reflects a very bright long-term future.

P.S. We're so excited about Total Yield that we've decided to devote an entire newsletter to it. And right now, we're giving readers an exclusive glimpse at some of the top stocks we've already uncovered using this method -- including one that's gained an astonishing 247% over the last year. To get the name of this stock -- as well as 11 others that are currently posting "total yields" as high as 27.7% -- you can view our free research by following this link.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.