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The Smartest People on Wall Street Are Buying These 3 Stocks — Should You Follow?

According to 13F filings at the SEC, asset managers were buying stock in multi-industry industrial 3M (NYSE: MMM) ,infrastructural equipment company Caterpillar (NYSE: CAT), and railroad Norfolk Southern (NYSE: NSC)in the third quarter. That was a few months ago -- is there any upside left in these stocks?

Performance against the market

First let's take a look at the stocks' performance compared to the S&P 500 Index since the end of the third quarter. It's been an excellent period for the markets in general, but 3M has clearly underperformed the market. Why?

Image source: Getty Images.

Caterpillar has had a strong run due to a combination of hope that stimulus spending will drive infrastructural investment and a belief that economic growth will improve in 2021. Is it justified?

Finally, Norfolk Southern has improved in line with the other major listed railroads, as the market has priced in improving conditions in the industrial economy. Is the stock still a good value?

Let's deal with these questions in turn.

Data by YCharts

3M

It appears that 3M has lost the premium valuation rating it once held over its industrial peers. The reason comes down to a combination of missing its own earnings estimates, lackluster performance in two of its four segments (healthcare and consumer products), and market fears over its potential PFAS liabilities. In addition, there are concerns that its products may be losing pricing power as growth in online sourcing makes it easier to find cheaper alternatives.

However, many of these concerns appear to have already been priced in to the stock. Moreover CEO Mike Roman is aggressively restructuring the company for growth, 3M's sales are already in recovery mode, and the company is set to generate $5.8 billion in free cash flow in fiscal 2020 alone. Throw in a highly attractive dividend and 3M remains a good option for value investors. If Roman is successful in expanding margins and growing sales, then 3M has substantive upside ahead.

Caterpillar

Caterpillar is a great company, and in common with many other highly cyclical stocks, it has a history of exceeding expectations when the economy turns up. The good news is Caterpillar's retail sales (the company mainly sells through independent retailers) do appear to have bottomed and are now on an uptrend.

Data source: Caterpillar presentations. Chart by author.

Typically, a bottoming in sales is a good sign for the stock. For example, the chart below shows how its enterprise value (market cap plus net debt), or EV, to earnings before interest, taxation, depreciation, and amortization (EBITDA) tends to rise strongly after a sales bottom -- see 2010, 2016, and 2020. Clearly, the market is pricing in a substantive increase in earnings in the years to come.

Data by YCharts

In other words, the EBITDA is expected to increase and, EV being equal, the EV-to-EBITDA valuation will fall. Indeed, Wall Street analysts are forecasting EBITDA will rise 24% in 2021 to $7.5 billion putting Caterpillar on a forward EV-to-EBITDA multiple of 18 times at the end of 2021. Meanwhile, the EV-to-EBITDA multiple at the end of 2020 is forecast to be around 22 times.

Frankly, those multiples suggest Caterpillar has already had a recovery priced in, so unless you are very confident the company will exceed expectations in 2021, then the stock's valuation looks fair. Throw in some concerns over the strength of the recovery in Caterpillar's end markets and there's reason to be cautious about the stock right now.

Norfolk Southern

Railroads are the veins and arteries of the industrial economy and typically mirror growth in the U.S. There's no doubt that the market-busting performance of the railroad sector over the last five years has left the railroad sector's valuation looking superficially high -- note Norfolk Southern's EV/EBITDA valuation in the chart.

Data by YCharts

That said, there are reasons behind the price rise and the valuation rerating. The main one is the wide-scale adoption of precision scheduled railroading, or PSR, management techniques, which are widely seen as responsible for raising the long-term earnings margin potential of the railroads. Indeed, Norfolk Southern and others were on track to do so in 2020 before the coronavirus pandemic began.

Looking at Norfolk Southern now, it does look expensive on an estimated 2021 EV/EBITDA multiple of 14 times. However, it's worth noting that railroads are very safe investments. They own their own infrastructure and are highly likely to be around as long as the U.S. economy requires the shipment of goods cross-country.

As such, Norfolk Southern's safe and sustainable dividend yield of 1.5% is going to suit many investors looking for a reliable, low-risk stream of income that pays more than you might earn in a bank account right now.

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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool recommends 3M and Union Pacific. The Motley Fool has a disclosure policy.


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