God is a Capitalist

Tuesday, October 25, 2016

Caterpillar needed the Austrian business-cycle theory

Caterpillar is facing its fourth year of declining sales, the longest in its history. It expects total revenue this year to be 39% below its peak in 2012 and profits will be down 68%. Its stock is now 25% below its peak. Through the first six months of 2016, the company’s overall revenue was down 21% from the same period in last year.

CEO Doug Oberhelman is stepping down, but when he took the reins in 2010 the world, especially China, couldn’t get enough metals. Prices were soaring and everyone thought the good times would last. That’s the first mistake most investors and businessmen make – linear forecasting instead of thinking in terms of cycles. Oberhelman should have understood cycles after working for Caterpillar for 35 years. The capital goods sector is the most volatile in the business cycle. But he didn’t understand them. Caterpillar’s problems began when it invested heavily at the peak of a cycle according to an article in the Wall Street Journal:
Mr. Oberhelman voiced determination to avoid production-capacity constraints that had clipped Caterpillar’s sales growth before the recession. He increased production of the equipment that contractors use to construct buildings and roads and pipelines—Caterpillar’s forte—in existing plants. Caterpillar built new factories such as one in Victoria, Texas, to produce some excavator models and another near Athens, Ga., for small dozers—machines it previously made overseas and imported.
Unable to build new plants fast enough, Oberhelman bought Bucyrus, maker of the giant mining shovel, in 2011. He doubled their plants in China to twenty-six and bought Chinese manufacturers.
'Everybody was convinced that this time would be different,' said Ken Banks, who retired in 2013 as manager for Caterpillar’s electric mining shovels. 'They thought the Chinese market was so hot, that commodity prices would continue to be very strong and Caterpillar would increase sales substantially.'
Then in 2013 the bottom dropped out of the oil and metals market as world growth stalled. Prices began a long slide that has only recently plateaued. And with the collapse in prices, demand for new mining and construction equipment vaporized like the smoke from a dozer’s exhaust pipe. Over the past four years Caterpillar has closed dozens of plants and shed 30,000 workers.
'They overlooked the possibility that the whole market would collapse,' said Charles Yengst, a Connecticut equipment consultant. 'They opened factories all over the place to operate at a market peak that doesn’t happen every year or even every 10 or 15 years.'
The long descent in commodity prices was part of the commodity super cycle and not a typical business cycle, but the two are related. Both are launched by central banks printing money and driving interest rates below the market rate. Commodity super cycles last 15 to 20 years from bottom to bottom. At a bottom in prices, mining companies shut down marginal mines and quit buying equipment. It takes almost a decade for declining supply and growing demand to erode the excess supply and cause prices to start rising again. The ascent of prices tends to last years because it takes that long for companies to recognize the change, buy new equipment and expand.

Capital goods businesses, like real estate, are highly sensitive to changes in interest rates. Artificially low rates increase demand for loans to buy capital equipment, such as Caterpillars. When Oberhelman took over, Caterpillar enjoyed artificially low interest rates and high commodity prices. But it was a trap for suckers.

Successful businessmen don’t have to be experts in the Austrian business-cycle theory. I have known several who grasped nothing about economics. One was my grandfather who had a sixth grade education. His main business was ranching, but he increased his wealth significantly by buying failed ranches in recessions, dividing the land and selling small acreages for people to build homes on. He understood cycles. Another was an oil man who never expanded his business when prices were high. Instead he socked away piles of cash. Then when the inevitable crash in oil prices happened he would buy the companies that had borrowed and expanded at the cycle peak, as Caterpillar did.

Businessmen need to understand the Austrian business-cycle theory as well as investors. In the commodities business they need to grasp commodity super cycles as well in order to survive.

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