When quality over valuation can be murky

The tenet of proper investing has always been clear and straightforward.

As I seek to diversify my portfolio from being tech heavy, this has led me to dive deep into evergreen businesses that I am quite certain will be around at least until I leave this world.

As I embark on a thought process to discovering great companies to invest outside of tech, the approach led me to look at the picks and shovels of businesses from a variety of industries.

Shortly after that is done and dusted, my head is now turned towards the picks and shovels. Literally.

The heavy machinery industry, in my opinion, even though cyclical, do have investing gems.

Firstly, there are already a handful of companies within this industry that has outperformed the S&P 500. There are also companies within this industry that Dividend Aristocrats.

And to top the cherry on the cake, they have been around for more than 100 years. They will not be disrupted by AI (unless if you refer to mining intangible coins on the internet).

And as I dug deeper, I am pretty sure both Deere and Caterpillar are the creme of the crop within this industry, in terms of quality and track record.

The headache arises when I was determined to pick a winner out of the two.

The heavy equipment vehicle segment can be competitive. There are easily a handful of companies that operate in this segment.

Caterpillar holds the largest market share, albeit at just 16% based on the latest data in 2022 which I can obtain. Other notable players include Komatsu Ltd (TYO: 6301), Sany Heavy Industry Co Ltd (SHA: 600031) and Zoomlion Heavy Industry Sci & Tch Co Ltd (SHE: 000157).

Source: TradingView.com

Investing my own capital, my mandate is to outperform the SPY on a long term basis. Returns for Deere and Caterpillar seem to fit the bill very much.

I acknowledge both companies look promising. But if I were to pick one out of the two to spend more time on, this is where the headache arises.

When I take a look at operating margins, its clear that Cat and Deere are way ahead of its peer, easily coming in with more than 20%.

Source: TIKR.com

The same observation goes for return on assets.

Source: TIKR.com

Deere used to report a better FCF margin than Cat, but has recently seen Cat outperforming it.

Source: TIKR.com

So from a basic screening and comparison, Cat looks to be relatively a better company than Deere. Thus, it would justify it a premium valuation.

The valuation portion stumps me a bit. How much of a valuation premium to assign to Cat, or how cheap it is to convince to scoop up Deere. The quality and valuation conundrum surfaces.

Deere is still a company with, albeit just a bit less if compared to Cat.

Deere looks cheap at a price-to-earnings of 14x, while Cat is also trading at just below its long 6-year average of 20x.

So should an investor fork out the cash to the better company - Cat, or justify that Deere looks cheap with quality on its belt as well?

As I was still contemplating choosing the best between both in terms of balancing the quality and valuation barbell, I was reminded by how similar the situation is as with NVDA and AMD.

Both NVDA and AMD are in the same business, but both have slightly different key focus area. AMD has always traded at a discount versus NVDA, but that doesn’t mean it isn’t a good business.

Cat will provide quality equipment and machineries to the construction and mining industry. I don’t foresee a future where construction and mining becoming obsolete.

The same theory applies to Deere as well. If agri-commodities will continue to be the building blocks of feeding the global population, Deere’s business is as evergreen as ever.

Perhaps rather than bicker and get myself into a spiralling headache of choosing one among the both, maybe just consider having both in my buy and hold portfolio?