Why You Should Sell Caterpillar Inc. (CAT)

Hedge fund manager and noted short seller Jim Chanos targeted Caterpillar Inc. (NYSE:CAT) on Wednesday, in a presentation given at CNBC’s Delivering Alpha conference.

Chanos argued that Caterpillar Inc. (NYSE:CAT)’s business is largely dependent on the Chinese construction boom. He also cited issues with Caterpillar Inc. (NYSE:CAT)’s accounting. China’s economy is exhibiting signs of a property bubble, and if that bubble pops, Caterpillar Inc. (NYSE:CAT)’s business could be devastated.

Caterpillar is dependent on China

Over the last few years, Caterpillar Inc. (NYSE:CAT) has been a tremendous performer. Since the March 2009 lows, Caterpillar Inc. (NYSE:CAT) is up more than 260% (in addition to a steady stream of dividend payments).

Most of that gain has been due to the Chinese economy.

Since the financial crisis, China’s economy has been consuming raw materials at a rapid rate. In November 2008, the Chinese government announced a massive ($600 billion) stimulus program. The result has been unprecedented infrastructure spending.

In 2010, China surpassed the US in terms of energy consumption and is on track to surpass the US as the world’s largest importer of oil by 2014. In addition to energy, China has been a big consumer of iron ore and copper. China surpassed the US in copper consumption back in 2002, and the gap between the two countries had been widening ever since. Over the last decade, China’s consumption of copper has increased by over 200%.

Caterpillar, as a maker of heavy machinery, has benefited from the commodity boom. As Chanos noted in his presentation on Caterpillar, 30% of the company’s revenue, and 50% of its profit, is tied to global mining capital expenditures.

China’s property bubble

But that commodity boom could be coming to an end. A growing number of economists and money managers have warned of a bubble in China’s real estate market, and if (or when) it bursts, it will devastate commodity prices and the companies dependent upon them.

Perhaps there is no better way to illustrate China’s property problem than to observe its “ghost cities” — enormous, seemingly abandoned metropolises.

Anyone interested in the space should watch 60 Minutes’ report on the phenomenon. The video footage of empty highways and shopping malls is reminiscent of a Hollywood apocalypse movie.

Famed economist Nouriel Roubini has said China’s economy is the biggest risk facing the global economy in the second half of 2013. He has been warning since 2011 that China was suffer from an “economic hard landing” as over half of its GDP has been going towards fixed investment — an unsustainable amount.

Other stocks that could crater

Of course, if China’s real estate market collapses, and it brings commodity prices down with it, it won’t just be Caterpillar that suffers.

In particular, Freeport-McMoRan Copper & Gold Inc. (NYSE:FCX) would be exposed to downside even more so than Caterpillar. As a miner, the company’s business is dependent on the market for copper, gold, and other minerals. As management admitted on the company’s last conference call, the Chinese economy “remains an important demand driver.”