The boom days that preceded the global f inancial crisis of 2008/09 were influenced, to a large extent, by a number of sectors, most notably the platinum, but also construction stocks as the 2010 FIFA World Cup, Gautrain and general infrastructure spends boosted their profits and margins soared. That was followed by a general market collapse, one from which construction companies have not as yet recovered. This was in large part due to the Competition Commission investigations, but even when that was resolved the stocks remained stuck to a large extent.
So what do we look for when investing in construction stocks? First, and perhaps most importantly, is to understand that these stocks are very cyclical in that they are characterised by boom periods followed by bust periods. In between, there will be long, uneventful stretches. This boom-and-bust nature of the industry means that we need to time investments in this sector, getting in during the long periods where nothing happens, and ideally close to when the boom starts. Then, when the stocks are booming, we need to exit as close to the top as possible. But neither of those is easy to do and as a result I have decided to avoid this sector.
That said, the first thing one should look at with a construction company is its order book. We really need a lot of detail on the order book. What time frame are the orders over? What margin is expected? How risky is the order book? The first two are simple enough for the company to answer, the risk question is perhaps more difficult. Certainly, the company would say that the risk is not higher than normal, but what we have seen over the last few years is a number of contracts that ended up being lossmakers, hurting profits.
Also look at the sectors the construction companies are operating in, for example, contract mining, civil and roads. Some sectors are a lot more profitable and far more stable. Contract mining, for example, can be great as such companies don’t carry the risk of commodity prices falling but in truth they do because if prices fall, contracts can be cancelled. Further, mining companies will typically cancel the contract miners before retrenching their own staff.
Then of course there’s a company’s operating profit margin. We need to look at this not only at group level, but also focus on the different sectors a company operates in. Ideally, we should even scrutinise the different large contracts. As already mentioned, we would ideally like to know the proposed operating margin of the order book.
Cash generation is also very important, not just the making of cash, but also how much a particular company has on the balance sheet. Construction is very capital intensive and runs the risk of all sorts of cost overruns and penalties. So a lot of cash is needed and while that looks attractive on the balance sheet, it can soon slip away. So look for cash, but don’t bank on it as you would with a stock in a sector such as retail.
Another issue is geography. After the crisis, a lot of companies headed for Australia or the rest of Africa looking for easier profits. But Australia has its own challenges right now and while the rest of Africa may seem like an easy win, it seldom is. Sure, margins can be higher, but is the work effectively being managed out of South Africa or are the companies taking it seriously and operating on the ground? My view is that it only really counts if the company has a track record in whatever region it operates in. A new office in some far-f lung country may sound exciting, but I want to see a track record of profits first.