Building sector overdone?
Summary: Construction growth will have to grow strongly to justify the hefty premiums of building materials stocks. While policy settings remain supportive, analysts are concerned about the ability of the non-mining sector to lift. The sector needs a building boom similar to that of 2003-2007 to warrant further ongoing share price outperformance. |
Key take-out: Lack of a meaningful rebound in construction investment after the end of the mining boom may suggest building material stocks have been overbought, after sustained share price growth. |
Key beneficiaries: General investors. Category: Economy |
Despite what has been solid share price performance over the last twelve months, there doesn’t appear to be much in the way of good macro news for our building materials stocks - such as Adelaide Brighton(ABC), Boral (BLD), Fletcher Building (FBU), James Hardie (JHX) and Brickworks (BKW). The end of the mining boom already declared and the absence of any meaningful rebound in construction investment elsewhere, may even suggest that the sector has been overbought.
You can see from the chart, price gains have been sizeable for the major building material stocks, the rally really taking off from mid-2012. At the outset, the economics behind these gains is sound. The RBA has slashed rates to their lowest in around half a century, and there is a big push to lift non-mining construction. Table 1 shows gains for the key stocks in the sector on a 6, 12 and 24 month view. They’ve paid handsomely and outperformed the market.
One of the key problems is that to date, and as we found out last week, there is little movement in actual non-mining building. Analysts are genuinely concerned about the ability of the non-mining sector to lift. Indeed total building work done actually fell in the December quarter by around 1½%. It’s flat for the year. This is even worse for the private sector with residential construction down 2% and non-residential building off closer to 3%. It’s not good.
So how then can we justify the aggressive price moves by construction material stocks? Especially when we add in table 2 below. Each stock listed is expensive - well above the average price-earnings ratio and that doesn’t change too much on a forward basis - assuming 16% earnings growth over the next two years.
With that in mind there are several issues we need to consider.
Firstly, what kind of earnings growth profile can we expect? Is growth of 8% (or something high single digit) reasonable? Could it be stronger? Well, from my viewpoint I think high single digit growth (like) 8% per year is an easy achievement and not a controversial number. Most of the stocks listed above have already done that - or better - over the last couple of years and if they haven’t done it on an EPS basis they’ve certainly achieved the revenue growth. Over the next 2-3 years, you’d think they’d easily exceed that performance, given current policy settings. But to what extent? 10%, 20% or 30%? EPS growth of around 20-30% is what you’d need to see for this sector to come back down to fair value. But how confident could we be in anyone’s estimate anyway? Not very, I would have thought.
Nonetheless, concentrating on simple metrics of value can overlook the fact that stocks often spend a good deal of time trading above. That is they trade rich and can do so for some time. So the issue isn’t whether investors are prepared to pay a premium - they are and they’ve demonstrated this time again. The issue is whether investors are prepared to pay a premium for these stocks on a sustained basis. For building materials, I think the answer is yes. Why?
- Policy setting are strongly supportive
- A lift in non-mining construction is a stated policy aim
- We are coming off an exceptionally low base
Remember that from every pay cheque, 9.25% of most people’s earnings has to be invested somewhere. Investors rightly aren’t putting that money into government bonds, and there is no point in investing in cash. Your return after inflation and tax is practically zero. That leaves equities and property. With that in mind, the market conditions are already ripe for stocks to trade rich. Aggressive multiple expansion should be expected in that environment - if the narrative is there. And construction material stocks do certainly have the right narrative.
So in our builder materials, we do have a sector that is a prime candidate to trade at a premium, and it is doing so. Yet it’s already at a fairly substantial premium. Consider, going back to table 2, that some of those stock’s earnings multiples are already pushing the decade high. The key stocks have run hard and that’s despite any meaningful lift in construction. The question is whether it’s reasonable to expect such a large premium? I suspect if there was more certainty regards future earnings, then the answer would be yes. But there isn’t. Construction hasn’t fully turned yet and we don’t know how big the turn will be when it does - if it does. That isn’t an environment where I would have thought a stock would be trading near a 10-year high earnings multiple. It doesn’t suggest to me there is too much multiple expansion left, without some evidence of a sharp lift in earnings. In short, the market is already expecting a lot from these guys.
Reconciling these crosswinds
Building approvals out this week suggest construction could lift materially in 2014 and this is occurring at a time the construction cycle has already turned in NZ and the US.
With that in mind, I don’t want to become negative on the sector because it’s entirely plausible that earnings growth will be very strong. We’ve seen it before and in the period from 2003-07 the key building stocks recorded EPS growth averaging around the 20-30% mark every year. Seeing that again now, would put the sector back into value territory and would certainly see further ongoing strong outperformance from the sector. But we would need to see that kind of earnings growth, at these already very high multiples, to keep investors loyal to the sector.