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The Value Line page of a Building Materials company is in the standard industrial format. But this sector can be highly cyclical, giving investors cause for caution. Various Building Materials subsectors do not always move in synch with each other. Investors should note the specific end markets that each company serves. There are a number of subsectors, some mature, others growing. The group is fragmented, but there are companies that dominate certain niches.

Cyclicality

Historically, the housing market has accounted for about 60% of all annual domestic construction spending. This market has proven volatile. Those interested in this industry have a bevy of leading indicators to monitor, including housing starts, building permits, home sales, foreclosures, unsold home inventories, mortgage rates, and employment figures. Data is accessible from regular news, business, and government publications. Trends reveal which direction the housing and, essentially, the Building Materials markets are headed.

Infrastructure (e.g., roads, bridges, and water projects) is one of the most stable subsectors. Still, this area is not immune to macroeconomic conditions. For instance, highway construction is largely funded through government taxes on gasoline and diesel fuel, suggesting dependable funding. But receipts can rise and fall, depending on driving patterns, which are influenced by the health of the economy. Though infrastructure construction is often delayed due to budget constraints, projects are rarely cancelled. Lawmakers’ careers can depend on meeting their constituents’ related needs.

In between these two extremes are commercial (office and retail building), institutional (schools and hospitals), and industrial construction. It’s true these markets are economically sensitive, but they are not as volatile as housing. Key indicators are nonresidential construction spending, office vacancy rates, and the Architectural Billing Index.

Analytical Measures

Appropriate price/earnings ratios for Building Materials stocks can be tricky to determine. P/Es are often highest when earnings have hit bottom and lowest when profitability is topping out. We use average historic, or mid-cycle, figures for our 3- to 5-year multiples. Comparing this projected figure with an issue’s current P/E is helpful in determining whether the recent share price is reasonable. P/E comparisons are valid for companies serving the same markets, having like capital structures, and similar stock betas.

Price-to-book value per share can also be a useful investment measure, since Building Materials companies consist mostly of hard assets. Brands and research & development are not critical in cementing good customer relationships. Book values often set a floor for share prices. In a typical earnings cycle upswing, the P/BV multiple is close to 2.0.

We recommend that investors keep a close eye on a company’s balance sheet, as well. In good times, building suppliers increase leverage to expand inventories and satisfy rising customer demand. It’s important for management to accurately assess specific points in the market cycle, and not get caught over-levered in a downturn.

Many Building Materials stocks have a small market capitalization and trade lightly. Thus, institutional investors can have a notable impact on price volatility. Betas tend to be on the high side. Small investors with a long-term view do not need to watch their holdings on a daily basis. Sharp swings in trading volume, or heightened put and call option activity, though, could indicate a change in the business trend.

The Business Description

This section of the Value Line page should be studied carefully. Although building product usage often crosses several subsectors, many companies are dependent on one single market. For example, housing products might be found in commercial construction, though residential demand is much more significant. The Business Description may show that a company mainly serves the home repair & remodel market, a stable venue, as opposed to new home construction. Other companies may dominate a niche market, such as drywall or insulation. This usually doesn’t translate into substantial pricing power, however; high sales volume can be more beneficial to the bottom line.

Geographic diversity is also an important consideration. The health of the construction sector can vary widely among domestic regions. Exports are not viable due to the high cost of shipping heavy materials. Some suppliers have overseas operations, which can help to offset problems in the U.S. The Description may indicate that a company is a market leader, suggesting it has the strength to compete through the entire economic cycle.

Regulatory and Legal Factors

Often, legislation has been more helpful than harmful to the industry. For example, mandates requiring biofuels have resulted in an explosion of ethanol plant construction. Too, alternative fuel subsidies have created a growing market for wind towers and solar panels. And improved safety standards have led to increased sales of hurricane- and blast-resistant window products.

Litigation can pose significant risk. Building products, used in everyday construction, can subject suppliers to widespread injury claims. In the past, lead paint and asbestos lawsuits were prominent in the headlines. More Building Materials companies have been driven into bankruptcy because of liability claims rather than the pressures of a weak economy.