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The 3 Best Construction Stocks To Own Forever

Published December 18th, 2018 by Josh Arnold

Construction stocks can be defined very widely to include materials companies, home builders, service companies, etc.

However, we think the purest plays on construction relate to equipment and construction services companies and thus, these stocks offer the best way to take advantage of long-term fundamentals we find attractive.

Before we get to our list of stocks, let’s take a look at why we find the construction sector attractive.

Why We Like Construction Long-Term

First, rising global gross domestic product, or GDP, means that construction activities and services will be in demand over the long-term. Data from the World Bank on global and US GDP is below from 2010 through 2018.

GDP Growth

Source: World Bank via Google Public Data

While growth has slowed slightly from 2010’s levels, we have seen global and US GDP very steady in the 2% to 3% range annually. This constant increase in economic activity means office buildings, retail, housing and other core infrastructure items are being built across the developed world. In order for those things to happen, construction equipment and services are needed, and that is a key reason why we like the construction sector.

Complimentary to the growth of world GDP is the growth of the world’s population. Even in times of economic distress, the world’s population grows at fairly steady rates. Global and US population growth from the World Bank for the same time period as above can be seen below.

Population Growth

Source: World Bank via Google Public Data

The US has seen lower population growth than the rest of the world, but population is still growing.  This is a steady, long-term driver for demand for things like residential and shopping space, as well as roads, utilities and other infrastructure items that support the daily lives of the world’s population.

Combined, population and GDP growth create a powerful long-term tailwind for construction stocks. In addition, the many under-deveopled countries around the world offer emerging growth markets for construction companies to capitalize on down the road.

Further, in the US, specifically, existing infrastructure has a poor rating. The American Society of Civil Engineers updates its infrastructure report card on a regular cadence and the most recent update for the US was a D+. That implies billions upon billions of dollars of infrastructure investments and upgrades are needed just in the US over the long-term to fix things like roads and bridges, which will power revenue streams for companies like the ones below.

Three Companies To Profit From Long-Term Construction Demand

Given all of this, we’ve selected three companies we think are best positioned to take advantage of these long-term trends.

We’ll begin with Fluor Corporation (FLR), a construction engineering firm that serves a wide variety of industries including government, energy, chemicals and mining, industrial, as well as infrastructure and power.

Construction Stock #1:  Fluor Corporation (FLR)

Fluor Corporation produces about $19 billion in annual revenue and after a recent, large selloff, the stock has a market capitalization of just under $5 billion.

Fluor’s attractiveness begins with its very diverse base of clients. Fluor serves just about every major industry that needs construction engineering services and thus, during downturns, it is perhaps more insulated than other, more specialized firms. Indeed, during the Great Recession, Fluor’s revenue dipped only slightly in 2009 and 2010 before rebounding strongly in 2011 in excess of pre-Recession highs. Earnings actually rose during 2009 before taking a hit in 2010, but just like revenue, earnings rebounded much higher in 2011.

The company’s dividend wasn’t raised during the Great Recession but it was maintained when so many others weren’t, which is another sign of the strength of the company’s model.

We see very attractive long-term prospective returns from Fluor as the stock has sold off meaningfully of late. Shares are at a 10-year low as of now, levels they haven’t seen since the depths of the Great Recession. Concerns over the company’s customers delaying investment projects that would see significant revenue for Fluor have hit the stock.

However, for long-term investors, even if projects are delayed, they must be completed eventually as they are critical infrastructure upgrades. Thus, we see near-term volatility as opportunity for new investors.

Fluor Awards & Backlog

Source: Q3 earnings slides, page 5

Indeed, this slide from the Q3 earnings presentation shows that Fluor’s book-to-bill ratio was in excess of 2 in Q3, indicating it took twice as many orders as it filled. Anything above 1 is an indicator of strong demand so a value of 2.07 shows that longer-term, demand for Fluor’s services is intact. Indeed, its backlog is up to $34.9 billion as of the end of the quarter, nearly two years’ worth of revenue.

We see robust earnings growth for Fluor moving forward as it should achieve about 10% earnings growth annually, per management guidance. The stock is yielding 2.3% after the selloff and we also see a sizable tailwind in the high single digits from a rising valuation. Fluor trades for ~11 times next year’s earnings estimate today, which compares very favorably to its long-term average around 15 times earnings. Thus, we see Fluor as a strong pick for long-term investors who don’t mind the short-term volatility in the stock.

Construction Stock #2:  Caterpillar (CAT)

Next up is Caterpillar Inc. (CAT), a manufacturer of heavy equipment used in construction including diesel engines, industrial gas turbines, as well as ready-to-use machines for mining and construction activities. It competes in diverse industries including construction, mining, energy and transportation. The company produces about $55 billion in annual revenue and after a recent weak period in the stock, its market capitalization is $74 billion.

Caterpillar showed strength during the Great Recession despite an enormous reduction in revenue in 2009. In the years after that, however, revenue grew at very high rates as pent up demand for construction and heavy equipment drove outsized gains for Caterpillar.

Importantly, Caterpillar remained profitable during the worst of the recession and not only did it maintain its dividend, but it actually kept its streak of increases alive, a streak that continues through today. Despite a huge reduction in global infrastructure spending during the Great Recession, Caterpillar remained profitable and kept shareholders a priority with the dividend.

Caterpillar - Global Infrastructure Growth Potential

Source: Investor conference presentation, page 5

This slide from a recent investor presentation shows how Caterpillar is leveraged to long-term growth potential globally, specifically related to infrastructure. The company competes in the major industries that will be able to take advantage of an ever-higher world population total, including increased urbanization and energy usage. This need for constant infrastructure investment is key to the bull thesis for Caterpillar and the outlook globally for the long-term is robust.

We see strong total return prospects for Caterpillar given that it is poised to continue to produce meaningful earnings growth, its yield is solid at 2.8%, and its valuation is quite low. After the Great Recession, Caterpillar shed a huge amount of overhead expenditures in order to downsize for its lower revenue amounts. That lean operating model continues through today, meaning that revenue increases that do accrue tend to produce operating leverage.

In addition, the valuation is down to just 9 times next year’s earnings estimates against our fair value estimate of 15.5. That implies a low double-digit annual tailwind from a rising valuation alone. We see these factors as combining to drive nearly 20% annual total returns in the coming years.

Construction Stock #3:  Deere & Company (DE)

Our third and final pick, Deere & Co. (DE), is a manufacturer of heavy equipment used in agriculture, forestry, turf care and construction. The company also fairly recently solidified its dominant position in road construction and maintenance with its acquisition of Wirtgen. Deere produces about $36 billion in annual revenue and has a market capitalization of $48 billion.

While Deere is similar to Caterpillar, the former held up much better during the Great Recession. Indeed, Deere saw a roughly one-quarter reduction in revenue in 2009, but very quickly rebounded in 2010. In addition, while earnings fell in 2009 on lower revenue, they also quickly moved higher the following year. And just like Caterpillar, Deere managed to raise its dividend every year before, during and after the Great Recession. Deere’s strength, even in times of great economic duress, is certainly a selling point for long-term investors.

This slide from a recent investor presentation shows why Deere continues to see strong demand over the long-term, something that should continue indefinitely.

Deere Macroeconomic Tailwinds

Source: Investor update, page 30

Deere shows that steady population growth, increasing urbanization and the constant need for more food all fit into its strategic plan. Deere is poised to deliver the equipment and services needed to support all three of these long-term global tailwinds with its diverse base of products.

In addition, Deere has more recently pushed into becoming an end-to-end solution for road construction as a way to capitalize on the global need for infrastructure investment.

Deere Road Construction Portfolio

Source: Investor update, page 24

This slide shows how Deere’s Wirtgen acquisition has made it a true end-to-end provider of road construction equipment. Given the weak state of US infrastructure and similar situations around the world, we think Deere is well-positioned for long-term demand for all of its business segments, but this one in particular.

We see Deere as accruing lower prospective total returns than Caterpillar simply because Deere shares haven’t fallen as far and thus, the valuation isn’t as favorable. Indeed, shares trade today for 13 times this year’s earnings estimates, which compares to our estimate of long-term fair value at 14 times earnings. However, we do see ~6% earnings growth combining with the 2% yield and a ~2% tailwind from a rising valuation to give investors a ~10% annual total return in the years to come.

Final Thoughts

While construction stocks can be cyclical and therefore, volatile, they also offer investors access to long-term macroeconomic demand factors. The three companies listed here are all diversified in their revenue streams, are strategically aligned to long-term economic forces, and maintain profitability and dividend payments even during the worst downturns. To boot, all three offer investors strong prospective total returns today.

We see Fluor, Caterpillar and Deere as strong picks for those investors looking to gain exposure to what should be a booming industry for decades to come (except during recessions, when investors must hold to take advantage of prosperous times). Indeed, these are three stocks one can buy and own forever.

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