Should You Invest In Construction Companies? Insights From A Civil Engineer.

It might be easier to invest in tech or retail businesses since the industry is quite relevant to most people. However, the construction industry, in general, is quite complicated and less popular, making it difficult to invest in, especially in an industry that requires huge overheads costs. I spend years working as an engineer, project manager and investing in the stock market with a long term approach. This post will share my experience as an engineer and investor in the construction industry.

Construction is a highly competitive industry where companies take on huge debts and risks for projects that can go for many years before a tangible profit is brought back to the investors. In the construction industry, people’s lives are at stake, which makes many companies liable for any incidents and lawsuits regarding injuries, loss of lives and quality of work, making them difficult for investors to analyse.

In general, construction companies’ success lies in their ability to

  1. Deliver projects on time and within budget
  2. Secure future projects to stay operational
  3. Market and sell their finished product effectively to bring profit
  4. Provide excellent quality control with minimal maintenance

To make good investment decisions, the investor should learn about the challenges in this industry. While construction might seem profitable, there are a lot of risks associated. If a company is taking a huge amount of that risk, it might hinder its growth in case of setbacks. Understanding how this industry works can help make good investment decisions. All of this is explained in detail in the following sections.

What is the ideal construction company you should invest in?

The value investor should not invest in the risk-takers companies but rather invest in risk deflectors while carefully analysing the company’s current and future debt and making conservative assumptions to ensure that the company will still be in business in the next 5-10 years. Construction companies’ strength lies in their ability to handle project risks.

What are the construction risk-takers companies?

Those are the specialist companies that execute the project, which naturally takes on huge risk in terms of quality of work, loss of lives and huge debts. For example, residential building companies take all the risk of procurement of materials and labours, building the house and providing a warranty for the structure. If any issues arise in the future within the building, it is the builder’s fault.

Usually, risk-takers can bring huge profits; however, the risk of investing in this business is that it might take on huge initial debt to pay its workers and acquire materials, where the profit will not be immediate. Sometimes it depends on the quality of the final product.

What are the construction risk deflectors companies?

Those are the companies that do not have a direct influence on the project. Those companies can plan, propose a project and secure funding for the project but hire other companies to execute the project for them. The end product is usually owned by the risk deflector, which can bring an ongoing profit such as toll bridges, rented property, or sold to consumers such as selling houses or apartments.

The major difference between risk deflectors and risk-takers companies lies in their involvement in the construction phase. If the company can remove itself from the execution phase by hiring other competent companies to do the hard and risky work, it has successfully deflected the risk and can just benefit from the end product.

However, risk deflectors might remove themselves from the construction phase, but it does not mean it is safe from any risks. Such companies are the owners of the end product, which usually take on the burden of future maintenance issues by engaging the same risk-taker companies or new companies. At the same time, most of these companies fund their projects by taking on debts. In addition, the risk of not securing future profitable projects.

Usually, a risk deflector is a management company that proposes a program and manages other companies to finish the job. Project management sits the highest in the construction hierarchy, followed by developers, then specialist companies who own technology or have the unique capability to do some type of work and finally, the typical construction companies who use conventional construction methods and own a fleet of workers that can mobilise very quickly.

Comparison between risk-takers and risk deflector business in the construction industry

Usually, the risk deflector company can be the client (the owner of the project) or the superintendent (A company that is acting on behalf of the client), while the risk-takers are either the main contractor (Tier 1) or the subcontractor (Tier 2, Tier 3 .. ).

You might think by now that you should only invest in risk deflector companies. However, not many wonderful businesses can succeed at deflecting all the risks to others. And certainly, distinguishing deflectors from takers is not that easy as many companies can be risk deflectors in one project and risk-takers in another.

As mentioned earlier, the construction industry is quite complicated and competitive, which means many of those companies, especially the public ones, can be quite dynamic. They have many resources under management that enable them to be the main contractors at one job and subcontractors at another.

The best type of company to invest in is the one that can deflect risks to others that do not fall into its speciality while reasonably taking on risks that are confident in finishing the job to the highest quality and bringing exponential profit. And vice versa, avoid companies with no specific speciality that jump to any work opportunity without analysing the risks.

A value investor must look into the company’s history to understand its specialty and how much it has deviated from it over the years. What was the outcome of moving away from the core speciality? You can find such information in old annual reports and by reading about the company’s projects in the last 5-10 years.

However, for those who want a more broad comparison of the risks deflector versus risk-taker companies, the following table provides a detailed description of the nature of those companies. This is by no means a comprehensive comparison as the list is quite intensive, but it should give you an idea of the type of companies out there.

Risk DeflectorRisk Taker
1- Concession developer: Companies that develop and operate toll roads. Those companies make fast highways that link different parts of the city and charge a toll when people use those roads. 1- Construction contractor: These companies take most of the risk during construction. The profit might be high. However, the risk is always high. Those companies might have to hire other companies and manage everyone to ensure no issues during the construction phase.
2- Property Development company: Companies that plan and develop residential houses, apartments and shopping centres. The property can either be rented or sold to consumers. 2- Subcontractor: The companies hired by the main constructor also take a substantial risk, especially if it does something highly technical.
3- Planner: Companies that specialise in forecasting, implementing studies, researching the feasibility of a project or proposing a design. They are engaged in the early stages of any project. Planners take minimal risks as they are not involved in the execution phase. 3- Structural companies: While design companies do not do the work, their design is what makes everything possible. Those companies will have to come up with safe and innovative designs while also making sure they gain profit and stay relevant in the industry by saving the client a lot of money by being cost-effective.
4- Has government relations: Such companies have strong ties with the government due to their ability to keep the economy moving through work opportunities. For example, companies that develop residential properties from government land to provide jobs and also build new homes. The government highly favours them, enabling them to secure huge contracts. 4- Remedial companies: Structures have a life span that they must constantly maintain. Remedial companies work on existing structures to improve and elongate their remaining useful lives. Those companies carry many risks as they are heavily involved in the remediation process where the company needs to provide a warranty and guarantee to the client.
5- Manufacturer of materials: These are the manufacturers of the construction materials such as steel and concrete. Those companies are the providers, not the builders, who carry minimal risk. However, construction materials have grown to be more of a commodity as the materials have not changed much in the last 100 years, and the competition is very high. 5- Manufacturers of equipment: While it might look like the equipment manufacturer do not have much involvement on-site, some heavy machinery, if fundamentally flawed or not serviced, can cause incidents.
Such machines can cause issues if not maintained by a technician.
6- Labs/R&D: This is where new and exciting experiments take place. Labs are usually in charge of testing materials to ensure that it has not been compromised during construction. In contrast, R&D tests new materials, which can significantly impact the industry’s future. 6- Labour and Equipment hire: Any construction project needs labour and equipment to do the work. Many companies train labour and rent equipment to big construction companies to do their work. These companies have a high risk as injuries and faults can happen on-site, so they must ensure that labour is well trained and equipment is serviced frequently.

A company is more attractive to investors if it deflects as many risks as possible. However, it is not all black and white, as there is a lot of a grey area. Most of the big players in this industry have grown substantially by offering a range of services. The investor should study the business in detail and compare it to other companies for a more reasonable approach.

What about debt?

The primary issue with construction companies is that they tend to take on huge debts, which is usually not attractive to investors. Debt can be a way to leverage resources and increase the company’s ability to take on more projects simultaneously. It is also risky if the company takes on huge capital to finance current projects that will run for a few years before a tangible profit is earned.

Construction companies are not an attractive business to many investors due to the complexity, which is why many companies in this industry pay high dividends to their shareholders. If the company is cash poor, it might take debt to pay its investors dividends.

Debt can be good sometimes and sometimes bad; you can learn more about the types of debts companies take and when you should sell a stock if it has too much debt.

How much will the construction industry change in the next 10-15 years?

Construction has not changed that much since the last century. Although materials have improved considerably and we integrated computers which enabled us to do innovative designs that were just impossible to do by humans. Structures have gone significantly taller, with longer bridges and massive dams. Yet fundamentally, concrete and steel is still the main component in construction.

Concrete is very cheap to manufacture, and steel provides that high strength that gives the structure adequate stability. Therefore, due to the complexity of this industry, we can safely predict that this industry will not change much fundamentally in the next 10 – 15 years.

What does this mean for investors? We can rest assured that there will not be any significant changes that might put companies out of business, such as what is happening to the Auto industry, where companies are moving away from combustion engines to electric cars.

However, there are still changes at the micro-level, such as improving the way we produce concrete or increasing its strength, or finding a better way of taking advantage of using steel. All those changes should be well adopted by any public company to stay relevant.

Value investing viewpoint concerning construction companies

Because this is an ultra-slow changing industry, fundamental changes make no threat to any businesses. However, as someone who worked and invested in this industry, I have identified the following concerns:

1- Competitive advantage:

The market is very saturated due to the demand for construction development. Hiring experts is not that challenging, considering how slow this industry has changed over the decades. This makes it difficult for companies to have or build a competitive advantage that distinguishes them from other companies in this industry. This makes the future of any company full of uncertainties and subject to market demand and its ability to secure new projects.

2- Huge overhead costs:

As mentioned earlier, construction companies tend to take on huge debts to finance their projects, which is why you must undertake a thorough investigation to understand the necessity of the debt taken.

3- Competent Management:

It is tough to find competent management in this industry; due to the nature of this industry. It makes it hard to bring profit in some years or keep a consistent level of dividends and number of active projects without taking any risks.

The above issues should not discourage investors from looking into this industry; they are fundamental issues you must consider. Understanding those issues can help the investor make better decisions. You can learn more by reading How you can become a better value investing.

The Bottom Line

As an investor, you want to ensure that you get a return on your investment. Going out of business is a real threat due to the high competition and the lack of competitive advantage between those companies. The market demand is the only fuel for thriving in this industry. If demand is over or the economy slows down due to recession, it can significantly impact those businesses.

Moreover, the complexity and the risk in this business hinder any significant development in this industry. Many companies are forced to take risks to stay relevant by taking debt or doing complex projects beyond their ability.

On the other hand, construction is an ultra-slow change industry. It can be attractive to investors if they can find a company that has built a brand with sustainable income and trades significantly below its intrinsic value.

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