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Investing in tech or retail businesses might be easier 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 as it is pretty hard to know which construction companies are good if you are not an insider, especially in an industry that requires huge overhead costs. This post will give you all the insider knowledge to understand the construction industry and will answer the ultimate question of why you should invest in construction companies.
Construction is a highly competitive industry where companies take on huge debts and risks for projects that can go on for many years before a tangible profit is realised. Companies usually work with thin profit margins and huge overhead costs, which make them vulnerable to bankruptcy. However, building an economic moat is not hard as the industry rarely changes, making it difficult to innovate in technology and engineering, which makes it an excellent investment for long-term investors.
In general, construction companies’ success lies in their ability to:
- Deliver projects on time and within budget
- Secure future projects to stay operational
- Market and sell their finished product effectively to bring profit
- Provide excellent quality control with minimal maintenance
As an outsider, you want to understand how this industry works, which companies can make money with minimal risk of going bankrupt and which have a high return and low risk; all of this is explained in detail in the following sections.
Understanding The Construction Industry? Investor Guide
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 associated risks. If a company is taking a huge amount of that risk, it might hinder its growth in case of setbacks. Below explain how the industry works by answering some questions that investors should know.
How do construction companies make money?
It might sound straightforward: the company charges for its services or tolls, but there is more to it.
The construction industry adapts a very competitive bidding system where the winning bidder for a project can provide a comprehensive package of expertise, innovative design and engineering, and a competitive price.
This makes the industry subject to extreme price cutting, where the winning bidder is usually the one who offers the lowest price. This consequently brings the industry down, where most companies operate on a thin profit margin.
In addition, all construction projects require huge operating cost, which usually exceeds forecast due to the ongoing problems throughout the project life. Understanding this issue is fundamental to understanding the construction industry.
The above is an oversimplified explanation of how this industry works; we explained this in detail in How Construction Companies Make Money?
How do construction companies go bankrupt?
Because of the competitive nature of this industry and the high cost associated, bankruptcy is a high probability. Tech companies are very hard to go bankrupt because they do not have high debt, but this is not the same. Construction companies take debt to fund their projects, with many sitting on millions of long-term debt. This can make the future clouded for many companies.
In general, there are 5 ways construction companies go bankrupt:
- Low-profit margin
- High operating cost
- Unfavourable economic recessions
- Project issues and delays
- Failure to capture market share
We have gone through those reasons in detail here: Top 5 Reasons Why Construction Companies Fail & Go Bankrupt.
What is the ideal construction company you should invest in?
There are two types of construction companies risk taker and deflector.
The value investor should try to avoid the risk-takers companies and invest in risk deflectors construction companies 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. However, that does not mean investors should only look for risk deflector companies, as risk takers usually have high growth potential.
Too much to unpack? Below is a breakdown of the types of construction companies:
What are the construction risk-takers companies?
Those are the companies that execute the project, which naturally takes on considerable risks in terms of quality of work, workers’ safety and debt. For example, residential building companies take all the risk of procurement of materials and labour, 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 with the highest growth potential; however, the risk of investing in this business is that it might take on high 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 risk deflector usually owns the end product, which can bring an ongoing profit, such as tolls from highways and rental income from residential and commercial property. Profit can also come in by selling the assets such as selling residential 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.
Risk deflectors might remove themselves from the construction phase, but it does not mean it is safe from any risks. Such companies are the end product or asset owners, 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 or selling a percentage of the asset by going on partnerships with other companies. In addition, there is also the risk of not securing future profitable projects as competition is always high, which means working with a thin profit margin.
Usually, a risk deflector company is an asset management company that proposes a program and manages other companies to finish the job and own and manage the final asset.
Project management companies sit the highest in the construction industry hierarchy, followed by developers, then specialist companies that own technology or have the unique capability to do some type of work and finally, the typical construction companies that use conventional construction methods and own a fleet of workers that can mobilise very quickly.
Comparison between risk-takers and risk deflector construction companies
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 easy, as many companies can be risk deflectors in one project and risk-takers in another.
The best type of company to invest in is 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.
For those who want a broader comparison of the risk deflector versus risk-taker companies, the following table provides a detailed description of the nature of those companies. This is not a comprehensive comparison as the list is quite intensive, but it should give you an idea of the type of companies out there.
| Risk Deflector | Risk Taker |
|---|---|
| 1- Concession developers: Companies that develop and operate toll roads. Those companies make fast highways that link cities and charge a toll when people use those roads. Those companies usually enjoy sustainable income from toll fees. | 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 and manage other companies. |
| 2- Property Development company: Companies that plan and develop residential houses, apartments and shopping centres. The property can either be rented or sold directly 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, and their impact during construction is very minimal. | 3- Structural design 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 profit and stay relevant in the industry by saving the client a lot of money and 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 developing residential properties from government land provide jobs and build new homes. The government highly favours them, enabling them to secure huge contracts. Those companies they usually quite big and have size and authority moat. | 4- Remedial companies: Structures have a life span that must be constantly maintained. 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 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. However, it can be very profitable for companies who have established an authority and specialist moat. | 5- Manufacturers of equipment: While it might look like the equipment manufacturer do not have much involvement on-site, some heavy machinery, if not serviced, can cause incidents. In addition, the operation cost can be very high. Yet, some companies can be very profitable if they establish influence and size moat. |
| 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 of worker injuries and fatalities, 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, mostly by taking big risks.
The investor should study the business in detail and compare it to other companies for a more reasonable approach.
The 4 types of economic moats in the construction industry
If you want to invest in any construction company, you must be able to identify its economic moat. In general, any construction company must have at least one of the following; not having any of those moats mean that the business is a commodity business and quite risky to hold:
1- Authority moat
These are the companies that have achieved authority within the construction space, and it is well known to the public and within the industry. The result is a high networking effect where investors realise both its capability and authority in the space.
Such companies usually have a portfolio of completed projects in a specific sector within the industry, making it well-known beyond comparison. For example, Aecom has dominated infrastructure consultancy for decades as the leading company in structural design.
2- Specialist moat
These companies have niched down to a specific area in construction with a very specific business model, which has made it very difficult for competitors to even compete in this space. Such companies are very hard to find, as maintaining a specialist advantage is very difficult because most of the engineering can be replicated by other companies.
The best specialist companies have gone beyond engineering design advantage to a more capitalistic form. This is very common in toll road and residential developers by securing the project, subcontracting the work to other companies, and owning the final product. Transurban is a leading example of a toll road developer that has niched itself down to only this area in the construction industry.
3- Monopoly moat
These companies have taken control of a specific product or service and monopolised this opportunity due to a lack of competitors because of geographical advantage, price advantage or both.
This is very common in steel and construction material manufacturers; although it might seem to be a commodity business but if the company manage to cut down its manufacturing cost to slice its price and thus beat its competitors or increase its supply chains to have more presence in areas of high demand. Anhui Conch Cement is an excellent example of leading cement manufacturing.
4- Size moat
These are the companies that have grown so big that they have influence in every sector within the construction industry. Those companies maintain their size by acquiring other businesses that have a competitive advantage in a specific sector within the industry or by establishing divisions within their company to specialise in those sectors.
Such companies have complete influence in all sectors of this industry: design, consulting, manufacturing, R&D and construction, making them the jack of all trades and also making them recession-proof. Companies such as Vinci have dominated almost all the construction sectors by acquiring businesses in all construction fields, which helped this business’s substantial expansion and influence.
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 attractive businesses to many investors due to their complexity, which is why many companies in this industry pay high dividends to their shareholders. This also imposes the risk of taking debt to pay its shareholders dividends If the company is cash-poor to keep investors happy.
An investor should be careful when analysing construction companies as the debt some companies take are not good debt.
What is the construction industry’s future in the next 10 to 15 years?
Construction has not changed that much since the last century. Although materials have improved considerably, we integrated computers which enabled us to innovate significantly in the building information modelling (BIM) space that were just impossible to do by humans. Structures have gone considerably 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, but steel fluctuates throughout the year depending on market demand. Therefore, we can safely predict that this industry will not fundamentally change in the next 10 – 15 years. This might be very good insight because if the investor was able to find a company with a strong competitive advantage, they could rest assured that the company will be in business for at least the next 5 years.
The investor 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. These changes are easy to adapt.
4 Reasons You Should NOT Invest In 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- Weak Competitive advantage
The market is very saturated due to the high demand, and because the industry does not change much, it has made it relatively easy to duplicate expertise in this industry. This makes it difficult for companies to 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 thoroughly investigate the necessity of the debt taken by those companies and their ability to pay their long-term debt within the next 5 years.
3- Difficulty in finding competent management
It is tough to find competent management in this industry, and this is usually because most management pays high dividends to make the business attractive to investors. However, when those businesses are cash-poor, the management takes on more debt to pay its investors dividends instead of reducing dividend pay. This phenomenon is very common in this industry.
While there is nothing wrong with paying dividends, most construction management is very concerned with keeping investors happy over the short term by paying dividends instead of improving the business fundamentals and finding ways to reduce debt.
4- Projects are unpredictable
There is a reason why investing in this industry is high risk and why most companies go under and out of business: it is so unpredictable. There are many ongoing problems companies will have to solve when working on a project. Most projects drag on due to multiple issues affecting each project’s cash flow.
We have extensively discussed this issue here 10 Reasons Why Construction Take So Long To Complete? For those who want more understanding of this industry.
4 Reasons You Should Invest In Construction Companies
Despite the above, there are very good reasons for investors to be in the construction industry.
1- High-growth potential
Despite the thin profit margin on each project, most companies compensate for this issue by taking o a high volume of projects. This, in turn, brings high growth potential. The highest return on investment usually happens during economic growth and low-interest rates, where narrowing money for those companies is very cheap, which enables them to work on multiple projects to increase their income.
2- Slow change industry
Construction will not change much and will stay the same for a very long time. This means if a company manages to establish an economic moat, it will likely keep it long-term. Let’s compare this industry to the microchip industry. We can see that technological advancement can result in a loss in an economic moat if you make microchips and you have to keep investing in R&D to stay relevant.
However, this is not the same in the construction industry. Expertises are a commodity in this industry. Only by establishing an economic moat, you stay competitive in this industry.
3- Easy to understand businesses
While the industry might sound complicated, understanding businesses is not that difficult. This is because this industry does not use complicated jargon and profound specs naming as we see in the tech industry. Outsiders can easily understand construction businesses even if they have never invested in this space.
4- Demand is mostly stable
Even if the economy is in recession, there is still a fair demand for this industry; work does not stop, and this is mainly because the main clients for big construction industries are governments which make for bulletproof income during recessions.
The Ultimate Question Should You Invest In Construction Companies?
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 a recession, it can impose a risk to many businesses.
However, despite the above, construction is an ultra-slow change industry which makes for an excellent investment. 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.
If the investor wishes to invest in any construction company, it should be done under the Value Investing Strategy – Warren Buffett Style.
If you are new to this industry, you can read the Top 9 Best Construction & Engineering Stock To Buy to get some ideas of the big players in this space.
