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Construction and Engineering: Investment Essentials

The construction and engineering industry offers one of the most compelling long-term growth stories in investing. The investment thesis is simple: As long as the global population grows, so will the need for infrastructure. With that said, it's a broad sector, and growth rates are likely to vary across elements of it. In addition, it's a highly cyclical industry that requires specialized knowledge within its individual segments. It's time to take a closer look at how you might invest in construction and engineering.

Source: The Motley Fool

What is the construction and engineering industry?

In a nutshell, it's the architecture of life. Wherever communities are growing, they will need public infrastructure, churches, military infrastructure, water and wastewater treatment works, ports, energy infrastructure, roads, bridges, dams, airports, bus stations, residential and non-residential buildings...

While the immediate investor focus will fall on the traditional engineering companies undertaking construction activity, like Chicago Bridge & Iron (NYSE: CBI  ) and Foster Wheeler (NASDAQ: FWLT  ) , increasingly it includes technology companies that are servicing the sector. For example, Autodesk's (NASDAQ: ADSK  ) AutoCAD is used in engineering design. The product lifecycle management software of PTC  (NASDAQ: PTC  ) and the U.K.'s Aveva  (LSE: AVV  )  allows engineering firms to manage and model a project's lifecycle from design to completion. What's the benefit? When operators take over a completed power plant, for example, they can learn about it in great detail by looking at the 3-D model of the plant beforehand. This helps reduce any potential downtime in starting operations.

How big is the construction and engineering industry?

According to a PricewaterhouseCoopers' "Global Construction 2025" report, "[T]he volume of construction output will grow by more than 70% to $15 trillion worldwide by 2025." China, India, and the U.S. together are expected to contribute 60% of all global growth, but Western Europe's construction market is expected to decline by 5%.

This suggests that exposure to emerging markets, which is expected to make up 63% of construction activity by 2025, according to PwC, and the types of infrastructure those markets will need to build, is of critical importance to your stock selection.

Source: The Motley Fool

How does the construction and engineering industry work?

A typical construction and engineering project will involve four main parties. An engineering consultant or technical services company like Jacobs Engineering (NYSE: JEC  ) or AECOM Technology (NYSE: ACM  )  will design the project for a client. Once that's done, the client will put work out for tender, and then hire an engineering contractor like Fluor Corp. (NYSE: FLR  ) to undertake construction. A project manager will also be hired to oversee the contractor's work, and liaise with the consultant on the client's behalf.

One feature of the industry is the tendency for cost overruns to occur. For example, China's Three Gorges Dam was estimated to cost $8.4 billion at the time of approval, but the eventual figure was closer to $37 billion. Cost overruns can cause complications for engineering companies, and arbitration and legal actions are not uncommon in the industry. Furthermore, foul play is also part of the industry, with two-thirds of engineering and construction CEOs surveyed by PwC expressing a concern that bribery and corruption could slow growth.

What are the drivers of the construction and engineering industry?

As discussed above, the key driver is likely to be emerging market growth, and a combination of an increasing population and urbanization. In particular, public spending on infrastructure within emerging markets is likely to guide growth. Emerging market growth has its own demand drivers, with an area like water resources -- where a consultancy like Tetra Tech (NASDAQ: TTEK  ) is well placed -- is likely to see good growth in future years.

Within developed markets, you should also consider that the defense industry is traditionally an important factor in the construction and engineering industry. In addition, new residential construction tends to lead to new construction investment as infrastructure is built up around the new community.

All told, the sector looks set for long-term growth -- but don't expect a smooth ride. It's still a cyclical industry with its own risks. For example, in an upturn, consultants tend to hire lots of new, highly specialized staff in order to service the work. Unfortunately, when a downturn hits, their margins take a hit, as some of their employees are unproductive due to lack of work. Similarly, when contracting work dries up, contractors may have to decrease the prices they charge in order to secure work, and their margins take a hit accordingly. It's a cyclical industry, but the long-term trend looks positive for investors.

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Lee Samaha

Investing commentary to help retail investors outperform professionals. I research and write post-earnings analysis of leading companies. Follow me on Twitter or Google+ to receive quick and thorough earnings analysis of your favorite stocks.

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