Many investors like to imagine they are contrarians, but going against the crowd isn't easy. As economist John Maynard Keynes once observed, "Markets can stay irrational longer than you can stay solvent."
It's tough to buy into what looks like the teeth of a bear market for construction as rising interest rates put a significant damper on demand. Mortgage rates are currently around 5.5% and pressure from the Federal Reserve could cause them to rise to over 6% in 2023 and possibly above 7%.
Image source: Getty Images.
Yet when things look bleak and valuations are cheap is just when you should be looking to buy -- particularly if construction stocks offer a buffer to the overall decline, downside protection that the market may be ignoring.
So despite outward signs the construction market could be hit hard, there are underlying factors that suggest there may yet be a strong tailwind pushing them forward. And these two industry stalwarts could be stocks to buy and hold on to for the long haul.
Builders FirstSource
Builders FirstSource (BLDR -1.53%) is the largest U.S. supplier of building products, prefabricated components, and value-added services to the professional residential homebuilders as well as those involved in remodeling and repair.
Although Builders FirstSource is a major supplier of lumber and oriented-strand board (OSB) to the industry, the higher-margin value-added components of its business are the reason it can continue growing and generate profits. It also happens to be a key consideration of its merger and acquisition strategy.
Over the past 25 years, Builders FirstSource has been an aggressive acquirer, buying over 50 companies in that span. Last September it bought Trussway, a leading provider of prefabricated roof and floor trusses particularly for the multifamily market. Before that, it bought National Lumber, a maker of prefabricated millwork components, and arguably one of the most transformational acquisitions was its merger with building materials supplier BMC, which expanded Builders FirstSource's geographic footprint, giving it a presence in 42 states.
Providing builders with a one-stop shop for materials, along with value-added components contractors would need to source from multiple suppliers, gives Builders FirstSource a competitive edge. Value-added products account for 48% of revenue today.
The supplier's stock is also cheap. It trades at just 4 times earnings, a fraction of both its projected earnings growth rate and sales, and just 3 times the free cash flow (FCF) it produces. It's not often Builders FirstSource trades at a premium, but even this valuation is low by historical standards.
The National Association of Realtors said in its most recent update that there are just 1.14 million unsold existing homes, or just 3.3 months' worth of inventory, about half the number there should be for the housing market to be in equilibrium. While high interest rates and inflation could dampen some demand, the housing inventory shortage suggests the market may not fall as far as some believe and the long-term growth trend remains robust.
Image source: Louisiana-Pacific.
Louisiana-Pacific
Many of those same arguments apply to Louisiana-Pacific (LPX -0.33%), a leading manufacturer of building products, including engineered wood products, siding, and other products used in residential and commercial construction. They likely also convinced Warren Buffett's Berkshire Hathaway to buy almost 6 million shares at a price of $51.19 per share, for a total of about $296 million.
Like Builders FirstSource, the lumber company has staked out a bigger position in the remodel and repair market while also pushing more profitable value-added products. For example, it is taking boring OSB plywood and moving it in new directions to make it a more valuable offering for builders. Louisiana-Pacific's OSB segment now derives the majority of its revenue from the innovations it added to its specialized structural solutions portfolio.
Moreover, Louisiana-Pacific's siding business generated more revenue than OSB in the third quarter and it's less affected by any decline in new housing starts. Only 40% of siding volume comes from new homes; the lion's share is renovation and repair. So while single-family starts fell 5% on a trailing-12-month basis in the quarter, siding volume grew 6%.
Buffett was also likely attracted to the lumber company's solid balance sheet as it has just $346 million in long-term debt with $469 million in cash and equivalents. Its low valuation is also notable, trading at 4 times earnings, a fraction of its earnings growth rate, and 5 times its FCF.
It's true Louisiana-Pacific could stall if things really crash, but it has the financial wherewithal to fund future investments in its business while waiting for the industry clouds to pass.
