If you have ever gone by a construction site and looked in awe at the heavy machinery on display, then you will already be familiar with some of the biggest names in the construction machinery sector. Companies like Caterpillar (NYSE:CAT), Deere (NYSE:DE), and Manitowoc (NYSE:MTW) are all household names, and if something big is being built, somewhere, then you can bet they will have a hand in it. The construction machinery sector can be difficult to invest in, mainly because its fortunes can fluctuate wildly with the economy. But it can also be highly rewarding if you get the timing right. Here is what you need to know before investing in the industry.

What is the construction machinery industry?

Caterpillar. Source: The Motley Fool

Simply put, the construction machinery industry covers companies that produce machinery for use in civil engineering projects. The most visible components of the sector tend to be excavators, cranes, and earth movers on building sites. But engineering projects also encompass activities as diverse as mining, dam construction, water and waste-water systems, bridges, ports, and tunnels.

In other words, you shouldn't just think of the sector as an investment play on commercial building activity because a large number of the engineering activities listed above will be public infrastructural projects -- a point I will return to later.

How big is the construction machinery industry?

According to International Construction magazine's Yellow Table, revenue for the top 50 construction machinery firms came in at $163 billion in 2013. Here is a breakdown of construction equipment revenues from the 10 leading players.

Company 2013 Construction Equipment Revenue ($B) Share of Total
Caterpillar 31.0 19.0%
Komatsu 17.6 10.8%
Volvo Construction Equipment 8.1 5.0%
Hitachi Construction Machinery 7.9 4.9%
Liebherr 7.5 4.6%
Terex 7.1 4.3%
Zoomlion 6.1 3.7%
Sany 6.1  3.7%
Deere 5.9 3.6%
Doosan Group 5.3 3.2%

Source: International Construction magazine's Yellow Table

To put this list into context the current market capitalization of the two U.S. companies in the list is $63 billion for Caterpillar, and $31 billion for Deere -- although not all of their activities encompass construction machinery.

How does the construction machinery industry work?

Manufacturers tend to use distributors to get their products to end customers. This can cause some variability in sales for manufacturers like Caterpillar, as sometimes distributors will buy too much machinery, which they will then need to sell off in subsequent quarters. Conversely, distributors may buy too little machinery in previous quarters, which then needs to be corrected by placing large equipment orders.

In other words, revenue and orders at companies like Joy Global (NYSE:JOY)(largely mining equipment), Komatsu (NASDAQOTH:KMTUF), Caterpillar, and Deere can vary a lot from quarter to quarter depending on their distributors buying patterns, and ultimately, end-market demand. This adds to the unpredictability in the industry.

What are the drivers of the construction machinery industry?

The industry tends to be, what the investment industry calls "cyclical." In other words, its fortunes are largely dependent on the economy. When the going is good, investment in construction activity takes place. When economic growth starts to falter, construction plans get shelved and orders for machinery dry up.

Construction machinery. Source: The Motley Fool 

But in previous recessions governments across the globe have stepped up and invested in large-scale public projects (roads, public infrastructure, ports, etc.) as a way of supporting economic growth when the private sector is weakening. This type of public investment has, traditionally, helped reduce the cyclicality of the industry. For example, China's response to the last recession was to launch a $586 billion stimulus plan to be spent largely on national infrastructure and social welfare projects -- something that undoubtedly helped to reduce the pain for the construction machinery industry in the recession.

Fast-forward to today and the increasing debt burdens being built up by governments -- including China -- suggest that they will be hard-pressed to repeat this kind of investment if a recession occurs in the near future. In other words, the construction machinery sector appears to be getting even more dependent on private sector growth, and therefore becoming even more cyclical. It's also getting more reliant on China as -- according to the Statista website, China will continue to contribute more than 30% of global construction machinery demand in 2015 -- compared to 27% from North America.

All told, it's a great industry to be invested in when the economy is starting to make an upturn. On the other hand, it appears to be becoming more cyclical, so potential investors should be aware of the extra risk involved if the global economy turns down sharply. In addition, keep a close eye on construction activity in China.