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Are building stocks like James Hardie, Brickworks and Boral about to take off?

According to a report in The Australian Financial Review, the Construction and Property Services Industry Skills Council will shortly release modelling that predicts demand for new homes to rebound to 164,000 homes per year for about the next 11 years, thanks to the combination of low interest rates and population growth. The council predicts that at this volume there will be a shortage of skills to build all the homes.

Given that the building cycle is still bouncing along at its lows, it is hard to imagine a shortage of workers. It is this same thinking — that the recent past will continue into the future — which can lead to investors imagining building material companies will never be as profitable or valuable again. This view can create appealing valuations for Foolish investors. It would be unusual for the stock prices of building material suppliers to have all the future potential already priced in at this point in the cycle.

As the chart below shows, James Hardie’s (ASX: JHX) exposure to the USA housing market looks to have helped its share price to significantly outperform the broader S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) over the past couple of years. Brickworks (ASX: BKW) has also performed very well thanks to management’s focus on costs and its other diversified investments, while Boral (ASX: BLD) has significantly underperformed the index.

tmchart1

Source: Google Finance

Foolish takeaway

A tailwind of increasing home builds is without a doubt beneficial to building material suppliers. Home building is a very cyclical business, pronounced with building booms which lead to oversupply followed by busts when builds drop to very low levels.

The business models of material suppliers involve significant fixed-cost investment. Consider for example a brick maker. The brick maker must build a kiln, employ a workforce, set up supplier arrangements for inputs to the brick making process and distribution channels for selling the bricks. This is all very expensive; however the marginal cost of producing an extra brick is very low once the brick maker covers the fixed costs. This creates significant ‘fixed-cost leverage’ within the business.

Buying cyclical building stocks at the bottom of the cycle and benefiting from a cyclical upswing coupled with capturing the benefits of improving leverage off the fixed cost base can make for a very profitable investment. Perversely, it is often when the price-to-earnings ratio is high and the dividend yield low that it’s time to consider purchasing these particular stocks.

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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