Building Products: Sit It Out or Get In the Game?

Key Takeaways

  • Some investors may be missing out on opportunities in building products because they have fresh memories of the 2007-2009 Great Recession.
  • However, the segment’s fundamentals are strong: Housing starts trail the long-term average, the imbalance between supply and demand favors continued market stability, and repair and remodeling activity remains steady.
  • These positive indicators, combined with moderating valuations and less competition to contend with, make it a great time for investors to get in the game.
The Great Recession of 2007-2009 was a challenging time for building products investors. Many strategic buyers and private equity groups that invested in the industry at the height of the housing boom either held businesses for longer than anticipated without getting the expected returns or lost money.
 
Not surprisingly, the scars from that event are still fresh for some buyers. However, by being overly cautious, they may also be missing attractive opportunities, according to the Harris Williams Building Products & Materials Group.
 
“The fundamentals for building products are strong,” notes Tim Webb, a managing director at Harris Williams. “Housing starts are below their long-term average, demand for housing exceeds supply, and repair and remodeling activity remains stable.”
 
However, says Webb, not all investors fully appreciate the opportunity: “What we are experiencing with certain investors are the ‘animal spirits’ that sometimes affect investing, when emotions of confidence, fear, and pessimism can affect decision making.”
 
Investor caution is understandable, especially given the fact the recovery from the Great Recession is entering its 11th year—the longest period of economic expansion in U.S. history. Buyers saw what happened to some investments made in the building products industry at the wrong point in the last cycle and don’t want to make the same mistake.
 
However, as the team explains below, the data shows that if there is a shift in the business cycle, it is likely to be more modest than the last one from a building products perspective. In fact, there’s still plenty of potential upside for strategic buyers and private equity investors.
 
“If you think about the previous downturn and how badly people lost, it’s clearly having an impact on how some people are thinking about the sector,” observes Mike Hogan, a managing director in the Building Products & Materials Group. “It’s an example of what’s called ‘the recency bias’: people tend to overvalue recent information or experience. There could be a real opportunity for those investors who can get past this bias and see the current situation more objectively.”

Three Factors Contributing to Stability

The team points to three factors indicating current conditions are stable and strong, and that the
outlook for building products remains positive:
  1. Current housing starts trail the long-term average
  2. The imbalance between supply and demand favors continued market stability
  3. Repair and remodeling activity remains steady

​1. Current housing starts trail the long-term average

Housing starts have recovered steadily since their bottom in 2009, but as Figure 1 illustrates, they are still 9% below their long-term average.1 That means there is still room for growth and that any downturn should have a relatively modest impact on housing starts.
 
Figure 1: Current housing starts are below long-term averages
 

Source: U.S. Census Bureau

2. Imbalance between supply and demand favors continued growth and market stability

As Figure 2 illustrates, cumulative excess inventory of housing is at its lowest point in nearly 50 years—largely because housing starts have been below their long-term average over the past decade.“There’s a shortage of housing relative to demand, and that should keep home prices high in the medium term, assuming interest rates don’t increase significantly,” says Graham Rives, a director in the Building Products & Materials Group.

Figure 2: Current housing inventory below long-term average

 

Source: U.S. Census Bureau (1. 2019 Figure Represents Seasonally Adjusted October 2019 Data 2. Long-Term Straight Average from 1980-2000 3. Cumulative Housing Starts Minus Cumulative Long-Term Straight Average)

3. Repair and remodeling activity remains steady

Repair and remodeling (R&R) spend has recovered steadily since its bottom in 2010, and is now slightly above the long-term trend (Figure 3).The R&R market is expected to remain stable due to increasing home sales, aging housing stock, retrofits for older homeowners, and financially healthy consumers with growing disposable income.

Figure 3: Repair and remodeling spend growing steadily

 

Source: Home Improvement Research Institute (HIRI)

“With home prices appreciating as quickly as they have been in several large markets, many homeowners are thinking about staying in their current locations longer and remodeling instead of moving,” notes Hogan. “And owners of older houses see this as a good time to make their homes more relevant to modern living—adding bathrooms or bedrooms, expanding their kitchens, or creating more open space. All of this translates into steady demand for building products.”

Evidence for a Milder Cycle

Despite these solid fundamentals, some investors are shying away from the sector because of the length of the current recovery, believing that a downturn is coming. While the current recovery is long by historical standards, that doesn’t necessarily mean a recession is imminent. In fact, there are several reasons why the next downturn may be several years away, as well as more moderate.

“One reason is the sheer depth of the hole we had to climb out of a decade ago,” says Webb. As illustrated in Figure 4, the 2008 downturn was extraordinary from a housing starts perspective: The 73% peak-to-trough drop of housing starts was the most severe in the past 50 years by over 25%.4 As Webb explains, “With far more ground to recover, the market inherently should be expected to take longer to get back to ‘normal.’”

Figure 4: Historical housing starts

 

Source: U.S. Census Bureau

Closely related is the fact that housing starts have grown at a compound annual growth rate (CAGR) of 9% during the current expansion, lower than five out of the seven previous recoveries.

“In the majority of housing cycles of the past 50 years, this CAGR has exceeded double digits,” says Hogan. “It surpassed 20% in two of those cycles, both of which were severe housing cycles that saw starts drop by more than 45%.”

“And if you look at the underlying economic drivers of this recovery, annual GDP growth hasn’t broken 5% in this cycle, which it did in all prior economic recoveries,” says Webb. “So, while the current recovery is long, it has been muted in terms of growth and, therefore, the continued length of the expansion is not as surprising.”

Beyond growth rates, the total number of housing starts also suggests any near-term housing downturn would be relatively muted. Returning to Figure 4, over the past 50 years, there has not been a housing decline that began when starts were below the long-term average of 1.43 million. Today, starts stand at approximately 1.3 million—15% below the lowest peak before a downturn in the past 50 years, and 40% below the peak before the Great Recession.5

Current housing starts are only slightly above the trough average from prior downturns. This suggests that if there was a housing cycle in the near-term, it should be modest, in the mid-single-digit percentage point range. “With housing starts at the current level, a significant housing downturn in the near term would fly in the face of 50 years of history,” notes Hogan. 

There also are historical reasons to believe that if a downturn does eventually happen, it’s likely to be mild. In analyzing past housing downturns, the three least severe were 1999-2000 (4%), 1968-1970 (5%), and 1994-1995 (7%), each of which featured a macroeconomic backdrop similar to today—low unemployment and moderate inflation characteristics. Additionally, peak housing starts preceding each of these downturns were 10-20% higher than they are today.

“There’s a misconception that the length of a recovery is directly correlated to the severity of the next downturn,” Rives says. “But from a housing starts perspective, history suggests there is still room for growth, and if there is a decline, it will be notably less severe.”

Attractive Valuations, Moderate Competition

Despite this evidence, some investors remain skeptical—which creates opportunities for others.
 
“We are noticing a real sense of loss aversion with some investors who invested in building products ahead of the last cycle,” Webb notes. “The pain of losing is psychologically more powerful than the pleasure of gaining. This notion that losses loom larger than gains is impacting these investors and putting a governor on valuations.”
 
As a result, valuations have normalized: Multiples of public comparables are down by around two turns of EBITDA from their peak in the middle of 2015 (Figure 5). Strong fundamentals combined with depressed valuations are creating attractive investment opportunities for investors who can overcome the emotions, recency bias, and loss aversion. Plus, many sub-segments remain highly fragmented, presenting significant consolidation opportunities. And, with many investors moving to the sidelines, scarred by the Great Recession, there’s relatively less competition for deals.
 
Figure 5: Public building products companies’ valuations over time
 
Source: S&P Capital IQ
 
“A lot of buyers either were burned from the prior downturn or know someone who was, and that’s created a psychological mindset that’s not necessarily founded in the fundamentals of the market today,” says Webb. “There are real opportunities given the near-term positive outlooks for housing and longer-term trends. Overall, with moderating valuations and less competition to contend with, it’s a great time to get in the game.”

Published January 2020

Sources

1. U.S. Census Bureau

2. ibid

3. Home Improvement Research Institute

4. U.S. Census Bureau

5. ibid

6. ibid