Warning: Hope, Hype, and the Herd
That’s what value investor Seth Klarman told a group of investors last February. Klarman, portfolio manager and co-founder of the Baupost Group where he has averaged just under a 20% annual return for 25 years. So when Klarman talks, I pay attention.
But hey, this bit of wisdom was from a speech back in February. That’s ancient history for Wall Street and the masters of the universe apparently already forgot Klarman’s sage advice.
Think about it for a second – “most investors project near-term trends…indefinitely into the future.”
“Most investors” are average, at best. They buy high and sell low, jump on short-term trends, and move with the herd because it’s “safe”. Right now, most investors are moving headlong into infrastructure. But, as you’ll soon see, this is a very dangerous move to make right now and it’d probably be far wiser to wait out the rally and ride this wave back down. Let me explain.
The prevailing wisdom right now is Obama is going to spend like mad on infrastructure to create jobs and return America’s ailing roads, bridges, and water systems to greatness.
U.S. News & World Report states, “Basically, Wall Street is betting on an infrastructure and stimulus plan to fulfill some of the more optimistic hopes for a recovery in corporate profits and consumer spending.”
Early estimates put total new government infrastructure spending between $60 and $70 billion over the next two years. Don’t get me wrong, that’s a lot of money (nothing like the other bailouts, but it’s still a lot) headed directly to construction companies. And, already, Wall Street has started anticipating a big government-funded payday for a lot of these construction companies.
For instance, Fluor (NYSE:FLR) is one of the largest publicly-traded construction companies in the world. A large segment of its business builds roads, bridges, airports, etc. Since the November sell-off, the bulls are running and its shares have soared 65%.
But Fluor’s big. It has a $9.3 billion market cap and has booked more than $20 billion in revenues in the past year. Frankly, a few hundred million dollar contracts aren’t going to make much of a difference in Fluor’s annual performance.
That’s why, when it comes to the herd’s prevailing wisdom on infrastructure investing, their investment dollars are saying, “The smaller the better.”
Just take a look at Sterling Construction (NASDAQ:STRL). Sterling is a transportation infrastructure company which builds highways, roads, bridges, and light rail systems. The company is right in the sweet spot for the types of projects the stimulus package is aimed at.
And with a $250 million market cap, one or two big contracts could make a big difference in Sterling’s bottom line…or so the herd thinking goes. Sterling’s shares have climbed 90% in the past six weeks.
Perini (PCR), which builds bridges, highways, roads, and wastewater treatment facilities, is attracting a lot of attention too. Perini’s shares have doubled since bottoming out shortly after election results came out.
Clearly, there are some great expectations for infrastructure companies. As Prosperity Dispatch readers, we’ve learned great expectations usually lead to great disappointments. This run in infrastructure companies will only last if there is a sustained economic recovery. But with unemployment headed to double digits, real estate prices still declining, and more debt issues to get worked out, is highly unlikely.
The Fundamental Situation
I have absolutely no confidence this run in infrastructure stocks can last. In fact, I expect it to end abruptly in the coming weeks and months once reality sets in.
You see, the herd is once again acting irrational. The government funded build-out of U.S. infrastructure is a short-term trend which will not last indefinitely for many reasons.
First of all, states, which normally fund the majority of infrastructure projects, are in terrible financial shape. Sen. Olympia Snowe, "With 41 states experiencing budget shortfalls and unable to make the kind of commitment they traditionally make to infrastructure projects, the federal government must take steps to restore America's world-class infrastructure."
Will a practically bankrupt U.S. government be able to build its way out of this hole?
Secondly, the profit margins for these projects are going to be poor at best. It all comes down to supply and demand. And even a two year $60 billion boost in demand isn’t enough to tip the scales in the favor of builders. As a result, bidding wars will practically eliminate any profits to be had from these projects. It’s already started to happen.
California contractors are battling it out for work. California Builder and Engineer magazine states, “[There is] a rush by contractors to the public works bids. Caltrans (California’s transportation department), now gets up to 20-plus bidders on projects, where a year ago, the state would be hard pressed to find enough qualified bidders at all.”
It’s happening in New Jersey too. NJ Biz reports, “Competition among [construction] companies has reached a fever pitch, with some firms submitting bids that only cover project costs, Price said. A $10 million highway project might receive up to 20 bids, whereas in better times, such a job would get about eight proposals.”
Only cover project costs!?! That means firms are desperate and are willing to sacrifice any profit just to stay in business. That only happens when supply is far outstripping demand.
Now, a surge in demand could overwhelm the supply of contractors ready and able to take on the additional workload. Yes, it’s a long shot, but it could. Even if it does though, it won’t last long. Eldon Morrison, president of CPM Constructors in Freeport, Maine, says, “We could double the size of our company. We could expand very quickly and put a lot of people to work.”
Finally (and what should be most important to investors) is the majority of the construction industry is private. According to FMI, a construction industry consulting firm, only 9.6% of American construction firms are publicly traded. The rest are private companies which don’t trade on any stock exchanges.
When you break the numbers down, you can really see how little benefit the publicly traded construction companies will get from the stimulus package. If 90% of $60 billion in infrastructure spending goes to private companies, only $6 billion worth of contracts will be available to the publicly traded ones. That’s not going to amount to much when there are 20 bidders for every project and the heavy construction industry’s net profit of about 4.5% gets squeezed even more.
In Good Company
I’m not alone here. The leading short seller (a way to profits when stocks go down) in the world isn’t much of a believer in the hype as well. Jim Chanos manages the $7 billion short-only Ursus Fund made a name for himself identifying “irregularities” at Enron long before anyone else is right there with us.
He says about the high expectations for a government-funded construction boom, “It will not be profitable to the extent that people think. People are forgetting that there are always promises of infrastructure plans.”
As always though, the big money and the herd are going to do what it is going to do. Right now, it’s buying infrastructure stocks like Fluor and Sterling. And I’ve learned the hard way that in the fast-money hedge fund era, betting against the trend can be disastrous. But once this unsustainable uptrend reverses, get in on the ride down because it’s going to be a profitable one.
Chief Investment Strategist, Q1 Publishing
(January 6, 2008)