Review of 2006

15 April 2008

For a third year running the construction sector out-performed many of the mainstream stock market indicators in 2006. The CET Index for the whole industry gained +21,78% over the course of the year, a feat that was only bettered by the resurgent German DAX Composite, which rose +22,66%.

Contractors' shares impressed once again in 2006, with the CEC Index for the sector rising + 33,76%. With annual gains of +43,07% in 2005 and +32,77% in 2004, the contracting industry continued to perform consistently well, a fact that was underlined by the CEC Index finishing 2006 at a record high of 236,32 points.

The CEM Index of materials producers' shares also finished 2006 at a record high of 158,25 points. With a total gain of +20,34% over the course of the year, it beat many of the world's leading stock market indicators.

The Equipment sector was more subdued in comparison, although the CEE Index's rise of +14,92% over the course of the year was still respectable. However, it is significant that while the CEC and CEM ended 2006 on all-time highs, the CEE's position of 196,54 points was some 15 points – about -7% – below the high of 211,44 points set in May last year.

But despite the relative under-achievement of equipment manufacturers' shares, the construction industry as a whole performed extremely well in 2006.

The CET Index for the whole industry finished the year at an all-time high of 188,71 points, with the final week of the year seeing it beat the previous record of 188,28 points, set in May.

Major Indicators

Unlike 2004 and 2005, the Dow achieved some good gains in 2006. Its growth for the year was +14,53%, compared to the stagnation of the previous two years, and on 29 December it set a record high of 12566 points.

European bourses also had a good year, with the FTSE 100, CAC 40 and DAX Composite all building on the solid gains of 2005. The DAX was the pick of the bunch with its +20,66% climb, driven by the country's recovering economy, while the CAC 40 and FTSE 100 also performed well with gains of +15,81% and +10,16% respectively.

Although these gains fall short of what was achieved by construction industry equities, they still represent good returns for investors. With interest rates around the world generally in the 4% to 5% range last year, the US and European stock markets clearly delivered better returns than investments such as savings accounts and Government bonds.

In contrast to Europe and the US, it was a pretty lacklustre year on the Japanese markets. Following a stellar gain of +42% for the Topix 500 in 2005, the various ups and downs this year meant it only gained +1,36% over 2006 as a whole.

But despite the strong gains over the course of the year in the US and Europe, 2006 was not without a few scares for investors. May saw a steep drop in the markets when worries over inflation and the risk of rising interest rates bubbled to the surface in the US.

Curiously the US markets were least affected by these concerns, and the European and Japanese markets, along with the construction sector reacted much more violently. As reported in our June edition, the mid-April to mid-May period saw just -2,16% knocked off the value of the Dow, while the losses for European and Japanese market indicators varied from -6% to -9,5%, and the construction sector lost some -7,8%.

But as it transpired, May's slip did not herald the start of a long decline for the markets. In hindsight it seems to have been a case of profit-taking by investors following the previous two to three years' share price gains. As our graphs show, by the end of the year the Dow, FTSE and CET had all recovered, surpassing the previous highs set in May. Only the Topix 500 did not achieve the same feat.

Construction Shares

As in 2005, the contracting sector was the star sector within the construction industry this year. The CEC Index gained +33,76% in 12 months, contributing about +40% to the overall growth of the industry-wide CET Index.

This compares to a contribution of about +35% to the CET's overall growth by materials producers' shares and +25% from equipment manufacturers. The disproportionately high contribution from contractors is even more impressive considering the sector has a lower capitalisation than the equipment and materials industries, due to its inherently less capital-intensive structure.

The CET Index for the whole industry finished the year at an all-time high of 188,71 points.

Within the contracting sector, the leading companies last year were Kier, OHL and Strabag, which all saw their market valuations increase by more than +70%. Three of the other four Spanish groups in the CEC – Acciona, ACS and FCC – all outperformed the Index as a whole, as did the two other German contractors – Bilfinger + Berger and Hochtief – along with Italy's Impregilo, France's Eiffage and Vinci, and Sweden-based Peab.

Peab was the only Nordic over-achiever in the CEC last year. NCC, Skanska, Veidekke and YIT all saw their shares rise, but their growth was less than that of the CEC as a whole. Similarly, Kier was the only UK contractor to beat the CEC - Amec, Balfour Beatty and Carillion all came in below the Index's growth for the year, as did Spain's Ferrovial and France's Bouygues.

But these performances are all relative. With two exceptions, all the companies that make up the CEC did as well as (if not significantly better than) the mainstream Indexes in 2006. For example, Amec's +23,32% growth may have been relatively poor among its peer group of contractors, but it was more than twice the size of the +10,16% growth for the UK's FTSE 100 Index.

The only real disappointments were the CEC's two Dutch contractors, Ballast Nedam and Bam, which gained just +1,74% and +0,54% respectively over the course of the year. Bam's poor share price performance is due to heavy losses in its German operations in 2006, while Ballast Nedam's flat share price reflects the fact that it's profit margin was not forecast to improve significantly last year.

Materials

Unlike the contracting sector with its wide spread of gains, the performance of individual materials producers' equities were generally closer to the overall CEM Index. Its gain of +20,34% over the course of the year took it to a record high of 158,25 points in the final week of 2006, underlining the generally strong performance of it's constituent stocks.

CRH, Hanson, Holcim and Saint-Gobain all finished the year with similar gains to the CEM. However, five other companies – Cimpor, Heidelberg Cement, Italcementi, Lafarge and Schindler – outperformed the Index by noticeable margins. Top of the league table was Lafarge, which saw its share price rise +48,08% over the course of the year.

While strong profits across the industry generally drove investors' appetites for construction materials stocks last year, there were two companies that did not find as much favour. Schneider Electric saw its stock rise a below-average +9,48% last year, due to market concerns over its acquisition of American Power Conversion, a manufacturer of uninterruptible power supplies.

Wolseley on the other hand did not see its share price recover from the market-wide slump in May. It is heavily exposed to the North American residential construction market, which ran into trouble last summer, and this seems to be one of the key factors that stopped Wolseley's share price bouncing back as well as other companies' following May's upset.

With two exceptions, all the companies that make up the CEC did as well as – if not significantly better than – the mainstream Indexes in 2006.

Equipment Spread

In stark contrast to the materials sector, equipment manufacturers' shares displayed a massive range of performances last year. At the top end of the scale was Manitowoc with a +122,17% share price rise, shortly followed by Terex with a +110,63% improvement.

At the other end of the scale, both Gehl and Ingersoll-Rand saw their stock fall slightly over the course of the year. Both these companies operate at the lighter end of the equipment market and, like Wolseley, the US residential construction market is a critical driver for their revenues and profits.

The mixed bag of results in the sector translated to a +14,92% rise for the CEE Index – better than some of the mainstream markets, but the weakest of the construction-related sectors and disappointing compared to 2005's +47,56% gain.

In general the Japanese manufacturers had a weak year on the markets, with three of the four companies in the CEE – Hitahci, Kubota and Kobe Steel – performing worse than the Index itself. Only Komatsu beat the average with a +18,97% rise.

Having said this, the biggest drag on the Index last year was Caterpillar, who's stock saw a net rise of rise just +3,48% in 2006. With a capitalisation of just over € 30 billion at year-end exchange rates, this company alone accounts for more than 20% of the CEE Index. Stripping-out the effects of Cat's below-par share price performance shows the rest of the CEE Index gained +22,10% in 2006 – much more respectable compared to the materials and contracting sub-sectors.

This explains why 13 out of the 19 companies that make up the CEE outperformed the Index in 2006. All the European manufacturers beat this benchmark, with Metso the pick of the bunch thanks to its +63,66% rise over the year.

It is also important to note that while Cat, Gehl and Ingersoll-Rand disappointed, CNH, Deere and JLG outperformed the CEE, in JLG's case this was largely thanks to being taken-over at the end of the year by specialist truck manufacturer Oshkosh.

The spread of results illustrates the mixed fortunes of the sector. The overall stagnation of Caterpillar's share price reflects its fairly flat outlook for revenue and profits growth. In contrast, Manitowoc and Terex are up-beat about future growth, thanks in part to their heavy involvement in the crane sector, which is still growing well.

Currencies

The major news this year on the currency markets was the depreciation of both the US Dollar and Japanese Yen against the Euro. As 2006 came to a close the Yen was trading at an all-time low against the Euro, around the € 1 = JPY 157, some -11,92% below its position at the start of the year. Similarly, the US Dollar lost -9,06% of its value against the Euro, and at € 1 = US$ 1,320 by the end of the year, was looking dangerously close to its all time low around € 1 = US$ 1,36, seen at the end of 2004.

The major news this year on the currency markets was the depreciation of both the US Dollar and Japanese Yen against the Euro.

Compared to these, the Euro was relatively stable against Europe's other currencies in 2006. Its biggest gain was against the Swiss Franc (+4,15%), while it lost -2,19% to the world's other main reserve currency, the British Pound. Its biggest loss however was -5,00% against the Czech Koruna.

There are risks of course, and top of the list is the concern that the US economy will slow down significantly next year.

Outlook

With economic growth in the Eurozone improving, inflation under control and oil prices retreating a little from the highs seen in 2005, conditions look good for the stock markets in 2007. There are risks of course, and top of the list is the concern that the US economy will slow down significantly next year.

These worries were reflected in some construction shares this year – most notably Gehl, Ingersoll-Rand, Wolseley and to a certain extent, Caterpillar. The US remains the undisputed economic motor of the world, and any weakness or slowdown in growth this year will doubtless have ramifications around the world.

The exchange rate situation will also be interesting this year. With economic growth apparently increasing in Europe and slowing in the US, it seems likely that European interest rates will generally rise in 2007, while the cost of borrowing in the US will fall. Rates may also rise in Japan, but probably not as fast as in Europe.

This would suggests that the Euro will strengthen further in 2007, which will put pressure on profits generated outside the region by Europe-based exporters.

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