PKB - PKB: Building And Construction Stocks Facing New Risks In 2024

2024-01-12 05:41:17 ET

Summary

• Building and construction stocks performed well in 2023 as the U.S. economy averted a recession.
• The market expectation that interest rates may decline is expected to support stronger growth and earnings going forward.
• Following the big rally, we expect to see renewed volatility in PKB as operating conditions in the industry have yet to match the bullish sentiment.

The Invesco Building & Construction ETF ( PKB ) was a surprising winner in 2023 with shares up more than 50% and currently trading near an all-time high. Despite high interest rates and a challenging environment for real estate, the leading U.S. construction and engineering companies ultimately benefited from resilient economic conditions.

Acknowledging what has evolved into an improving outlook for this segment, we highlight several risks to consider in assessing whether the ETF performance momentum can continue through 2024. In our view, the rally in recent months has likely already priced in many of the positive macro developments for the underlying PKB stocks. We expect to see some renewed volatility going forward.

What is the PKB ETF?

PKB is intended to passively track the "Dynamic Building Construction IntellidexSM Index". The benchmark includes 30 U.S. building and construction companies involved in a variety of activities from residential, commercial, industrial, or infrastructure construction along with related engineering services.

Beyond the industry focus, the unique methodology features a series of screening criteria across factors like price momentum, earnings momentum, quality, management action, and value. The strategy features a modified equal weighting where the fundamental ranking is utilized as an input to overweight the top-scoring stocks in the model. There is also a quarterly rebalancing.

Notably, this is in contrast to comparable ETFs like the SPDR Homebuilders ETF ( XHB ) which simply includes all the stocks in the industry, or the iShares U.S. Home Construction ETF ( ITB ) with a more specific approach just with homebuilders.

The idea with PKB is to capture fundamental factors in the security selection process to ultimately identify the best constituents with the greatest potential for capital appreciation.

There are not too many surprises in terms of the current portfolio. The leading construction companies are included among the top holdings. Lennox International Inc. ( LII ), a leader in heating, ventilation, and air conditioning systems has a 5.7% weighting. Homebuilders like NVR ( NVR ), Lennar Corp. ( LEN ), PulteGroup, Inc. ( PHM ), and D.R. Horton, Inc. ( DHI ) are well represented, each with around a 5% weighting.

Down the list, we find a more diverse group of related stocks including cement giants Vulcan Materials Co. ( VMC ) and Martin Marietta Materials ( MLM ). Home Depot, Inc. ( HD ) is also within the top 10 holdings.

So while each of these companies has a distinct business model, with varying exposure to different construction segments or even at the regional level, the understanding is that they all face similar market trends. Overall, the operating environment and financial performance of PKB stocks are influenced by themes in the real estate sector, industrial activity, consumer spending, interest rates, and broader financial market sentiment.

What's Next For PKB?

We mentioned the strong performance of building and construction stocks over the past year. The story was the otherwise stronger-than-expected momentum of the U.S. economy including the housing market.

The underlying companies within the PKB portfolio benefited as declining inflationary pressures translated to lower input costs and higher operating margins as an earnings driver as demand remained stable.

Fast forward, the theme in recent months has been an expectation that not only a recession has been averted but also that the Fed will have room to cut interest rates through this year.

This is important as the outlook for lower interest rates supports not only lower funding costs for building and construction firms but should also drive a new cycle of credit growth as a boost to the demand side of the business.

Naturally, this backdrop is positive for the sentiment towards the sector although the data we're looking at remains mixed. Favorably, the latest update for residential building permits and housing starts for November showed a solid uptick in activity on an annual basis, although still well below pandemic-era highs.

On the other hand, the " AIA/Deltek Architecture Billings Index ", recognized as a benchmark for commercial development, has been in a contraction with new billings and contracts for new projects sluggish. That apparent weakness is also evident in broader indicators of industrial activity like the Institute for Supply Management PMI .

So when looking at the underlying stocks of the PKB portfolio and high-level trends for building and construction, the sense we have is that the recent trading action, particularly in recent months, has been based more on positive expectations than an actual improvement to current operations.

That divergence could become a problem if some of the macro assumptions for improving conditions going for fail to materialize.

PKB Price Forecast

We rate PKB as a hold, implying a "neutral" view of the price over the next year. Considering the recent strength, our baseline is that this ETF consolidates its recent gains with relatively limited upside from the current level.

Risks are titled to the downside considering a scenario where economic conditions disappoint or the timetable for an expected decline in interest rates gets pushed back further out towards the second half of 2024. The potential that inflation re-accelerates or the U.S. economy underperforms would likely pressure building and construction companies.

On the upside, the upcoming Q4 earnings season will be a good chance to hear updated guidance from management teams that can set the tone for the year ahead. From the price chart, we believe shares would offer a more compelling buying opportunity on a potential correction below $55.00 with an improved reward-to-risk setup.

To conclude, we believe PKB is a high-quality fund that performs as expected for targeted exposure to this key industry group. Keep in mind that PKB yields a modest 0.4% through a regular quarterly dividend.

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