New Moneyweb contributor Simon Brown shares his thoughts with brave souls looking to invest.

Simon Brown&nbsp|&nbsp@Moneyweb &nbsp|&nbsp4 July 2014&nbsp00:20

There is never a dull moment in the JSE construction sector.

This week, Wilson Bayly Holmes Ovcon hit a new 52-week low; we learnt that Protech Khuthele is totally bust and cant be saved; and Aveng issued a trading update that at best says earnings will be flat if we exclude write downs that (while of a non-cash nature) are worth some 100c per share.

Aveng also mentions a need for raising extra capital that currently does not include a rights issue, but in truth certainly could. The industry remains tough, very tough for both the listed companies and investors who keep on waiting for the infrastructure spending to hit home and get the share price booming again. Trips to Australia and into the rest of Africa are yielding some fruit but not nearly enough to offset the dismal South African operations.

The bigger issue is the extremely cyclical nature of the industry. It has severe boom-and-bust, and the bust can be followed by years of going nowhere while investors hold on, hoping for better days. Then the boom eventually comes and we all forget to sell, deciding that this time the industry wont bust. But it will, so always remember to sell your construction shares when the boom firmly sets in.

Investors: what to look for

For those brave souls looking to invest hard-earned money into the construction sector, what should we be looking for? Firstly forget about government promises of billions of rands in infrastructure spending. It may or may not be happening but it simple is not flowing fast enough to get the industry going again.

Order books look decent, but I have long been sceptical of them. They are essentially promises of work, but at what cost or, put the other way around, at what profit? One of the CEOs mentioned to me that loss-making contracts are always a factor in the industry, its just that in the good times nobody notices them. These days every results presentation has mention of the end of some or other loss-making contract, but the next loss-making contract is always just around the corner.

So what should you be looking for as an investor? A strong balance sheet; good cash and reduced debt. Construction is about managing cash flow so current assets and current liabilities are critical, otherwise you find yourself in a squeeze.

You also want a company with limited exposure to the mining sector as this space is going to be tough for a long time. Ideally you probably want a specialised niche construction company. When times are tough everybody does everything but when the wheel finally turns the experts will again dominate their niches.

Another point to watch out for is when companies start entering new markets. It suggests that they are desperate more than anything else, and in time were likely to see the write-downs after they either overpaid or couldnt make the new market work properly. I like companies that stick to their knitting, even during the tough times.

The following three stocks meet my criteria:

Raubex (PE 12.3x, 7 year average PE 12.8x)**

It does roads. It knows roads. Sure it is a tough space right now as everybody wants to build and maintain roads but Raubex is the expert and roads is one place we are seeing spending happen. Current assets are around twice the current liabilities, while cash flow is decent and it had R871 million on hand at the February year-end. In other words a solid balance sheet that is not going to need any propping up

Calgro M3 * (PE 9.9x, 7 year average PE n/a, not enough data)

Housing is a massive issue in South Africa and Calgro builds houses across the different LSMs, focusing on whichever sector has strongest demand at that time. Its current asset to liabilities ratio is the right way around (assets greater than liabilities) albeit not by a lot and cash has been under pressure, as it spends on building initial infrastructure that is not yet income-generating for it. But it will start building, and selling, the houses and thatll boost revenue markedly. Whats especially attractive is that it only builds houses when the buyer has a confirmed loan (or government grant) in other words it starts only when it has a buyer and this markedly reduces risk.

Afrimat (PE 14x, 7 year average PE 9.4x)

This is the real winner in the space perhaps because it doesnt actually do any construction. Rather it supplies into the space. It also has a decent-looking balance sheet with decent-looking cash flow. The Infrasor stake is working very well and it has two key advantages. In the aggregate business, location is everything. Aggregates are heavy so the less distance they have to be moved for road construction the better Afrimats quarries are very well positioned. Its second advantage is its new mobile offering that helps when distance is an issue.

What youll notice with all three is that they have their niche and stick to it. No venturing off in the desperate search for revenue. This lack of spending on random new ventures makes for stronger balance sheets so they can weather the storm that is currently some six years old and shows no sign of abating.

* I hold shares in Calgro M3

** I look at an average seven-year PE as that is through the cycle and gives an indication where the price is relative to the trend. Ideally one wants to buy at around the seven-year average but there is more to it than just that. Fast growing earnings will see the PE moving lower quickly and in the case of RBX the forward PE is around 11x.