Sam Stovall's Sector Watch

Building Products' Stock in Trade

With home remodeling and the economy still humming, S&P sees healthy profits for makers of faucets, cabinets, and other accessories

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From Standard & Poor's Equity Research

Just because the S&P Homebuilding Index may have finally run its course, does that mean that the Building Products group has also seen better days? Not according to its year-to-date performance -- up 14.3% through May 5, vs. a 7.0% advance for the S&P Composite 1500 Index -- nor its rolling 12-month relative performance, in our opinion.

Unlike the Homebuilding Index, which consists of companies engaged in residential construction that are found in the Consumer Discretionary sector, Building Products companies are found in the red-hot Industrials sector and serve both the residential and commercial marketplaces. Mike Jaffe, S&P's Industrials & Materials Sector group head, as well as our Building Products analyst, believes the fundamentals remain sound for this group.

Jaffe's investment outlook for the Building Products subindustry is positive. Building product demand is centered on home sales and renovation. Low mortgage rates have been driving housing demand for the past few years. After reaching an over 45-year low of 5.3% in June, 2003, rates rose to 6.6% as of late April, 2006, which we still view as accommodating. S&P projected that 30-year mortgage rates would continue to move higher but stay at full-year averages of 7.2% or below through 2007. We forecast a 7.7% average in 2008.

CONFIDENCE DROP.  As such, uncertainty had crept into the housing market, and upcoming sales levels seemed likely to fall below the records of the past couple of years. Yet, based on S&P's mortgage-rate forecast, it wouldn't be surprising to us if home sales were able to stay relatively solid. Remodelings also have been driven by funds from high refinancing levels.

While a rise in rates would likely reduce refinancings, home values have risen sharply over the past few years, so home-equity loans have become a major source of funds. We also think a still growing economy will lead commercial parties to start long-delayed projects.

The fall of 2005 marked the first point in several years, in Jaffe's view, when building-products demand gave indications of softening. He attributes this to a big drop in consumer confidence readings, which he thinks was related to worries about the impact of Hurricane Katrina on energy prices. It also caused a temporary big drop in U.S. employment growth.

AGED STOCK.  As a result, he believes that certain consumers started to hold off on home-improvement work in light of the very high winter heating bills that seemed likely. However, with employment numbers at more solid levels in November through March, 2006, the consumer-confidence reading also strengthened. Based on these trends, he thinks building products demand will remain fairly solid in 2006.

Jaffe also thinks segment performances will be driven by industry-specific factors. For instance, while somewhat higher interest rates might cause some to reconsider renovation plans, he still sees the need to repair an aging housing stock keeping remodelings at a good pace. This should aid demand for products such as bathroom and kitchen cabinets, shingles, and roofing products.

Also, based on S&P's forecast of ongoing economic strength over the next few years, he thinks companies that make climate-control systems used in commercial applications will see the modest recovery of the past couple of years reach a more vital pace.

TOP PICKS.  So there you have it. From both a fundamental and momentum standpoint, S&P believes the investment outlook for the S&P Building Products sub-industry index continues to look favorable. S&P's top picks in the group include American Standard (ASD), a worldwide maker of commercial and residential air-conditioning systems, and bathroom and kitchen fixtures; and Masco (MAS), which produces faucets, cabinets, coatings, and other consumer brand-name home=improvement and building products. Both stocks are ranked 4 STARS, or buy.

Industry Momentum List Update
For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of May 5, 2006.

Subindustry
Agricultural Products
Coal & Consumable Fuels
Construction & Engineering
Construction & Farm Machinery & Heavy Trucks
Diversified Metals & Mining
Human Resource & Employment Services
Multi-Sector Holdings
Oil & Gas Drilling
Oil & Gas Equipment & Services
Oil & Gas Refining & Marketing
Railroads
Steel
Trading Companies & Distributors

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