Investing: The Best Water Plays

By David Bogoslaw, BusinessWeek
July 26, 2009

Put on your snorkel and get ready for an expected flood of investing in water-related stocks as the push for government spending on water infrastructure and services to meet higher environmental standards accelerates. That bodes well for a number of water-related stocks and mutual funds.

On July 15, Representative Earl Blumenauer (D-Ore.) introduced a bipartisan bill that would create a water trust fund for investing in America's broken drinking-water and sewage-treatment systems. The Water Protection & Reinvestment Act (H.R. 3202) would create a $10 billion annual fund to repair decaying pipes and sewer systems that threaten public health, the environment, and overall security.

And a bipartisan Senate bill (S. 1005) that would reauthorize the Clean Water State Revolving Fund and Drinking Water State Revolving Fund and provide $38.5 billion for Environmental Protection Agency water-infrastructure programs over the next five years reportedly has the support of both parties and is expected to be acted on by the Senate in the near future. These revolving funds haven't been reauthorized in 22 and 12 years, respectively. A House version called the Water Quality Investment Act of 2009 (H.R. 1262), which would reauthorize the Clean Water State Revolving Fund at $13.8 billion over five years, was passed in March.

Of course, there's quite a bit of fiscal stimulus already flowing toward companies that can help rebuild the country's faltering water infrastructure. William Brennan, co-manager of the $17 million Kinetics Water Infrastructure Advantaged Fund (KWIAX), estimates that $13.9 billion of the Obama Administration's stimulus package has been put toward overhauling water infrastructure and other water-related activities but says "that's just a Band-Aid on an open-heart-surgery patient." The U.S. is roughly $600 billion behind in revamping water pipes and sanitation systems, Brennan says, and he expects the government to push for rebuilding with greater voracity.

Expecting a Surge of Investment

U.S.-based water funds are currently much smaller than their counterparts in Europe. U.S. investors have been slow to appreciate the importance of water as "the backbone of every activity," from manufacturing to energy to daily living. And so far, Americans haven't experienced water shortages to the same degree as people in other parts of the world, Brennan says. He expects a surge in water investment to begin over the next one to three years: "Water-stress areas in California, Texas, and Florida are real and are only getting worse."

Other states have water woes, too. In a dispute over water in the Apalachicola-Chattahoochee-Flint basin, which includes Lake Lanier, that dates back to the 1970s, Florida and Alabama are seeking a permanent injunction to prohibit withdrawals in Georgia in excess of 2000 levels, according to the metropolitan Atlanta Chamber of Commerce. A U.S. District Court ruling on July 17 declared almost all of the water Georgia has withdrawn from Lake Lanier illegal, since the lake was built to provide hydroelectric power. That means Atlanta may soon need to find alternate sources of water. The judge said the Army Corps of Engineers needed to get approval from Congress before the Atlanta metropolitan area could use Lake Lanier as its primary water source.

Among Brennan's top holdings are Veolia Environnement (VE) and URS (URS), which provides engineering, construction, and technical services to the power, infrastructure, federal, and industrial and commercial market.

Calvert Global Water Fund (CFWAX) holds 30% of its assets in water utilities, 40% in infrastructure companies, and 30% in water technologies. Jens Peer, a portfolio manager for the $1.4 billion fund, says 65% to 70% of the 100 to 105 water stocks he's identified worldwide are pure plays, which he defines as deriving more than 50% of their revenue from water-related activities. The pure plays tend to be small- and mid-cap stocks, while the larger-cap names usually include other components besides water.

"We only invest in non-pure plays if they have at least 10% of their revenue coming from water activities, and they have to be a top-three player in their markets," Peer says. While General Electric (GE) owns a top desalinization business, its overall water exposure is too small for him to invest in the company.

Timing is Key

Of the $480 billion in fiscal stimulus that is expected to be spent by governments around the world over the next two years on green components, Peer estimates that roughly 20%, or $96 billion, will go to water-linked projects. Half of that will be spent in China, and the majority of the remainder will be spent in the U.S., he says.

Although the enormous spending on water infrastructure Peer foresees should trigger greater investment in water companies, he says the timing of the fiscal spending is important. For example, Tetra Tech (TTEK), a consulting and engineering company, will be one of the initial beneficiaries, while companies that make larger pipes will benefit closer to the end of the projects.

Peer thinks American Water Works (AWK), which provides water and wastewater services to residential, commercial, and industrial customers in North America, looks cheap and is benefiting from the regulatory climate that supports higher rates.

Slightly more risky but worthy of attention is Calgon Carbon (CCC), which specializes in filtration equipment but also does mercury removal, which Peer says will be a big topic in 2010 and 2011. He also likes Insituform Technologies (INSU), which repairs sewers and water pipes with minimal digging up of streets and disruption of traffic. He expects to see repairs accelerate in some states because of underinvestment in recent years.

Manufacturing and Pharmaceutical Discharge

Brennan estimates that 70% of the 2 million miles of underground water pipes in the U.S. are beyond their useful life and need to be replaced. Water quality has declined over the past 50 years, with manufacturing discharge going into rivers and surface water, and bigger concentrations of prescription pharmaceuticals being discharged in wastewater. That will drive the need for wastewater treatment and other water-purification services. Brennan expects the EPA to target those areas for improvement in the next couple of years.

Bozena Jankowska, who co-manages the $53 million Allianz RCM Global Water Fund (AWTAX), focuses primarily on water utilities in view of the relative shortage of other pure-play water stocks. That's mostly a result of industry consolidation in recent years, in which smaller technology manufacturers have been swallowed up by conglomerates such as GE, Siemens (SI), and ITT (ITT).

"So if you want to invest in technology, you're getting other types of products," she says. "If you buy ITT, you're getting part defense, part water pumps. At Danaher (DHR), industrial technology [generates just] 25.7% of total revenue and includes water technology, while the remainder is medical technology."

Utilities are a good way to capitalize on the global growth prospects of water because of the need to replace aging infrastructure and build new systems in emerging markets, as well as the need to comply with tighter environmental standards, says Jankowska. Growing awareness in the U.S. of the need to invest in infrastructure is prompting regulators to approve higher rates for public water utilities, which will enable them to replace equipment and should improve returns over time, she says.

Water utilities are expected to spend up to $1 trillion over the next 20 years to improve their systems, according to Neil Berlant, lead manager of the PFW Water Fund (PFWAX). He says he avoids utilities entirely on a belief that none of the money these companies spend to improve their systems in order to meet tougher local and state regulations will result in higher revenues.

But Isn't Access to Clean Water a Human Right?

True, utilities will have to charge higher prices to pay for their capital spending, but that in turn will drive consumers—both households and manufacturers—to look for ways to cut down on their usage, which will only exacerbate the problem for utilities, he says.

While water utilities have "enormous opportunities," when it comes to "parlay[ing] an explosion of interest in water, I don't see them as primary candidates for [investment]," says Berlant. "Their prospects, by and large, are nowhere near those of companies they have to purchase from, like pump makers and filter makers."

Another challenge utilities face comes from the growing trend by states such as Connecticut and other countries to declare access to affordable, clean water and sanitation a human right. What the pricing implications are for utilities whose business it is to supply water is one issue the Interfaith Center on Corporate Responsibility is flagging in a new report that scores public and private utilities on 21 key disclosure issues.

Berlant prefers technology companies such as Energy Recovery (ERII), whose products can remove salt from water in a much less energy-intensive way. That should attract money from socially responsible investment managers. But at nearly 36 times projected 2009 earnings and more than 24 times estimated 2010 earnings, it's too expensive for some fund managers, including Jankowska.

Indeed, one good bet for the future is that water—and the shares of the companies that supply it and make it fit for human consumption—will become more costly as the world's thirst for the life-giving liquid intensifies.