It's also the most in-demand commodity around the world. Once cleaned, water is necessary to sustain life, grow crops, and recently, bring oil and natural gas to the ground via fracking. In the developed markets, especially the United States, water company stocks are expected to grow at a slightly faster rate than general GDP growth, thanks to further investment in infrastructure projects and growing demand.
Elsewhere around the world, specifically emerging markets like China and India, water demand should grow exponentially with a rise in a new middle class. So where's the opportunity for investors? Let's dive in!
Emerging Opportunity in Water
There are a few radical shifts that could make water stocks an excellent investment:
- New “Water Rights” – Mineral and oil rights have been around for centuries, but water rights are quickly emerging as it becomes a scarce commodity. Shortages require the reasonable distribution of resources. Historical precedent already exists. The Colorado Compact, for example, requires reasonable and fair use of the Colorado River by the seven states it flows through. In the future, one can expect that the ownership of water rights will create a meaningful change insofar as what companies are legally enabled to profit from its use. This is similar to regional monopolies in utility companies.
- Changing Regulatory Codes – Water has to meet new safety and cleanliness thresholds each day. New pollutants, which are referred to as PPCPs by the industry (pharmaceuticals and personal care products), pose very serious environmental and water quality risks. New technologies in filtration create more opportunities for water stock investors.
- Changing Pricing – Water is the most available resource on the planet in the oceans. However, inland rivers, lakes and reservoirs are much more scarce. Seeing as the amount of water consumption in the United States has tripled in just three decades, the economics of water are rapidly changing. Water has been priced terribly inefficiently so if to assume that it was a forever available resource. As fresh water (water which is most economically turned into clean drinking water) is tapped out, economics will dictate higher pricing for fresh and desalinated water.
Investors can tap different kinds of water exposure through some publicly-traded companies.
Top Water Company Stocks
The largest water company stocks are Aqua America (WTR) and American States Water (AWR.) Both of these companies fit within the realm of the water utility space.
Aqua America derives more than 60% of its revenues from residential water sales to the public via municipalities. It's track record is cemented in its ability to acquire water facilities and then seek approval for significant increases in water rates. I would most compare it to a business like private prisons and utilities, in that it is very capital intensive like a utility, but it also relies on the inability of local governments to fund their own investment into infrastructure (such as what you see in private prisons.)
Unlike a gas or electric utility, Aqua America has much better pricing power. Certainly, it does have to get local regulatory approval for price hikes, however, a 10% increase in water rates is much more digestible (and therefore much less protested) than a similar increase in electricity and gas rates.
American States Water (AWR) is another water utility. It differs in that it generates a minute amount of net income from electricity, roughly one-fourth of income from government contracts on military bases (for water projects) and the remainder from the water utility business. The company also uses significantly less leverage than Aqua America given that it isn't an extremely aggressive acquirer.
Water…a Good Play, but Capital Intensive
Investors should remember that not all growth is free. Water utility companies are extraordinary asset heavy plays as they have to acquire, build, and maintain water lines and treatment to boost operating earnings. While the demand for water is growing, revenues and profits from water demand does not come without serious investment on the behalf of a water utility.
In short, for water profits to grow at a given rate, water utility investments in capital projects must grow by an equal percentage. That means more debt or shareholder dilution to encourage growth.
Water stocks are a safe bet much like utilities, and for that reason, they're no get rich quick play, especially at their current valuations. American States Water (AWR) trades at 16 times forward earnings estimates, and generates very low returns on invested capital (5.15% in the trailing 12 month period, which was higher than in any period in the last 10 years.)
Likewise, Aqua America (WTR) saw its return on invested capital peak at 4.74% in the most recent trailing twelve month period, and trades at 18.3 times forward earnings estimates.
Ultimately, the strongest limit on growth is a company's ability to generate returns on its internal investments. Single digit ROIC figures in water stocks should be unattractive for any investor focused on total returns. However, for the defensive income investor looking for a little dividend yield at the cost of total return, they're a safe bet…safe in the sense that water utilities won't be going out of business any time soon, though capital losses should be expected should rates rise.
Water may have been an interesting play before the beginning of the year and subsequent first quarter rally, but it seems investors have priced in virtually all the upside, leaving new investors with very little reason to hop on.
What are your thoughts on investing in water company stocks? Do you believe in the long-play on scarce resources?