The best ways to invest in water

“If you think the upcoming energy shortage is going to be bad,” says hedge fund manager John Thomas on Resourceinvestor.com, “it will pale in comparison to the next water crisis.” It will result in “water becoming more valuable than oil”. It’s little wonder, then, that there’s an army of firms focused on finding a solution. And that means there is now a range of opportunities for investors. Investment in fresh water infrastructure, in particular, says Thomas, “is going to be a recurring long-term investment theme”. The key issue for investors is how best to play it.

In the West we usually enjoy a plentiful supply of clean water. Here in Britain, demand for water may be high, but despite periods of sparse rainfall, mainly in the south, we still have enough water to be able to turn on the tap and watch it pour out. More broadly, with 70% of the earth’s surface covered in water and nature continuing to replenish supplies, water appears to circulate around the system in a never-ending cycle.

Yet the overall water figure is deceptive. Of the planet’s water, 97.5% is salty. And of the remaining 2.5% that’s fresh, more than two-thirds is locked away in glaciers and the polar ice caps. Much of the remainder is underground in aquifer wells. So only a tiny portion (around 0.25%) of the overall water on earth is easily accessible in rivers and lakes.

Moreover, much of this fresh water is not actually usable by consumers. In places such as China, which has a quarter of the world’s population, up to 90% of the fresh water has been contaminated by industry. Some is so badly affected that it can no longer be purified. Even in America, more than 40% of rivers and lakes are considered to be dangerously affected by pollution. Meanwhile, demand for fresh water is already outstripping supply. With the world population more than doubling over the last 60 years, some 18% of people now lack access to drinkable water. Almost twice that number have inadequate sanitation. This has already led to major international tensions.

As Thomas points out, one reason for “the endless wars in the Middle East since 1918 has been [disputes] over water rights”. But any water shortages the world has seen so far are set to pale into insignificance compared to what’s in store. That’s because the key dynamics of water demand and supply are altering fast.

The major change here is urbanisation. These days more and more people worldwide are becoming city dwellers and require extra water as a result. Since the mid-20th century the populations of most developed economies, such as North America and Europe, have been concentrated in cities. In these countries the so-called non-agricultural parts of the economy (the municipal and industrial sectors) have for years been the largest consumers of water. But now the urbanisation baton is being picked up by the emerging economies. Indeed, in developing economies, ‘mega cities’ are growing exponentially – faster than at any time in history.

Let’s take London as an example: it was the world’s most populous city throughout the 19th century. By 1900 it had seven million inhabitants. Today, it has nine million. Yet compare this with modern-day Shanghai’s 15 million, Delhi’s current 16 million and Mexico City, at more than 20 million. These cities are far from unique. In 2003 there were three billion city dwellers worldwide. By 2008, for the first time ever, the rural population was topped by the number of city dwellers. These have since already swelled to 3.5 billion. At this rate, by 2018 there are likely to be four billion people living in cities globally.

This trend is set to continue, says the Global Equity Strategy team at Citigroup Global Markets, with 70% of the earth’s population forecast to live in urban areas by 2050. That will drive extra demand for further infrastructure, including additional amounts of water. This is because it will raise each person’s ‘basic water requirement’ (the daily amount of drinking water required by the average adult, which works out at between three and nine litres).

 

Urbanisation is now a one-way street, which affects our demand for water in all sorts of ways. For starters, as people become city dwellers they tend to eat more meat. Although meat consumption per head in developing countries is less than half the levels of developed countries, the gap should keep narrowing. Compared with a purely vegetarian menu, a diet that contains just 20% of meat doubles that basic water requirement. Animals in the food chain consume water directly, and their own food requires water too. “While it may take 16 pounds of grain to produce a pound of beef,” says Thomas, “it takes a staggering 2,416 gallons of water to do the same.” Then there’s the need for extra water for personal hygiene, cooking and cleaning. Much more will be required for mundane household needs, such as flushing the loo. Indeed, CIRA, the Inter-American Centre for Water Resources, has highlighted a forecast of 400 million new toilets to be installed in emerging economies over the next three years.

Furthermore, more gardens will need watering and more cars will need washing. Then there are other infrastructure users, such as hospitals, restaurants and hotels. While the amounts consumed in such institutions vary from 20 litres per head per day in Africa to 100 litres in Europe and 400 litres in North America, the net effect of emerging-market urbanisation will be spectacular. Research from Citigroup suggests that, as urban areas increase in size and become more wealthy, a mix of changing diets and sanitation needs could cause demand for water to increase fivefold beyond the “basic water requirement”. That translates into a forecast that global water demand will increase by over one-third between 2000 and 2050. That’s one heck of a lot of future demand. So what about the potential supply needed to meet it? The picture here isn’t a pretty one.

Indeed, some major sources of long-term water are now running out. Deep underground aquifer wells, which took nature many millennia to create, are now approaching exhaustion as they are being drained more rapidly than they can replenish. This isn’t just happening in developing countries such as India. In the US, the Ogallala Aquifer, which stretches across eight states and provides nearly a third of the groundwater used for the country’s irrigation, is steadily depleting. Then there’s the extra damage that will be done by more pollution, as well as ongoing leakage from supply pipelines. Throw in climate change, which is expected to cause longer droughts and more regular flooding due to more extreme weather, and the earth’s fresh water supply won’t even remain static. It’s actually likely to shrink.

Worse, global water resources are very uneven. Sparsely populated regions, such as Siberia, have plenty of water but few local users. Yet many densely inhabited areas, such as large parts of Asia and southern Europe, are major consumers compared with the available supply. This means that the global price of fresh water must rise to reflect its scarcity. And, like it or not, it will increasingly become a commodity that will be traded like oil and wheat. Australia, the world’s most developed water market, has already introduced tradable ‘water rights’ to allocate resources more efficiently. Some people don’t like the idea of commoditising water in this way, but there are benefits.

Arguably, rising prices will stimulate people to find ways of supplying more water and will encourage countries with the most surplus water to maximise their resources, which will eventually benefit water-poor nations. This means that finding different ways either of producing more water, or preserving what the planet already has through recycling and conservation, is becoming a big and fast-growing international business.

The UN reckons that $11bn a year is required for water infrastructure investment – $15bn of last year’s US stimulus was spent on it. Overall, the global water market is now worth $480bn – including $175bn of municipal and industrial water and wastewater capital expenditure, services, engineering, maintenance and chemicals – and is growing at a 6% annual rate, according to the 2011 Global Water Report by Global Water Intelligence. So what are the big investment themes in worldwide water spending?

 

There are two. First there’s the business of making more useable water – raw ‘source’ water, like seawater, is treated to make it drinkable. Then there’s the wastewater sector, which focuses on the collection and treatment of liquid waste. “At the higher end of the water-technology spectrum are systems associated with desalination, treatment, filtration, and water tests,” notes Citigroup. “These systems typically see the highest growth, strongest pricing and highest barriers to entry [and are] where product and service differentiation and technological know-how matter.”

In theory, this is where the best long-term returns will be made. Desalination, though, is expensive and energy absorbing. As The Economist has said, “people go for desalination when they have few other options and are able to bear the costs”. But evolving technology will make the process more cost-effective by reducing energy usage.

There are also moneymaking opportunities down the scale. As “the distinction between service companies and equipment providers is becoming increasingly blurred”, says Citigroup, some businesses that were once seen solely as service providers are now joining forces with equipment manufacturers to build the likes of desalination plants.

Even at the low end of the value chain, where you find makers of commodity products, including basic pipes, pumps and valves, plenty of cash is still being spent on replacement kit. That’s because drinking water pipes last between 50 and 100 years. Many developed countries’ urban pipe networks were laid at the beginning of the last century, while maintenance has often been poor, meaning that between 1% and 2% of the network will need replacing every year.

In the wastewater arena, even sewage is being put to work. Today’s treatment processes increasingly mean this can be used as for agricultural irrigation, as it is rich in the nutrients that high-value crops require. In fact wastewater, both treated and untreated, actually accounts for about twice the amount of water derived from desalination – and wastewater that’s treated costs about a third less.

So what does all this mean for your portfolio? Philippe Rohner, portfolio manager of Pictet Water Fund, sums it up well. As he tells the Financial Times, “investors are now looking at water from a risk/return perspective. They want to get the best returns for the lowest risk.” To that end, we look at the best water-related stocks to buy below.

The seven best water investments

“Water will eventually become the single most important physical asset class, dwarfing oil, copper, agricultural commodities and precious metals,” says ex-Bank of England rate setter Willem Buiter, writing for Citigroup. Nonetheless, investing in water directly isn’t simple. There aren’t many firms whose revenues come entirely from water-related activities. Furthermore, as Dieter Küffer, portfolio manager of the SAM Sustainable Water Fund tells the FT, the stocks on offer can be “volatile”. And for the utilities that are among the purest water plays, regulation is a key risk for investors. Currently, “water prices aren’t set by supply and demand but by governments in almost every region of the world”, says Buiter. “When regulation isn’t in favour of utilities they might come under pressure.” We agree: the British water utilities have done well recently, so we wouldn’t chase them. But elsewhere other water stocks now look good value for long-term investors.

Paris-based Veolia Environnement (FP: VIE) derives 39% of its revenues from its water businesses. It supplies more than 100 million people worldwide and handles about 63 million tons of waste. It has recently gone into partnership with equipment manufacturers to build desalination plants. After the August market fall, it sells on a price-to earnings (p/e) ratio of ten. Then there’s the 9%-plus yield: Veolia shells out most of its profits to shareholders. Clearly, that means part of the dividend payment could be cut if the firm’s profits fall. Short term, that’s quite possible under new boss Antoine Frérot – he’s reversing the firm’s earlier global expansion by cutting costs and selling off assets “to clean up the company and get a fresh start”, says Jean Farah at RBS Securities. Nonetheless, Veolia has been a huge underperformer in recent years and now looks like an interesting recovery story.

Another French giant, Suez Environnement (FP: SEV), gets a similar percentage of its turnover from its water businesses. Suez has just reported an 18% first-half profit increase led by higher waste treatment volumes. It’s a bit pricier on a forecast current year p/e of 12.8, although the prospective yield is still a very respectable 6%.

Three stocks are good bets further down the market-cap scale. Japan’s Kurita Water Industries (JP: 6370) makes and sells water treatment chemicals and systems. It has strong positions in Asian markets and “over the past five years investor interest has focused on its ultra pure water business, supplying water on multi-year contracts to a number of Japanese electronics companies”, notes Citigroup. It isn’t over-cheap on a current year forecast p/e of 14 and a 2% prospective yield. However, with cash to spend, it’s well placed to go for more overseas growth.

Last year, we tipped Singapore-listed Sound Global (SP: SGL), a water and waste treatment provider in China. After an initial spurt the shares have since slipped back again. But on an expected 2011 p/e of just 11, which is forecast to fall to just over nine next year – and again, with a cash-rich balance sheet – this looks a good long-term water play to lock away.

Lastly, US diversified electronic products manufacturer Pentair (US: PNR) obtains more than 50% of its revenues from water-related markets, mainly filtration and pumps. Its current year multiple of just over 12 and is forecast to drop to sub-10.5 in 2012.

For instant sector diversification there’s the PowerShares Water Resources ETF (US: PHO), which aims to track companies that focus on water provision, treatment, and technology and services related to water consumption. It has an expense ratio of 0.64%. More globally focused is Claymore S&P Global Water Index Fund (US: CGW), with an expense ratio of 0.65%.

Category: Market updates