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Monday, January 11, 2010

Hydrocommerce Corner-Where Water & Money Meet - January 11th

Hydrocommerce Corner-Where Water & Money Meet

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January 11, 2010 Edition
By William S. Brennan
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The never ending growing imbalances in global water supply and demand have been well documented over the last 20 years. Based on recent surveys, groundwater levels, reservoirs, lakes and other forms of water capture/supply sources are running dangerously low around the world, exacerbating an unquenchable and unsustainable water consumption/replenishment scenario with no solution in sight. Somewhat quietly in our opinion, water prices continue to rise well above inflation in developed countries, which should have spurned investor interest to a higher degree than what has taken place.

So where is the disconnect? Investment in the infrastructure-pipes, reuse systems, metering, and the like and even the primary source of our daily water-water utilities has been dismal to nonexistent. The EPA presently estimates that we are $600 Billion behind in US water system upgrades alone. No stimulus package or packages will solve the funding criticality that we are now facing. The only sources will be taxes on goods that potential foul or contaminate water on contact, a significant increase in your water bill that will reflect full cost pricing-energy use, treatment and conveyance to your shower head, bathtub, residential irrigation system etc and lastly, private funds (in the form of public-private partnerships) that have been active in other parts of the globe but have been given a relative cold shoulder here in the U.S.. While the rest of the emerging world recognizes that water infrastructure is critical for continued GDP growth, The U.S. falls farther behind in rebuilding our water infrastructure, there by jeopardizing not only our public health at the local level but our status as a key economic growth engine for the world as we enter into the second decade of the 21st century.

In the capacity of a portfolio manager in the water sector for the better part of the last decade, I always believe that there are two camps-the group that recognizes that opportunities abound for solution providers when problems arise and the second camp that relies on others to solve those problems for them. From an investor standpoint, the primary concern always comes back to the basic question that I have been repeatedly asked over the years - How do I make money investing in water stocks. With global water shortages looming and the availability of potable water continuing to dwindle, there will be significant opportunities for the companies that provide the solutions to these issues. Investments in water have been far below expectations but we see a changing mindset afoot. A greater level of investment will emerge in the next decade with a focus on areas where water shortages are prevalent.

A bifurcation investment approach of investing in developed countries where infrastructure is well established and emerging countries where the infrastructure build out is just beginning is a prudent approach. The underlying themes will include increasing the water supply through re-use technology (water recycling) and desalination where sufficient energy sources exist. Unless you live on the down slope of a mountain, water movement and treatment is an expensive proposition that investors don’t fully grasp in the context of energy usage and requirements (we will cover this in our next article). In the U.S., Flowserve and Energy recovery are two companies that come to mind which should benefit from activity these areas. The meters area will be used to regulate and reduce our daily usage, whether it is residential, agriculture or industrial. With energy providers and agriculture being the two largest daily users of water (home usage surprisingly is below 10%), a renewed interest on reduction in usage in gaining momentum, thereby benefitting companies like Itron and Badger Meter. At the home level, be prepared in the coming years for a massive replacement of water efficient devices that Congress quietly passed in January 2008. This is mandatory for any new construction! Any appliances and plumbing fixtures that use water will be replaced by a more water friendly device in the upcoming years. Geberit and Pentair sit squarely in the middle of this event.
Lastly, water utilities should not be overlooked. Water Utilities/Utilities involved in water usage such as hydroelectric may not grow very fast, but they are remarkably consistent—delivering solid but not spectacular returns every year. This enables these stocks to deliver impressive compounded returns over time. Just remember what we consider a key point- we have never seen a water utility trade on a j curve! One must be valuation sensitive and be aware of local and regional issues when wading into the water utility investment pool. Seasonality, rate case delays, droughts can have a positive or negative impact on each individual company. As a value investor, water utilities will likely be our favorite subsector for the foreseeable future providing cheap, high quality companies with solid dividends that have a lower beta relative to the broader market, prospects for continued earnings growth, and the possibility for valuation multiple expansions based on increased cost for water treatment and delivery leading to higher water rates. In the context of what many professional investors are calling he “new normal” - diminished growth, deleveraging, and increased government involvement that will reduce profits and their eventual distribution to investors in the form of dividends and interest - we believe that water utilities could experience significant investor interest in 2010 and beyond. Why? Bill Gross, PIMCO’s bond guru said it best in our opinion, validating our investment thesis: “why not just buy utilities if that’s what the future American capitalistic model is likely to resemble.” We wholeheartedly agree! In a low growth environment, it seems that a company’s stock should yield more than its less risky debt, and many utilities, especially water utilities bought at the proper valuation metrics, provide just that opportunity. A basket of high yield water utilities such as American Water, American States, Cascal, United Utilities and certain Hydro electric companies such as CEMIG should be considered by investors that are in search of sustainable yield and stable growth.
Water investing is not a direct investment based on some arbitrary value per gallon of water, but a strategic investment in the many sub-sectors that are involved in its extraction, treatment, regulation, metering, conveyance and resource management on both the domestic and global stage. Many investors look at water in varying capacities: commodity, natural resource, alternative, and utility are just a few of boxes that water is placed by the investment community. Although water is continually referred to as the next oil, our approach has always remained that the consistent growth of the sum of the parts of the global water business will likely provide investors exposure to a historically solid growth commodity that no one can do without.
By William S. Brennan
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Disclaimer: This column, Hydrocommerce Corner-Where Water & Money Meet with Bill Brennan, is the opinion of William S Brennan.Content found in the articles is subject to the terms found in the disclaimer and does not represent a recommendation of investment advice. Investors should seek the advice of a qualified investment professional prior to making any investment decisions.

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