Investing Daily

 

The water sector offers powerful, assured growth, the world’s safest yields and hype-free values.

-- Roger Conrad, Utility Forecaster

Within the next two generations, water is expected to become the most important commodity in the world, easily surpassing oil.

-- Yiannis Mostrous, Portfolio 2020

It’s raining in the Washington D.C. area today and the forecast is for a washout weekend. Grey skies and showers for as far as the eye can see. Pretty depressing, but it got me thinking about water stocks. According to Roger Conrad over at Utility Forecaster, there are only a handful of publicly-traded water utilities and they provide water to about 10% of Americans (most water systems are government-run)

American States Water Has An Incredible Dividend Streak

As it so happens, one of this handful, American States Water (NYSE: AWR), reported earnings on March 11 and the numbers were mixed. The utility, which provides water to around 263,000 customers in California and Arizona, reported fourth-quarter numbers that missed analyst estimates, but this was primarily due to a one-time charge for employee terminations. The stock sold off slightly on the news. Full-year revenues and adjusted earnings looked much better, with each up 13%, but Wall Street is so short-term oriented these days that these positive longer-term performance numbers were ignored. Long-term value investors can take advantage of these trigger-happy sell-offs to snare bargains.

More important to me than the earnings numbers was the fact that this 80-year-old company had increased its annual dividend for the 55^th consecutive year. Wow, now that’s what I call consistency! In fact, there is only one other company that has increased its dividend for more consecutive years than American States (curious? I’ll tell you later). Dividends are cool because they put cash in your pocket and tell you that management is shareholder-friendly. American States’ solid and steady growth is pretty typical for the better-run utilities, which is why so many people like to own them! Given the zero-interest-rate world we currently live in, the company’s 3.1% dividend yield isn’t bad, especially considering its safety, but Roger likes other higher-yielding water utilities better. And I’m pretty sure that energy guru Elliott Gue over at MLP Profits would say that my dividend ambitions are too easily satisfied.

When Two Investment Stars Agree

I’m also a big fan of Yiannis Mostrous, Portfolio 2020 contributor, so when I realized that both Yiannis and Roger viewed the water industry as one of the best places to invest, I jumped out of my seat and took notice.

Is Water Boring or Sexy?

Initially, I was skeptical because what could be more boring than water? It has no flavor and restaurants don’t even charge you for it. It’s so plentiful that it covers 70% of the earth’s surface. 

Hmm…70% is also the percentage of the human body consisting of water. Coincidence?

Anyway, Yiannis tells me that 97% of the world’s water is salty, undrinkable sea water. A little more than 2% is locked up in glaciers and permafrost, leaving less than 1% drinkable.  Less than 1% . . . and this figure doesn’t take into account fresh water that has become polluted. No wonder a third of the world’s population suffers from water shortages! Furthermore, water shortages are only projected to get worse over the next 15 years, when almost two-thirds of humanity will not have enough water. Two-thirds! Yiannis is also our emerging markets expert over at Silk Road Investor and he says that China offers “by far” the best opportunity in water investing.  In fact he has a China water play in the Portfolio 2020 portfolio right now that has almost doubled since it was recommended but he feels it is so early in its growth cycle that its run is far from over and could triple from here.

Water suddenly doesn’t sound so boring anymore. It's starting to sound . . . sexy.

The United States Has a Drinking Problem

The U.S. is certainly not immune from the global water shortage. It’s common knowledge that the Western U.S. is in trouble.  The TV news magazine 60 Minutes recently ran a story entitled “California: Running Dry” discussing the crisis.  California has enacted comprehensive water legislation to promote conservation and upgrade water infrastructure.  A key part of the bill is an $11 billion bond issue that will be used to pay for infrastructure upgrades. Much of this money will go to water utilities.  And California is far from alone. According to the U.S. Government Accountability Office, 36 states expect to suffer from water shortages. Lake Mead, which provides water to Las Vegas and Phoenix, could run dry by 2021 and the Southeast U.S. (including Atlanta) is also in trouble. In 2008, the Environmental Protection Agency estimated that $485 billion is needed nationwide to build and upgrade water infrastructure systems.

Water Utilities are the Solution

Cash-strapped governments are likely to solve the water infrastructure crisis by selling off municipality-owned systems to investor-owned utilities. According to Roger Conrad, such distressed deals are “money in the bank”:

They buy, make upgrades and then file for rate increases, which in turn increase revenue, earnings and dividends. And as water rates nationwide are still proportionately well below electricity and telephone rates, increases tend to be non-controversial.

Bottom line: Water shortages are the problem and water utilities are the solution. Those that own drinkable water assets sell a product that is in high and ever-increasing demand. These utilities are paid a regulated but very healthy return on their investment (i.e., their rate base) to do so.  In fact, some utilities – including those in California like American States Water – are being paid not to sell water as part of state conservation programs.  Water utilities are also being paid to upgrade their distribution networks to improve efficiency (e.g., less leaks). What a great business! Governments want water utilities to succeed and it’s always good to own a business that has the government on its side.

Recent Outperformance is Just the Beginning

The market in its uncanny wisdom has already begun to recognize the privileged position that water utilities hold in the U.S. economy. Over the past three years, an index of water stocks has outperformed the S&P 500 by more than 25 percentage points (12.1% vs. –13.1%):

Source: Bloomberg

Water utilities did not just substantially outperform the S&P 500; they also outperformed electric utilities, a similarly “safe” sector, by almost exactly the same margin (23%):

Source: Bloomberg

This suggests that water utilities did not outperform the general market simply as a flight-to-safety trade during the recent financial crisis, but that the water industry is enjoying a secular growth story all its own.

Don’t Take My Word For It – Ask Southwest Water

It’s one thing to present an investment thesis as to why water utilities should perform well and it’s quite another to see it play out in the marketplace.  Talk is cheap but cash is king.

A little over a week ago on March 3^rd, Southwest Water (Nasdaq: SWWC) – another California utility – announced that it had accepted an $11 per share all-cash takeover offer by a private consortium led by JPMorgan Chase (NYSE: JPM). The offering price constituted a 56% premium over the stock’s $7.07 closing price on the day prior to the announcement.  

The Southwest Water takeover value could be a signal that the water industry is generally undervalued. At $11 per share, Southwest Water sells for a lofty 2.2 times book value and a low 1.9% dividend yield. That is a much higher valuation than many other water utilities currently trade for:

Oh, yeah, I promised to tell you which company has increased its annual dividend for more consecutive years than American States Water. The answer is Diebold (57 years).

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Roger Conrad’s Utility Forecaster has three water stocks in its core holdings growth portfolio. Portfolio 2020 has two more and even Elliott Gue over at Personal Finance has one. Find out which stocks made the cut in all three services by giving them a try risk-free. There is no obligation to subscribe.