This is the third in a three-part series on global water problems. In the first article in the series, data and analysis were used to highlight the primary problems. Water experts were interviewed in the second article. Here, we talk to experienced investors who believe the water sector offers some attractive opportunities. Previous in this series: Part 1 (Analysis) and Part 2 (Opinion).
My Investment Perspective
It is well documented that picking individual stocks is not a good bet. Market prices do a pretty good job at reflecting all available information, and when new information becomes available, you are not likely to be able to act on it before others. I am always struck by looking over Pensions and Investments’ list of the largest money managers (top ten listed in Table 1). They list 670. And in total, they are managing $32.2 trillion. Let’s say that on average, the managers are collecting a fee of 2%, and half of that is going into research. That would mean $322 billion of research trying to find the undervalued investment. That is a lot of research money. That means a number of investments managers have staff investigating all aspects of water-related opportunities, attending conferences, using computer-driven programs to buy or sell when prices get out of whack…. And that is why picking stocks is a near-random bet.
Table 1. – 10 Largest Global Asset Managers, end 2012
Source: Pensions and Investments, May 27, 2013
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In addition, history tells us that it is extremely difficult to predict major technological/energy transitions. In most of these transitions, large sums of money has been made and lost betting one way or the other.
Despite all of this, there are some who believe “certain water investments” are undervalued. Probably the most knowledgeable water gurus are Neil Berlant, the manager of the PWF Water Fund (PFWAX) and Willem Buiter, Citi’s top economist. For anyone considering a water investment, both Berlant’s and Buiter’s views are worth a read.
Here is a quote from the Berlant interview referenced above:
…the infrastructure of this country, as well as other countries, is in great disrepair. There are estimates in the United States today by the EPA that we are looking at $1 trillion of deferred capital spending to upgrade our nation’s water infrastructure – that is, the pipes and distribution systems throughout the United States – over the next 20 years. Secondarily, but even more persuasively, the driving force and change in awareness is coming about as a consequence of an increasing price of water, which I estimate will be up as much as two to three times on an average basis across the nation in the next three years. The increasing price of water is catapulting the awareness level of water problems and changing the way people think about water.
The reason why the price is going to increase falls back to the roughly $1 trillion of deferred capital spending that the water utilities are facing. It is important to understand that not one single penny of what has to be spent will go to add revenues for any of the water utilities. Therefore, in order to finance those repairs, the water utilities are going to be looking to users to pay for those repairs in the form of increasing water prices. The way the water utility industry works is, there are various local public utility commissions that regulate water utilities. As the utilities face capital expenditures, they ask their public utility regulators for what is referred to as “rate relief,” which is a euphemism for raising prices. To justify that, they say that they have to rebuild the distribution system or the pipes, etc. They almost always receive rate relief, which means they will raise the price of water. The problem is exacerbated by the fact that as water prices rise, consumers look for ways to cut back or become more efficient and use less water, which means that the revenues for the water utilities then drop yet again. It’s a constant cycle that will begin to unfold, leading us to substantially higher water prices.
M&A in the water industry is burgeoning. It has impacted our investment activities over the years; on average, I have lost two companies every year to the continuing consolidation. I think that the pace of this consolidation, that is merger and acquisition activity, is only going to increase. There are larger companies that I’ve referenced before that are entering the business. Notable ones would be GE and ITT, and several others are looking to continue to grow in the water industry. They will accomplish their goals by making acquisitions of other companies. The pace of M&A will intensify, with valuations continuing to increase, giving rise to an exceedingly rewarding investment area overall.
It is worth noting that Berlant said the above in an interview dated August 6, 2007. He is still waiting. And yes, the US water infrastructure is in great disrepair. But where is the money going to come from to fix it? DC governance is broken while state and local governments are still laying off people following the global recession. And don’t forget Turner’s quote from the second article in this series:
“I have already spent $100s of thousands on this quest and have been slammed by the bureaucracy and the technically ignorant and politically motivated courts. Crooked courts have been the bane of New Mexico for more than 100 years. Our fist Territorial Engineer was indicted by the Federal Government on October 24, 1906 for land fraud. His bail was paid by a business partner whose application for a large amount of water was approved by him on January 29, 1906 and who was also indicted for land fraud by the federal government in 1911.“
But never mind all this: on investments, it is always difficult to get the timing right. So how about water investments?
Water Is Not Like Other Commodities
Investing in most commodities is a gamble on the price of the commodity going either up or down: you buy or sell short the commodity. Water investing is different: instead of buying the commodity, you invest in one or more of the wide array of “water service industries“. Water infrastructure is a term that covers a lot of them: filters (including desalinization plants), disinfection/purification, pipes, pumps, membranes, and measurement equipment. You also can invest in private companies that take over water utilities and in companies that sell water in other forms such as soda or bottled water.
When you look at companies in this “water industry“, you find a number of very large firms that have water divisions. But in most cases, these divisions are not important enough to have much of an impact on the companies’ bottom lines. So let’s look at some of the smaller companies and investment vehicles.
The most frequently mentioned “water” mutual finds/ETFs are: PFW Water A (PFWAX) – this is Berlant’s fund, Guggenheim S&P Global Water Index (CGW), PowerShares Water Resources (PHO), PowerShares Global Water (PIO), iShares Dow Jones US Utilities (IDU) and First Trust ISE Water Idx (FIW). Performance data on these investments is presented in Table 2. One comment: note their performance relative to the S&P 500.
Table 2. – Performance of “Water” Funds and ETFs
Source: Yahoo Finance
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I have assembled the list of stocks included in Table 3 from numerous articles on water investments. And while recent performance of some of them has been excellent, it is also true that many of them are still below their 5-year highs reached back in 2008. They are ranked by 3-YR return.
Table 3. – Water Stock Performance, 2008 – 2013
Source: Yahoo Finance
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The Soda and Bottled Water Story
I have asked Thomas Schumann (TS) to help me with background on this subject. I communicated with Thomas first when I was considering “sin” stocks via The Vice Fund (VICEX) for investments. At the time, Thomas was co-founder and chairman of a German tobacco investment and holding company. He is now preparing the acquisition of “the purest, deepest and oldest known spring water source in the world to distribute its certified natural healing water” in bulk for home and office delivery in New York City and other markets. Thomas now views carbonated high fructose corn syrup sodas as beverage equivalent of cigarettes.
EM: My sense is that bottled water is a relatively new consumer good while Coke and other sodas have been on the market for a long time.
TS: That is correct, but keep in mind that while soda companies talk about their secret formula for syrup, they all need a source of good water near to their bottling plants. So with good water supplies, it was only natural to think if there was some other product to sell. So how about water: put it in a nice bottle that attests to its purity. Try adding a little color and flavor or maybe some sodium and potassium and sell it as a health drink (Gatorade, Activate). Or add some caffeine and sell it as an energy booster – Red Bull, Pepsi One or Mountain Dew.
EM: I guess the market for bottled water in developed countries is quite different than the market in developing nations.
TS: That is correct. In developed countries, municipal water is normally good. So bottled water is a luxury, a discretionary good. You can see this in the sharp drop in bottled water sales during the global recession. When times get tough, Westerners go back to tap. Given the tight regulation of municipal water supplies in the US and the relatively light regulation of bottled water, it is not much a stretch to say you are safer drinking water from municipalities than from “bottles“.
In developing countries, the story is quite different: people buy bottled water as soon as they can afford it because other water sources are dangerous. Developing countries are the target of the global bottling countries but primarily because of the escalating demand from their growing middle classes.
EM: Table 4 provides data on the revenues and consumption of soda and bottled water in the US. It appears they are going in different directions.
Table 4. – Soda and Bottled Water, US Revenues and Consumption
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TS: This is definitely so. Sugared drinks are starting to get the negative press that has had such an impact in reducing cigarette sales.
EM: Table 5 provides data on the US market shares of the largest soda and bottled water producers. Both industries appear highly concentrated. It reminds me a bit of the alcoholic beverage industry: highly concentrated and getting more so because of the tremendous economies of scale in marketing, shipping, etc.
Table 5. – US Market Shares
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TS: It is very similar: mergers and acquisitions are happening all the time.
In Part 1 of this series, I described a bet between Paul R. Ehrlich and Julian Simon back in 1980. Simon let Erhlich choose five commodities. Simon bet him $200 per commodity that its price would be lower at whatever future date Ehrlich chose. Ehrlich bet that the prices of chromium, copper, nickel, tin, and tungsten would be higher in a decade – 1990. Erlich lost the bet. The prices of all the commodities he chose were lower in 1990.
Betting on the future is tricky. So how about a bet today? What do you think the prices of uranium, natural gas, oil, coal and the profits of the water service industry will be in 2023? I am not sure. I feel safer predicting that US real estate prices will be higher in 2023 than they are today.
On the other hand, Berlant, Buiter, and Schumann do argue quite convincingly that the demand for the global “water service” industry will continue to grow. For reasons discussed above, I am not about to invest in a “water service” stock. But I am considering taking a small position in an ETF, maybe PowerShares Global Water (PIO).
. See Paul A Samuelson, “Proof That Properly Anticipated Prices Fluctuate Randomly”, Industrial Management Review, 6:2, 1965 (Spring) and Burton G. Malkiel, A Random Walk Down Wall Street, W.W Norton & Co., Inc., 2007.