From time to time, Morningstar publishes articles from third party contributors under our "Perspectives" banner. Here, Matt Sheldon, co-portfolio manager of the Kleinwort Benson Investors Water Strategy, explains away five myths of investing in water.
Many people get excited by the concept of investing in the global water industry, and those investors who recogniSed the opportunity a decade ago have been handsomely rewarded. Investors continue to be intrigued after hearing sound bites, such as that less than 1% of the water on the planet is fresh liquid water with most of that being polluted or in the wrong places, or after hearing phrases like “blue gold” or “peak water”. Others are intrigued by water footprint calculations that challenge our mental models of total water use, such as 1 pint of beer requires 20 gallons of water. As interesting as these facts may be, they are not all that helpful from an investment standpoint. How do you pick stocks based on these? And they don’t really answer what it even means to “invest in water”.
Ultimately, water investing is about investing in companies benefiting from the common set of long term tailwinds of increasing water supply-demand imbalances, massive infrastructure rehabilitation needs, new infrastructure requirements due to population growth and urbanisation, and increasing regulatory influences. These companies provide the operations, equipment, chemicals, and services that make water available for municipal, industrial, and agricultural markets. While easy to grasp in concept, there remains misconceptions about how to go about it. Piggybacking on a recent article by author Charles Fishman in the Washington Post titled, “5 myths about water”, and given the misconceptions, I would like to address 5 common myths about water investing.
Myth #1: Water Is Un-investable
This myth takes the form of three sub-myths: the opportunity is too small, the opportunity is too “impure” (i.e. it is hard to find companies that are sufficiently focused on water), and there is no category for “water” in a classic multi-asset diversified portfolio.
While there are a limited number of global stocks sufficiently levered to the theme, and most are mid- to small-cap in size, there is plenty of capacity to invest and achieve a diversified water portfolio. Water-focused public equity funds and ETFs represent only about 1% of the combined market cap of global water stocks. It’s important to note that the water industry stretches far beyond the municipal use that one automatically thinks about. Industry consumes twice as much water and agriculture 7 to 8 times as much. These days, these are healthier end markets and where some of the best investment opportunities lie.
Not all water companies are 100% water-focused. Many also partake in waste businesses, energy markets, health care, technology, general industrial, and other non-water markets. Companies with material water exposure, yet not 100%, make up an important component of the water industry and are often among the leading providers of a key product or technology. The key is to optimise the total portfolio water purity to ensure sufficient tie-in to the long term drivers while understanding and analyzing the non-water businesses at the company level in the stock selection process. That means combining stocks with 20% water exposure (say, US meter company Itron) with 50% (French utility Suez Environment) and 100% water-focused businesses (Japanese ultrapure water specialist Kurita Water). The result is most water stock indices and funds are in the 60%-75% water exposure range in aggregate – enough to benefit from the global water trends. A decent rule of thumb is the more exposure to utilities, the higher that percentage will be.
Investors struggle with where a water fund fits into a broadly diversified balanced portfolio and many pass on the opportunity. There doesn’t seem to be a seamless fit into any traditional asset class category. This is both a simple and complex conundrum. If you believe that it will add alpha, don’t fall into the dilemma created by a manufactured problem of having to fit it into a box. That said, you can shoe horn it into several categories: global equities, sustainable, natural resources, infrastructure, alternatives, and/or inflation-protected assets.
Myth #2: There Is a Water Sector
Unlike the energy, financial, or consumer discretionary sectors, which are heavily influenced by one or two drivers each (oil/gas price, interest rates and credit quality, and consumer spending, respectively), the water sector has a broad array of drivers. This is because there is no such thing as the water sector. The investable universe of water stocks is made up of a broad collection of companies, providing a diverse offering of niche products and services into various end markets, geographies, and regulatory regimes. While they have a wide range of business models across an array of utilities, industrial and technology companies, they all have the common element of water flowing through them. This is good news. One can construct a well diversified portfolio, not beholden to any particular driver yet well levered to the long term water trends.
Myth #3: Water Investing Is Defensive
Water is essential for life and therefore protected from cyclical downturns, right? Well, yes and no. Water demand for municipal uses varies little, but it is more cyclical for commercial and industrial uses. And capital spending on water equipment and construction services is deferrable, at least for a time. In the 2008-2009 downturn, water companies saw a broad range of sales changes, from up a bit to down more than 15%. The equities were even more cyclical than that as money left the markets and multiples compressed drastically on depressed earnings. Water stocks were not immune. That said, several companies refinanced debt in the peak of the Lehman fallout and regulated utilities acted defensively, as one would expect. Over the 11 year life since inception of the KBI Water Fund, the beta versus the MSCI World has been nearly 1.0. That is, the water portfolio has shared the risk profile of the broader global equity market. While there are defensive elements of water investing and one can construct a more defensive leaning portfolio, one can also access growth or create a more balanced portfolio through the market cycles.
Myth #4: Water Investing Is Offensive
Some may have a negative initial reaction to investing in water. Water is an inalienable right, a human right, and it should be free. Profiting from it violates common decency or moral standards, they’d argue. To make it worse, the industry preaches economic realities that water is undervalued and prices must rise over time to accommodate higher cost incremental supply and costs to play catch up in rehabilitating the dilapidated underground infrastructure. That’s what they say, but what is heard is that they are out to jack up prices.
First and foremost, none of the investment theses are predicated on or facilitated by hoarding, profiteering, inequitable distribution, or unsustainable extraction. Anyway, as it turns out, water is (with rare geographic exception) free. One is paying only for the costs of treating and transporting it, which is even true for the most part in regions with marketable water rights, though this is a more complicated discussion. A tonne of water delivered to your house costs roughly a dollar – try getting anything else delivered to your house that weighs a tonne for so little. And many utilities have rate structures and low income programs specifically designed to enable affordable water sufficient for basic drinking and sanitation requirements.
Some people are against the concept of the privatization of water and wastewater services. But it should be recognized that whether private or public enterprises are providing the water service, it is the government and its regulators that dictate the quality of water, quality of service, and the price. Also, since water is the most capital-intensive utility in an age of strained governmental budgets, there is room for both public and private solutions, sometimes in tandem. Joint public-private efforts are leading to increasingly innovative approaches to improve cost efficiencies and service quality – see the news on New York City and Veolia’s latest arrangement.
Finally, “investing in water” is really investing in companies providing solutions to water needs. Water portfolios consist of companies who sell into government utilities, investor-owned utilities, residential and commercial construction markets, industry, and agriculture. They represent the backbone of the hydro-economy, whether water is free and government-run or not.
Myth #5: The Water Theme Is Enough
Just because a company is in the water industry doesn’t mean that its stock is a good stock. In any given month, the best performing 10% of global water stocks will outperform the worse performing 10% by about 35 percentage points on average. This is a very large dispersion, and highlights several points: water stocks don’t trade as a lemming-like tight-knit group, there are risk-reward driven opportunities to dynamically rotate from the outperformers to the underperformers, and in the absence of a portfolio approach, one may face considerable volatility.
While a few water ETFs exist, are easy to buy and sell and are low cost, they may limit return potential in their approach to the opportunity. Reflecting their need for liquidity, water ETFs tend to be dominated by more liquid larger names relative to more illiquid, higher growth, smaller cap, pure plays. Active management of water stocks enables global cross-referencing of companies with common business models to evaluate and capitalise on the evolving relative valuations, end-market dynamics, and global competitive structures. Also, as various water-specific themes become more or less interesting over time due to emerging regulations or the economic cycle, active management allows shifting the portfolio to become more or less exposed to those areas. For example, one may desire more ballast water treatment, more late-cycle industrial water infrastructure, and less developed market government spending-related end market exposure than what one can get in a static index.
With a better understanding of what it means to invest in water, one can begin to dive into the opportunity and capitalise on the potential excess returns.
Matt Sheldon, CFA is a co-portfolio manager of the Kleinwort Benson Investors Water Strategy, which manages $600 million (as of 31 March 2012) for institutional and retail clients, including sub-advising the Calvert Global Water Fund in the US.
The views expressed in this document are expressions of opinion only and should not be construed as investment advice. Past performance may not be a reliable guide to future performance and the value of investments may fall as well as rise. This material is provided for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase any security, product or service of Kleinwort Benson Investors Dublin Ltd and its affiliates. Kleinwort Benson Investors Dublin Ltd. is regulated by the Central Bank of Ireland.
The views contained herein are those of the author(s) and not necessarily those of Morningstar.
