Water Investments: Saturated In Sustainability

Includes: CGW, FIW, PHO, PIO, PNR, XYL
by: Matt Sheldon

Sustainability as an investment theme risks transcending beyond meaning as it rises in the mind of some to join other overused buzz words. But there is a deeply practical application of overlaying a view on sustainability with stock picking: The majority of a company's value is in the "out years". We have all built discounted cash flow models and had that uncomfortable feeling seeing that a majority of the present value was tied up in the ironically named "terminal" value. And that value was very much a function of long term growth assumptions. Should it be 2%? 4%? It makes a big difference.

The value of any company is highly dependent on not only being around in a couple years, but also the sustainability and growth of the cash flows for decades to come. As investors, we need to know that the end markets for the products and services our companies offer have durability and the business models and cultures have the flexibility to deal with increasingly volatile environments - both economic and climatic.

In this light, we believe a portfolio of global water companies offers a long term, sustainable investing opportunity. The need to supply clean water for a growing population is one of the world's greatest challenges. Water is an essential ingredient to economic growth, not only sustaining life, but industrial production too. Companies providing water infrastructure, technology, and services into the various end markets can be assured of demand for their offerings for decades to come. This is driven by a combination of consistent demand for maintenance of aging assets as well as incremental needs resulting from population growth, urbanization, and the desires of a growing middle class. To address these needs, a study by Booz Allen points to about $22 trillion in infrastructure spending in water over a 25 year period (2005-2030), which is greater than the capital required for power plants, roads, railroads, airports, and seaports, combined. Investing in companies downstream of this water spending should provide sustainable revenues.

Given the recent sluggish global economic environment, it is encouraging that a lot of the spending in water is not a function of growth. We believe this is a core element of sustainability. Much of this spending is on a break-and-fix basis. That is, if a pump or pipe or piece of lab equipment breaks, it needs to be fixed. Not doing so can create environmental, health, or safety risks at best, and catastrophes at worst. Demand for other water offerings is quite stable because they are consumed throughout the treatment process, such as water chemicals or analytical testing samples. Water companies also benefit as their customers make efforts towards sustainable futures, lowering net water consumption and the energy associated with water movement and treatment, which in turn drives demand for water technology and services.

Another core element of water companies' sustainability is that water technology is rarely superseded or obsoleted. While very exciting developments are emerging for innovations in water treatment, data analytics, process efficiencies, and infrastructure diagnostics, there is very little risk of significant market share loss due to upstart competition in the majority of end markets served. For better or worse, most of the spending in the global water industry goes to tried and true approaches, which have been utilized for generations. Municipal employees and water engineers, both of which tend to be conservative, are making the decisions. A wrong decision on an unproven technology may not only cost them their job, but could create significant disruption in service and/or water quality. We are talking about water here - it is more important to get it right than to try to save a couple percent on costs. So the sustainable competitive advantage for water companies is derived not from having the latest cool widget, but from the four R's: Reputation, Relationships, Reference Lists, and Results. These take time to build. This should sound familiar to those in the money management industry.

With several elements of sustainability inherent in the end markets and business models of water companies, I find the following statistics quite telling. Half of our global water portfolio can trace their roots to before the Great Depression. Similarly, the weighted average age of companies is 90 years* old. That is, "born" in 1922. While they have all had their fair share of ups and downs and different corporate compositions through the decades, it does point to a critical investment tenet: water companies are sustainable.

To access the water investment opportunity, you can buy water stocks that would include the likes of Xylem (NYSE:XYL) and Pentair (NYSE:PNR), buy one of the water ETFs, or engage a specialist active manager/fund in the water space. While a basket of stocks and ETFs can get you broad exposure to the theme, our experience has been that specialist active management can add to performance by capturing valuation anomalies and participating in the unique cycles throughout the wide array of water end markets and geographies. For example, the Calvert Global Water Fund (CFWAX), which specifically has a Sustainable and Responsible Investing (SRI) mandate, has demonstrated strong returns (disclosure: we are sub-advisors on this fund). We believe having an allocation in your portfolio to water should be additive over the long term due its sustainability attributes.

*Weighted average age based on the year to which each company traces its roots and position sizes as of September 30, 2012.

Disclosure: I am long PNR, XYL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Please see profile page for full disclosure.

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