21 Alpha-Producing Water Stocks: Danaher Floats To The Top

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About: Xylem Inc. (XYL), ROP, ECL, DHR, WTR, Includes: AOS, AWK, AWR, BMI, BRKR, CMD, CTWS, IDXX, IEX, LMNR, LMT, MMM, SJW, TMO, TPL, TTC, WAT
by: Goose Hollow Investments
Summary

21 of the top water stocks.

Danaher is the top choice.

Ecolab, Roper, Xylem, and Aqua America are honorable mentions.

AO Smith, Limoneira, and Cantel Medical are currently in or near the buy zone.

A couple of years ago, I wrote an article on Seeking Alpha titled "A Guide to Investing in Water". While I hope the article achieved its goal of providing a general overview of investing in water, I decided to write a second iteration of sorts, with a focus on my favorite domestic water stocks. This list has been almost seven years in the making and amounts to a water investing dissertation of sorts (please excuse the long length).

My selections are based on two primary criteria, one objective (historical performance) and one subjective (my opinion on their future prospects). I understand that historical performance is no guarantee of future performance. However, I have found it can be a reliable indicator of companies that have some level of competitive advantage. This said, I did not blindly include any water company that has outperformed, but rather selected the ones I believe have a good chance to continue to do well.

Many of these companies trade, and have historically traded, at a premium to the broader market. While I do think valuation is important, I did not exclude companies from this list due to valuation, in part because I think many deserve their premium, and also because valuations change, and I hope readers will be able to reference this list in the future.

Similarly, for the list I used a loose definition of what constitutes a water stock, my reasoning being that the goal of investing in water is not to indiscriminately invest in water, but to use the water thesis to uncover stocks that look likely to produce alpha (though I will say I do like two of the water ETFs, the First Trust Water ETF (FIW) and the Investco Global Water ETF (CGW)).

Lastly, I would like to emphasize that this article does not advocate investors immediately begin shoveling money into these stocks. As noted, many trade at rich multiples; moreover, though I largely avoid market timing, it does feel late cycle, so if anything I would advocate a thoughtful and cautious approach to investing fresh capital in stocks. Additionally, for the most part, these companies are covered in a superficial way, so I would encourage any prospective investors to do their own due diligence, especially when it comes to the risks each business faces (the "risks" section in 10-Ks are a good way to learn about potential headwinds).

My advice and current strategy is to study and monitor each of these equities and opportunistically accumulate shares during sell-offs. With that, I give my list of top water stocks (21 in total), which I have listed in alphabetical order, though I go into more detail on my top choice, Danaher (DHR), as well as four honorable mentions (Aqua America (WTR), Ecolab (ECL), Roper (ROP), and Xylem (XYL)). I also go into more detail on several out of favor options that I consider to be currently in or near the buy zone (AO Smith (AOS), Cantel Medical (CMD), and Limoneira (LMNR)).

*Notes: all revenue and net income figures listed below are FY 2018 unless otherwise noted; additionally, all market caps, dividend yields, PE ratios, and forward PE ratios come from Charles Schwab, and 15-year returns include reinvested dividends and come from Dividend Channel. Also, for reference, the 15-year return with dividends reinvested for the S&P 500 (SPY) is 246% and for the Russell 3000 (IWV) is 247.2%. Please do your own due diligence and portfolio analysis before deciding to buy or sell any securities.

Top 21 Water Stocks

American States Water: American States Water (AWR) is a small-cap ($2.6B) water and electric utility based in California. The company serves water and wastewater services to 260,000 customers throughout California and provides electricity to 24,000 customers in San Bernardino County. These two businesses account for 67% and 8% of AWR's revenues, respectively. The other 25% of revenues come from AWR's military water and wastewater operations. American States Water has developed a formidable niche providing water and wastewater services to military bases; currently AWR serves 11 bases in eight states under 50-year contracts with the federal government. These contracts cover some of the largest domestic military bases, including Fort Bragg and Fort Bliss.

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With a net income of $63.9M on revenues of $436.8M, AWR has a profit margin of 14.6%. AWR's growth has come largely from rate increasing and netting new military contracts, but growth has been muted compared to other larger water utilities. However, AWR boasts one of the better balance sheets in the utility world, with a modest $321M in long-term and high grade (A+/AA) debt. AWR's dividend history is also worth noting. The company is a dividend king, as the dividend has been raised for 64 consecutive years, making it the longest current streak of any publicly traded American company.

Shares currently trade at $69.81, resulting in a PE of 40.6, a forward PE of 35.5, and a dividend yield of 1.6%. Over the past 15 years AWR shares have returned 765.8%.

AWR is one of the more uneventful stocks on this list, even compared to the other water utilities. It is conservatively managed and growing at a slow, albeit steady, pace. While I do like AWR as an investment option, I currently find shares significantly overvalued. Clearly, AWR is a well-managed company with an enviable history of delivering shareholder returns. However, I believe it should trade in line with, or even discounted to, its water utility peers. A primary reason for this is AWR's concentration in California. Drought increases the costs of procuring, delivering, and, in some cases, treating water. California has benefited from wet conditions the past several years, but I expect drought to be something AWR will need to increasingly contend with. Additionally, as the recent California wildfires sadly demonstrated, delivering electricity in California comes with substantial risks. I am not suggesting that AWR is neglecting its powerlines, but even well-managed lines could lead to a fire and/or increased maintenance costs. Also, as with the other utilities, interest rate risks, or failure to safely treat and convey water, could also pose a threat to the company. That said, there is a lot I like about AWR, and should the valuation ever come down, I would be eager to purchase shares. For now, I am on the sidelines and think there are more attractive water utilities to invest in.

American Water: American Water (AWK) is the largest water American utility by market cap ($19.3B), customers served (>14M people in 46 states and Ontario, Canada), and revenues and net income ($3.4B and $565M, respectively).

AWK derives ~85% of its revenues from regulated water and wastewater utility operations, while the other ~15% come from its market-based businesses. The market-based businesses provide warranty protection programs to residential and smaller commercial customers, provide water and wastewater services to U.S. military installations (typically 50-year contracts), and water services to E&P firms in the Marcellus and Utica shale regions.

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American Water's profit margin sits at 16%. Since the majority of AWK's revenues are derived from regulated markets, the margin should stay relatively steady over time. During booms, this can make AWK's stock less attractive (a recent example was in 2017, when AWK, along with other regulated utilities, had to return tax cut benefits to their regulated customers). However, during downturns, the regulated nature of AWK's business softens the blow of economic stagnation. If anything, I expect AWK's margins to slowly expand over time. This is largely due to the acquisition-heavy nature of AWK's business model, in which they steadily acquire water and wastewater utilities over time, and benefit from economies of scale. With over 50,000 water utilities in the U.S., there is a long runway for AWK's strategy of growth by acquisition. Through a combination of rate increases and acquisitions, management predicts that between 2019 and 2023 EPS will grow at a CAGR of 7-10%.

While AWK's bolt-on acquisitions have helped the company and its share price grow at a healthy clip, the acquisitions have come at a cost to date - AWK holds $7.6B in debt. Shares currently trade at $106.88, resulting in a PE of 33.2, a forward PE of 29.7, and a dividend yield of 1.9%. Since its IPO in 2008, AWK shares have returned 601.8%.

American Water is one of my favorite companies in the water sector, but I, regrettably, have never bought shares, always due to valuation concerns. Due to its large size, I do think AWK deserves to trade at a premium to the water utility sector, as AWK has the financial power to benefit from the trend of domestic water utility consolidation. Though weighted heavily towards the Northeast (primarily NJ and PA), AWK has good geographic diversity, which I also think warrants a premium. My understanding is that they also are interested in the next iteration of water treatment infrastructure, especially how sensors and artificial intelligence can be leveraged to improve water treatment. I have never had the chance to speak with representatives from smaller domestic water utilities, but I would be surprised if their R&D is as far reaching as American Water's.

This is all to say that I like American Water very much and can say with certainty I should have bought shares in the past. I continue to keep it high on my watch list and hope to have the opportunity to acquire shares sooner rather than later-though a surprise rise in interest rates is about the only way I see this happening (or if something company specific happens). One more conservative way to get exposure to AWK is through CGW. As of today, AWK accounts for over 10% of the fund.

AO Smith: AO Smith is a mid-cap ($9.4B) building materials company. The majority of AOS' sales are derived from water. Their water business can be thought of in two broad segments: water heaters and boilers, and water treatment equipment. AOS only breaks these segments down for North America, where water heaters and boilers had accounted for $2B in revenues, while treatment equipment amounted to $87M -in other words, AOS' North American business is essentially a water heater business. Water treatment has a higher slice of the Rest of World segment, which is a blend of water heaters and the water treatment equipment. Since the data is unavailable, the exact split is tough to gauge, but I have gotten the impression from conference calls and investor presentations that water treatment accounts for the majority of Rest of World sales. It's also worth noting that AOS also sells air purifiers in China.

AOS' North American operations drive the bulk of their profit ($464.1M; ~23% margins). AOS is arguably the leading manufacturer of water heaters and boilers in the United States and Canada. Their water heaters are sold to a variety of residential and commercial buildings, while their boilers are primarily used in large facilities, such as hospitals and schools. AOS manufactures a number of different styles, with recent models emphasizing energy efficiency.

Rest of World ($1.2B revenues) essentially amounts to China (85% of revenues), though India (10% of sales) is growing in importance. The segment's margins are notably lower, but still profitable ($149.3M; ~13.5% margins). China has been a large driver of growth, but growth in this market has recently slowed substantially.

AO Smith's water treatment segment manufactures a range of point-of-entry, point-of-use, and non-installed water purification equipment, including activated carbon filters, ultraviolet disinfection lamps, reverse osmosis membrane systems, and water softeners.

AOS is a dividend aristocrat holding a net cash position of $500M. With shares currently trading at $55.91, the PE is 21.7, the forward PE is 20.7, and the yield is 1.57%. Over the past 15 years AOS shares have returned 1308.6%.

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AO Smith is one of my out of favor picks. Shares have had an incredible run during the current bull market but have pulled back notably from their highs of early 2018. Much of the pullback can be attributed to China. Sales in China, which had been growing robustly, have recently fallen off a cliff, with the Rest of World sales falling 5% in Q4, and FY 18 Rest of World earnings falling by 22%. While some of this can be attributed to currency effects, there is reason to be worried that AOS' exposure to a cooling Chinese real estate market, which up until recently has been a tailwind, could be headed for a downturn. Compounding these issues is the trade spat between the US and China. AO Smith actually manufactures their Chinese products in China, so in a superficial sense the tariff war should have a minimal effect on their Chinese operations. However, I fear something larger may be at play. The Chinese government has a scoring system for their citizens. The factors that contribute to a score are wide ranging, everything from challenging the state on social media, to smoking in non-smoking areas, to spending "frivolously". One of the factors that goes into a score is whether citizens buy products made by Chinese companies versus products made by foreign companies. I admit, my knowledge of China is limited, particularly when it comes to state policy. However, it does appear this could be a factor working against AO Smith's favor, especially if relations between the US and China deteriorate.

AO Smith also faces domestic challenges (or at least perceptions of challenges). AOS' products are commonly used in housing construction and improvement projects. When the housing market booms, so do AOS' sales, as homebuilders build more aggressively and homeowners are more willing to invest in their homes. With housing data showing signs of a slowdown, investors are likely taking a more cautious approach with AOS.

Despite these negatives, I do think there is a lot to like about AO Smith and believe the selloff has made shares more attractive (though I'd suggest targeting a high $40s to low $50s share price). One positive is that much of AOS' domestic construction sales arise from water heaters. In the modern world, water heaters are an essential component of a household and are typically promptly replaced when they stop working. Given the average life of a water heater (8-12 years), AOS appears to be in good position to benefit from a new replacement cycle for homes built during the pre-financial crisis housing boom (2000-2006).

Another reason I am bullish on AOS is their exposure to India. Investors and companies often look to India as the next China. While I think some companies overhype the India potential, AOS appears to be in position to profit handsomely from their India operations, which are AOS' second largest Rest of World market (albeit a very distant second). My reason for bullishness is based on the water infrastructure of India, as well as AOS' niche as a provider of point-of-use treatment systems. Much of India's post-colonial urban growth occurred in a rapid and uncontrolled fashion. As a consequence, many neighborhoods went up without proper water infrastructure. In poorer areas, the government trucks in water. In wealthier areas, homeowners drilled private wells that support individual households or clusters of households. Moreover, for areas that do have municipal water service, it is not uncommon for water to only flow during certain times of the day. When pipes are empty, it makes it easier for pathogens and pollutants to infiltrate through cracks into the pipes, as there is no water pressure to force these pollutants outwards. Compounding this problem is that many private households and businesses use suction pumps to draw water from mains(water is typically stored on site so it will be available 24 hours a day). As a consequence, the mains can actually have negative pressure-meaning pathogens and pollutants can be sucked into the pipes.

This is all to say that there is a systemic, practical need for point-of-use water treatment systems in India. When this is put in the context of India's rapidly growing middle class, AOS' position as a leader in point-of-use water treatment equipment in India should pay substantial dividends in the coming decades.

AO Smith's headwinds are picking up at the moment, and, as a manufacturer of building materials equipment, the company is sensitive to the health of both the US economy and global economy. However, I believe their long-term story is intact and expect shares to outperform the broader market over time. Additionally, management is also very conservative in terms of debt (net cash of $500M) and dividend payout ratio (33%), so the company should be able to weather a downturn without much worries about solvency.

Aqua America: Aqua America (WTR) is a mid-cap ($8.3B) water and gas utility servicing 1 million customers in the eastern and mid-western US with water, and 740 thousand customers in Pennsylvania, West Virginia, and Kentucky with gas. WTR is the second largest publicly traded water utility in the US. Revenues were $838.1M and net income was $192M, for a very healthy 22.9% profit margin. WTR's water revenues largely come from Pennsylvania (53%), Ohio (13%), Texas (9%), Illinois (9%), and North Carolina (6%), with New Jersey, Indiana, and Virginia accounting for the remainder. The natural gas arm of Aqua America is a recent addition, so it is not reflected in FY 18 revenues.

Aqua America is a dividend aristocrat. With shares changing hands at $38.64, WTR has a PE of 35.9, a forward PE of 26, and a dividend yield of 2.3%. Over the past 15 years shares have returned 350.8%. Including their most recent debt sale, WTR has around $3.5B in debt.

Due to the recent acquisition of People's gas, this is an interesting time to assess Aqua America. Despite the transformative acquisition, Aqua America is still first and foremost a water utility (on a pro forma rate base basis, water accounts of 70% of the rate base while gas accounts for 30%). WTR offers water and wastewater services across the eight states it serves. Its traditional business model has been to slowly, but steadily, grow its rate base by acquiring water and wastewater systems from operators who can no longer afford to run systems and meet federal water quality standards (essentially the same model as American Water). With over 50,000 water and wastewater utilities in the US, the industry is ripe for consolidation, and I expect Aqua America (and American Water) to be the primary beneficiaries from this trend, as have more access to financing than their smaller publicly traded peers do.

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The People's acquisition, which shifts Aqua America from a water pure-play into more of a general utility play, got a tepid reaction for the market, at best. The initial reaction was harsh, as WTR, normally a low-beta stock, dropped nearly 15% following the announcement of the $4.3B deal, which is to be funded by debt and a significant share issuance. Shares have since recovered, though I remain, on the whole, skeptical by the deal. First, a few positives. If WTR's management is to be believed, the People's system is need of investment and will drive higher growth rates than WTR's water business. Management also stated the deal may help them grow their water business in Pennsylvania. However, I am wary of the deal. The market gives water utility stocks a premium that I now believe WTR has jeopardized. I am also concerned about the risks associated with gas pipelines-they do not fail often, but when they do, it can be catastrophic. In my opinion, management seems to have simplified the similarities between the water and gas businesses and appears overoptimistic in their ability to integrate People's into Aqua America. As an investor in Aqua America, I hope management is correct, but I am wary of the deal and do not believe it was in the best interest of shareholders.

Nevertheless, I am bullish on Aqua America and decided to give them an honorable mention. They are, along with American Water, in a unique position to benefit from what I view as the inevitable consolidation of water utilities, which has a huge runway in front of it. I'll also say that aside from the People's purchase, I have been impressed with WTR's management, as they appear to be thoughtful and cautious about which water utilities they acquire-and, with relation to the People's purchase, I'll also concede there are much worse things they could have done. Given the cheap and abundant natural gas in America, and its relatively environmentally friendly status, it seems likely to be an important source of energy for years to come, so WTR will see a decent return from the transaction.

A final reason I like WTR as an investment is that they have one of the most investor-friendly stock purchasing plans I'm aware of. Through Computershare, shares in WTR can be bought at no cost, and dividends are reinvested at a 5% discount. To sell shares, it costs $15 plus $0.12 for each share. I recommend investors who would like to invest in Aqua America open a Computershare account (I did so for the sole purpose of investing in WTR). I have a monthly purchase plan set up and occasionally add to my holdings when WTR dips to my buy range.

Despite the purchase of People's, I judge Aqua America as one of the safer stocks on this list. Because of the People's acquisition, I hesitated to distinguish WTR as an honorable mention, but overall I am still bullish on the stock and decided to keep the distinction. When friends ask for investment advice, one my top suggestions is to start an account on Computershare, set up a monthly purchase plan with WTR, and reinvest the dividends - and I suggest readers of this article do the same. I have full confidence that if this is done over several decades, the returns will be handsome, particularly on a risk-adjusted basis.

Badger Meter: Badger Meter (BMI) is a small cap ($1.6B) manufacturer of flow control equipment, namely flow meters. Badger sells its equipment to a number of industries, including automotive, aerospace, chemical, construction, energy, and water. Water accounts for the majority (84%) of revenues, with annual revenues coming in at $433.7M and net income amounting to $27.8M. This results in a profit margin of just 6.4%, though this was negatively impacted by pension costs. FY 2016 and 2017 margins came in around 8.5%, which, while an improvement, still fall on the lower end of the spectrum of the companies featured on this list.

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Badger Meter is a dividend aristocrat, with zero long-term debt. With shares currently trading at $54.88, BMI has a PE of 51.6, a forward PE of 32.5, and a dividend yield of 1.1.%. Over the past 15 years shares have returned 1,138.2%.

Badger Meter, like many of the companies on this list, trades at a premium to the market, though their valuation is expected to come down as earnings catch up in 2019. That said, I struggle to justify the degree of BMI's premium, though I do believe it partly arises from a buyout premium (as an aside, I think a merger between Mueller Water (MWA) and Badger would make a lot of sense). Despite my negative view of BMI's valuation, I decided to include them on the list due to their management, as well as their niche of water metering. To date, most users of water do not pay for water as a good, rather they pay for the treatment and delivery of water to their homes or businesses. An analogy would be filling up your car with gasoline only at the price it costs to extract, refine, and deliver the gasoline to the gas station. As water becomes scarcer, I expect this to change, and companies such as BMI, which manufacture equipment whose purpose is to track movement of water, will benefit from this shift. Regardless, even if treated water is largely delivered at cost to consumers, utilities will increasingly want to ensure high users pay more than low users. Badger Meter is investing in this future with an eye towards the technological shifts that will accompany an increasingly connected world, also known as the internet of things (IoT). Through R&D and acquisitions, Badger Meter has, and continues to, develop meters connected to the internet. The advantages to this are multifaceted for utilities. To name a few, employees won't be required to manually check meters, leaks can be detected more easily, and the vast amounts of data can help utilities better manage and predict changes in demand.

The primary threat I see to Badger Meter is competition, which has been stiffening over the years. This is another reason I think it would be Badger Meter's best interest to eventually merge with, or be acquired by, another company, but for the time being they seem to be doing quite well on their own. I will also mention that some in the medical and scientific community have suggested that radio frequency (which BMI and other smart meter companies use) could be carcinogenic. From what I can gather, this is not the case (this also seems to be the conclusion of the medical community), but I am also not a medical professional. I put this here not because I am particularly worried about this threat to smart meter manufacturers, but because I'd like to give readers the chance to assess the threat of this risk on their own.

Bruker: Bruker (BRKR) is a small cap ($6B) company that manufactures instruments used for the characterization of materials. The instruments Bruker manufactures are complex machines, and the offerings vary. To get a better idea of the machines (largely spectroscopes and microscopes) that the company manufactures, I encourage prospective investors to review Bruker's website.

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Revenue for the past year was $1.9B and net income was $179.7M, resulting in a profit margin of 9.5%. It is worth noting that Bruker routinely reports non-GAAP results. Under non-GAAP standards, for the last fiscal year Bruker earned $1.40 in EPS, compared to GAAP EPS of $1.14; the non-GAAP reporting results in a more respectable profit margin of 16.8%. Bruker's non-GAAP ROIC is quite impressive, having recorded ROICs of 27% over the past three years; moreover, management has been aggressively reinvesting in the company, with ~9% of revenues going into R&D. Management estimates the company will earn $1.56 in EPS in FY 19, on revenue growth of 6-7% (~4% organic). Bruker holds $310M in debt, but with cash of $324M, Bruker is actually slightly net cash positive.

Shares of BRKR currently trading at $38.49, the company has a PE of 33.7, a forward PE of 25.5, and a dividend yield of 0.4%. Over the past 15 years shares have returned 653.8%.

Bruker is one of the least water-focused companies on this list. Nevertheless, it is a leader in materials science instrumentation, which has a number of secular tailwinds, including water treatment equipment (particularly membrane material science). They also make mass spectrometers, which can be used to test water quality. Though I do not own shares in Bruker, I am partial to the company, as I have used some of Bruker's equipment. While it is challenging to use (largely my ineptitude with advanced microscopes), I can attest to the quality of Bruker's instruments and the data they generate. BRKR's valuation is high, and has consistently been so, but they are a quality growth story with a good moat.

Bruker's equipment is expensive, and while they do generate a meaningful portion of sales from consumables (and are investing in making consumables a bigger part of the business), a downturn would hit Bruker's sales as companies pull back on large capital expenditures.

Cantel Medical (note: due to a change in business structure, revenues are TTM from 1/31/18-1/31/19): Cantel Medical is a small cap ($2.8B) manufacturer of medical equipment and services, much of which is centered around infection prevention. Cantel's businesses are broken into three main categories: Medical ($501M in revenues), Life Sciences ($212M), and Dental & Alternative care ($151M). Cantel's Medical category is largely in the business of endoscopy equipment. FY 18 revenues totaled $871.9M, and, with a net income of $91M, profit margins arrive at just over 10%. However, it is worth noting that, as a serial acquirer, CMD often presents results in non-GAAP terms. Under these terms, they reported a net income of $104.3M, resulting in a profit margin of 12%.

CMD's relation to water largely comes through its life science division. The Life Sciences division manufacturers water treatment systems and ultrafiltration membranes. CMD's water treatment equipment is primarily used in dialysis clinics, though they are also employed in food and beverage plants, pharmaceutical laboratories, research laboratories, and general industrial settings. Cantel also manufactures water treatment equipment through its Dental & Alternative Care segment, which treats wastewater from dental procedures.

Shares of CMD currently trade at $67.31, resulting in a PE of 37.8, a forward PE of 28.5, and a dividend yield of 0.3%. Over the past 15 years shares have returned around 1,300%. Cantel has a net debt position of around $100M.

Cantel is another one of my out of favor picks. Shares have corrected nearly 50% from their highs reached in summer of 2018, and though still richly valued, shares trade below their 5-year average PE. The drop in CMD's price and valuation can be attributed to declining fundamentals. After consistently delivering 10%+ revenue growth (sometimes approaching 20%), CMD's top line growth has slowed notably, coming in at mid-single digits over the past couple quarters. Cantel's Medical division has continued to deliver 10%+ growth, but Life Sciences and Dental have struggled, with each actually seeing a modest contraction in sales for the last quarter. Following the most recent quarter's results, Jorgen Hansen, Cantel's former CEO, resigned, and George Fotiades, a longtime board member and former President and COO of Cardinal Health, stepped in as the new CEO. Shares promptly fell 12%, before somewhat rallying, though still sit nearly 10% lower than they did prior to the change in CEO.

By most measures, Cantel's sell-off is justified by a slowdown in fundamentals, with both sales and EPS growth stalling. However, Cantel's valuation has come down substantially since their fundamentals deteriorated, making shares attractive, in my opinion. For one, though Cantel's growth rates have stalled, they are still delivering mid-single digit organic growth. Moreover, I expect growth to pick up sooner rather than later. Medical continues to deliver, and with domestic endoscopy procedures growing organically in a mid to high-single digit range, it should continue to do well. I expect both Life Sciences and Dental to return to organic growth, though the growth will probably be modest, at least in the near term, particularly given the slowdown in dialysis center construction. On the most recent conference call, Cantel's confirmed their guidance for 8-10% organic revenue growth. With a new CEO in place, it will be worth watching whether they stick to this guidance, but I think it is achievable, especially on the lower end.

For Cantel, organic growth is only part of the story, as CMD is highly acquisitive; the company has spent $300M on acquisitions in the past five years and has completed 36 acquisitions since 2000. Given CMD's history of successful acquisitions, high free cash flow, underleveraged balance sheet, and low dividend payout ratio, I expect acquisitions to remain an important growth driver for CMD. While it is challenging to quantify the impact of acquisitions, Morningstar estimates that CMD will spend $500M on acquisitions over the next five years. Investors in CMD should be comfortable with their high rate of acquisitions, in part because the company is highly dependent on endoscopy procedures and dialysis clinics. While these are, on the whole, good businesses to be in, any major disruptions in these industries could significantly harm CMD's top and bottom line-so in some ways, CMD's acquisition-heavy strategy is necessary for the long-term survival of the company. An inherent risk to this business model is that they could to overpay for an acquisition if they become desperate for M&A. It is also worth noting that CMD does have a respectable R&D department, which focuses on generating new offerings that fit into their existing product lines. A good example of this is Cantel's REVOX sterilization technology, which can be used to sterilize medical equipment.

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Another factor weighing on Cantel has been the broad selloff in health care stocks due to talk on the presidential campaign trail to alter the American health care system. As a citizen of the US, I would support a less-expensive, more efficient, and more inclusive health care system, provided it was done in the right way. However, for better or worse, I am skeptical the rhetoric will result in much legislation and believe the recent selloff to be an opportunity to pick up shares of quality companies in the health care space. Additionally, while a change in the healthcare system would have an impact on the entire industry, I am of the opinion that equipment manufacturers such as Cantel would be less targeted than insurance companies, pharmacies, and pharmaceutical companies. So while any development on this front would likely be a negative, I am of the opinion that equipment manufacturers such as Cantel would be less exposed than other names.

An additional healthcare related risk is that Cantel's products must be of high quality and perform up to expectations; should they not, the results could be serious, especially given Cantel's weighting towards infection prevention. I have no reason to believe Cantel or any of the other medical companies in the article produce products of poor quality, but it is a risk to consider.

In terms of general economic health, Cantel strikes me as a company well-positioned to weather an economic downturn. During economic hardship, their focus on medical equipment is actually a positive, as it means many of their products are largely immune to the fortunes of the global economy. Moreover, their focus on consumable products (~75% of sales) means revenues should stay relatively steady during downturns. In an odd way, a recession could actually benefit Cantel, as it would likely allow them to make acquisitions at depressed multiples.

Lastly, it is worth noting that Cantel has significant insider ownership, which sits at 12.2%. Longtime Chairman of the Board and Director Charles Diker holds a very substantial stake (7.2%). Such high insider ownership can be either a good or bad thing; in the case of CMD I view at a positive, as these owners appear to be invested for the long-term and have overseen a period of spectacular growth for CMD.

Danaher: Danaher is a large-cap ($93.7B) conglomerate in the medical, life science, and environmental science fields and is my top individual stock pick for investing in water (and investing in general). For the most recent year, revenues totaled $19.8B and net income was $3.4B for a profit margin of 17.2%. Danaher reports in terms of four segments: Life Sciences ($6.5B in revenue), Diagnostics ($6.3B), Dental ($2.8B), and Environmental & Applied Solutions ($4.3B). Danaher truly is conglomerate, so rather than going through each segment in detail, I will highlight their non-water segments, while going into more detail on their water treatment offerings, which fall largely under Environmental & Applied solutions. However, I recommend prospective investors visit Danaher's webpage to get a better appreciation for their business.

Shares of DHR currently trade at $130.93, resulting in a PE of 38.7, a forward PE of 27.4, and a dividend yield of 0.5%. Over the past 15 years shares have returned 671.8%. Danaher has a net debt position of around $9B, though this is likely to rise to fund its recent purchase of what was General Electric's (GE) biopharma business.

Before diving into Danaher's water treatment products, I'll touch on their other businesses, which fall under the broad categories of medicine, pharmacology, and life science equipment. Danaher's Dental offerings include orthodontic, implant, and restorative products. Their Diagnostic products include hardware and software used in the diagnosis of injuries and diseases. Danaher's Life Sciences products involve hardware and software used to in fundamental scientific and pharmacologic research; products for this sector include microscopes and filtration/separation technologies, which can be quite related to water treatment (DHR's subsidiary Pall, which manufactures membranes, falls under this category). Lastly, Danaher's Applied Solutions provides product identification solutions to businesses.

Environmental Science is where most of Danaher's water treatment solutions are grouped. One such business is ChemTreat, which provides chemicals and suite of ancillary services for a myriad of water qualities, from drinking water, to wastewater, to industrial water. Chemicals have many uses in water treatment, from disinfection, to removal of chemicals, to odor control. Hach is another one of Danaher's subsidiaries. Hach manufactures water quality testing equipment. Hach equipment spans the spectrum of water quality testing, from lab instrumentation to simple field testing equipment. Hach also makes flow meters. Hach offerings can help utilities and industrial companies manage their water to ensure they are meeting government (or internal) water quality standards.

Danaher's flow metering business also includes its McCrometer subsidiary. McCrometer manufactures equipment capable of measuring the flows of a variety of fluids, including water, wastewater, oil, and petroleum. Like Badger Meter, McCrometer offers connected solutions that will become increasingly prevalent as IoT expands to industrial processes. Since I already covered my bullish stance on flow meters in the Badger Meter section, I won't rehash, other than to say this is a growing field, especially as water becomes more scarce.

The final water-focused subsidiary in Danaher's Environmental Science group is Trojan Technologies. Trojan primarily manufactures ultraviolet (UV) disinfection systems. UV is an attractive approach for controlling pathogens and harmful contaminants in water; a primary advantage to UV versus chemical dosing is that UV dosing limits use of chlorine, which can be harmful to the environment, as well as form carcinogenic disinfection byproducts. Trojan also makes select filtration equipment through the Trojan brand, as well as the Salsnes brand.

Before moving on from water, I'll touch on a few of Danaher's water focused arms that fall under their Life Sciences division. The main water treatment component of this arm is Pall. Pall manufactures a variety of fluid separation products, primarily membranes and filters for a broad range of industries. I know that one of Pall's selling points is their ability to provide comprehensive, tailored water treatment solutions to their customers. Many companies/subsidiaries aim to achieve this, and it may come across as corporate speak, but from what I can tell Pall truly does offer expertise in helping customers design treatment systems to meet their needs. Pall also has a heavy presence in laboratory research, offering everything from filters to Petri dishes. Lastly, through their Life Sciences division, Danaher has a good foothold in the research industry. Though research is a broad field, I can say with confidence that Danaher equipment is commonly found in laboratories doing environment science research; Leica and Beckman Coulter highlight two brands that manufacture equipment used in water quality analysis, materials science, and life science.

In my eyes, Danaher is the epitome of how to run a conglomerate and is an ideal company to invest in. They have a nearly unrivaled track record of integrating acquisitions and investing in profitable R&D. While I do think that is a good argument to be made for the moonshot R&D that Google and others practice, there is a fine line between productive R&D and R&D for the sake of R&D. Rather than swing for the fences with moonshot R&D, Danaher focuses on tailored, informed R&D that often results in non-revolutionary, but useful products being quickly brought to market. Danaher's management style is called the "Danaher Business System", or DBS. Danaher uses the keywords "People", "Plan", "Process", and "Performance" to characterize the pillars of DBS; for those interested in learning more I suggest watching this short clip on DBS. DBS sounds like corporate speak, and to a degree it is, but Danaher does truly seem to gain a competitive advantage from their business approach.

Danaher shares have done well this year, rising 27% since January 1 st. A good portion of the gains came after Danaher acquired GE's biopharma group for $21.4B. At 7x sales the acquisition was an expensive one, but it strengthens DHR's position in biosimilars, a rapidly growing niche of the pharmaceutical industry. Given their rise, shares look pretty expensive, though it is worth noting that, due to the spinoff of Danaher's industrial tools business Fortive (FTV), DHR likely deserves a higher multiple than it held in the past. Its business is now more focused on steadily growing, high margin, relatively acyclical industries, meaning it should see steady organic growth and be in good position to weather recessions-especially given that ~70% of revenues are considered recurring revenues, which should remain strong during a downturn. In the medium to long-term, I expect Danaher to generate mid-single digit revenue growth through a combination of organic growth and acquisitions. Shares are pretty fully valued at the moment, so I wouldn't call Danaher a buy, but I certainly wouldn't call it a sell and strongly advocate accumulating shares on dips.

The primary risk for Danaher is that, despite their historical aptitude in acquisitions, they either overpay for or fail to properly integrate an acquisition. Also, like Cantel, Danaher is a medical equipment company, meaning they could be exposed to political winds, as well as litigation should their products ever be defective (though again, I have no reason to believe Danaher, or any other company on this list, produces defective products, so in my opinion this is not a major concern).

Source

Ecolab: Ecolab is a large-cap ($53.3B) specialty chemicals company. Though Danaher is my top pick from this list, Ecolab was a close runner up. Revenues for Ecolab totaled $14.7B and generated $1.4B in net income for a 9.5% profit margin.

Ecolab's businesses center around food, water, and energy. Much of Ecolab's food business revolves around sanitation in the hospitality and restaurant business, which they categorize under Global Institutional. The sanitation component of Ecolab's business is their legacy business. It produces robust, predictable cash flows due to razor/razor blade model of business for many of their sanitation offerings. ECL's water treatment businesses fall under the Global Industrial and Global Energy segments. Ecolab's offerings vary widely, as the chemical uses and controls in water treatment are vast (in some ways Ecolab is like a scaled up version of Danaher's ChemTreat subsidiary). Ecolab's water products are primarily sold under the NALCO brand, and can be used to clean, purify, and control other parameters so the quality of water meets the required need, from ultrapure water in electronics manufacturing, to preventing contamination of equipment used in food processing, to reducing pollution in wastewater generated from oil extraction and refining. Though Ecolab is a chemicals company, NALCO also sells advanced filtration solutions, such as small-scale RO systems.

Ecolab's business derives the majority of its sales from North America (58%), though it has a large and growing presence in foreign markets. While EPS has steadily grown, net income and sales have been approximately flat over the past five years, as the downswing in oil prices hurt Ecolab due to their exposure to the energy industry. In about a year, Ecolab is planning on spinning off its upstream energy business, which should reduce earnings volatility.

Source: From 10-K

Ecolab is a dividend aristocrat, having grown the dividend for 33 straight years. With shares currently trading at $184.89, ECL has a PE of 35.4, a forward PE of 31.3, and a dividend yield of 1%. Over the past 15 years shares have returned 653.5%. ECL also holds a manageable $7B in long-term debt.

Ecolab stands out to me as a particularly compelling stock to own due to its predictable and steady growth in industries I am broadly bullish on: water, food, and energy. ECL's performance during the Great Recession gives confidence they can weather even severe economics downturns: EPS grew 12%, 7%, and 12% in 2008, 2009, and 2010, respectively. Overall, I expect Ecolab to continue to churn out top and bottom line growth, both through organic endeavors and acquisitions, all the while steadily returning excess money to shareholders via dividends and buybacks. My main hesitation with ECL at the moment is valuation-it is trading at an even larger premium to the market than usual. However, while it always seems to trade at some sort of premium, ECL does go on sale from time to time. When it does, I'd recommend picking up some shares, as it rarely stays down for long.

I don't have much more to add on Ecolab, as its businesses and business models are fairly straightforward. In addition to its high share price, I'd highlight oil and gas prices as another threat, as well as regulation - a recent acquisition of ECL is under scrutiny in England due to Ecolab's dominant position in the hospitality/food sanitation industry. Another potential threat is a general desire by the water treatment industry to move away from chemical use. Therefore, disruptive technologies could hurt ECL's fundamental expertise in chemicals, but as of now this is a hypothetical threat. A final threat worth considering is that chemical production can produce pollutants that, if not properly handled and disposed of, can harm the environment and lead to fines. To the best of my knowledge Ecolab's facilities are safe, so there is no reason to be overly concerned about this potential, though it does exist.

Idexx Laboratories: Idexx (IDXX) is a mid-cap ($20B) manufacturer of medical and water treatment products that are primarily used in animal healthcare diagnostics. Sales totaled $2.2B and generated $377 in net income for a profit margin of 15.3%.

Idexx breaks their business into three segments: Companion Animal Group ($1.9B in sales), Water ($125M), and Livestock, Poultry, and Dairy ($131M). While Livestock, Poultry, and Dairy was essentially flat for the year, Companion Animal Group and Water showed robust organic growth, which came in at 12.8% and 9.3%, respectively.

Idexx's water products are primarily used to detect microorganisms in water. These tests are commonly done by utilities to ensure that water is being treated to safe level that meets federally mandated drinking water quality standards. Idexx also offers chlorine detectors, which can be used to measure chlorine levels. Chlorine is a vital component to many water treatment systems as a disinfection tool. Yet too much chlorine can cause taste and odor issues, as well as react with organics to form carcinogens. Therefore, maintaining the right amount of chlorine in treatment and distribution systems is of high importance.

IDXX does not pay a dividend. With shares currently trading at $232.47, IDXX has a PE of 54.2 and forward PE of 49.2. Over the past 15 years shares have risen 1,433.4%. IDXX holds $800M in debt, a modest amount for a company of their size and profitability.

Really my only knock against Idexx at the moment is their valuation-the stock is priced for near perfection. However, I really like their focus on animal health, especially pet care. Pet care is a surprisingly lucrative business to be in, as most costs are out of pocket and many owners think of their pets as family members. With more and more Americans owning pets and treating them to an increasingly high quality of life, it is reasonable to expect that Idexx's core pet business will have a long runway for organic growth. Idexx has also done extraordinarily well to build their business around consumables and reoccurring revenues, which account for nearly 90% of their sales. They also appear to be in good position to maintain their position as a leader in animal healthcare diagnostics, as they retain nearly 100% of their customers and invest an industry leading amount of R&D into their diagnostics operations.

While their water business is a pretty small slice of their revenue (~5%), I think it is a good niche to be in, as testing for microbes will always remain an important component of drinking water treatment (as well as other relevant industries, such healthcare and food and beverage); moreover, the business is highly reliant on consumables, so it should be relatively immune to swings in the economy.

Given Idexx's products test for pathogens in drinking water, any failure in the company's products to perform well could lead to a loss of confidence from utilities. Microbiological testing is also a somewhat expensive and time-consuming process, so should a competitor emerge with a novel and superior way of testing water, it would put Idexx at a disadvantage-though given they are primarily an animal health company, this would not be a knockout punch. Another potential threat would be if pets become less popular, but I would be quite surprised if this happened.

Source

IDEX: IDEX (IEX) is a mid-cap ($11.9B) machinery company that operates under three segments: Fluid & Metering Technologies, Health & Science Technologies, and Fire & Safety/Diversified Products. Revenues totaled $2.5B and net income amounted to $410.5M, resulting in a healthy profit margin of 16.4%. Revenues are diversified by most measures, as half of sales are generated domestically, while the other half are generated internationally. IDEX's multifaceted business segments make it a mini-conglomerate of sorts, with Industrial (27% of sales), Fire and Safety (16%), and Life Sciences (13%) accounting for the top segments. IDEX's Water segment accounts for only 7% of sales, though many of IDEX's Life Science products are related to water too (or at least fluids), so it's not unreasonable to think of the Life Science segment as a derivative of the Water segment (with Water related to more municipal/infrastructure projects, and Life Science connected to scientific industries). IDEX's water technologies are related to flow management and measurement, with the company manufacturing pumps and metering equipment.

Source

With shares currently trading at $156.59, IEX has a PE of 29, a forward PE of 27.1, and a dividend yield of 1.1%. Over the past 15 years shares have risen 834.6%. IDEX holds a minimal amount of debt ($365M).

IEX is an interesting company offering an array of high-value products to a variety of growing industries, which IDEX deems "mission critical" components. While shares currently trade too richly for my liking, they are certainly on my watch list. I like IEX's model of consistently executing bolt-on acquisitions. While it can be risky to have such a diverse spread of businesses, IEX has a hands-off approach, where they let managers run their businesses. In turn, IEX's different segments benefit from their parent company's sales prowess and economies of scale.

The largest risk I see to IDEX is that they are tied to the health of the global economy. When times are good, IDEX should see robust growth, but when recessions or slowdowns occur, the company is likely to feel a greater impact than more conservative investments.

Limoneira: Limoneira (LMNR) is a microcap ($407.4M) agricultural company based in Santa Clara, California, with orchards in California, Arizona, Chile, and Argentina, and packing houses in California (full ownership) and Chile (partial ownership). Limoneira's main product is, perhaps predictably, lemons, which accounted for 80% of the company's revenues, while avocados and oranges account for a mid to high single digit percentage. Specialty crops (pistachios, wine grapes, and specialty citrus) and rental operations account for the remainder. Total revenues were $129.4M and net income was $20.2M, for a profit margin of 15.6%--though this was an abnormally high value due to tax gains; fiscal year 2017 and 2016 margins were 5.4% and 8.2%, respectively (it is common for margins to vary from year to year due to changes in crop yields and fruit pricing). The vast majority of Limoneira's sales are domestic (97%), though 16% of Limoneira's sales went to domestic exporters.

LMNR shares currently trade at $22.92, with the PE at 52.7, the forward PE at 29.2, and the yield is 1.3%. Since its IPO in 2010, shares have returned around 25%. The company holds $80.1M in debt.

In some ways, Limoneira sticks out like a sore thumb on this list. Shares are flat since their IPO-and that comes in the face of IPOing near the start of one the most prolific bull markets of all time. Moreover, their profit margin typically sits in the mid-single digits, hardly an inspiring profit level.

So why am I bullish on LMNR? For one, I like their agricultural business. Lemons, avocados, oranges, tree nuts, and wine grapes are all high-value crops, and I expect demand for these products to increase over time. Moreover, LMNR has 1,200 acres of citrus groves that will become fruit-bearing within the next several years and plans to plant another 500 acres of lemons in the near-term.

Limoneira is also in the business of real estate. Thus far this has traditionally amounted to minimal revenue and profitability; in fact, much of its rental housing is for workers, with Limoneira's management stating that the real value in their ability to use their rental units to retain workers. However, Limoneira is on the cusp of realizing significant cash flows from a land development project that has been around a decade in the making: the Harvest at Limoneira. Harvest is a 550-acre plot in Santa Paula, CA that Limoneira is developing into ~1,500 residential units. Lennar (LEN) and KB Home (KBH) are initial partners. In total, LMNR expects to earn $100M in cash flows from Harvest, $20M of which has already been received.

The Harvest real estate project segues nicely to the reason I found Limoneira in the first place: water. As a 125-year-old agricultural company based in California, Limoneira owns valuable land and water rights, primarily in California, though they also have acreage and water rights at their orchards in Arizona, Chile, and Argentina. Their properties are held on the books for their purchase price, many of which were purchased decades ago, and some of which were purchased over a century ago. Because of this, Limoneira appears to trade at a substantial premium to book value; however, by my rough calculations Limoneira trades at a discount to book value.

Source: 10-K; note: does not include recent business venture in Argentina, which netted Limoneira 1,200 acres of lemon groves and a commitment to buy another 1,200 acres over the next 3 years.

Water rights in California are extraordinary valuable, and I have to imagine they will only increase in value as time goes on. Limoneira's rights, which amount to approximately $28K/acre-foot and are largely concentrated in California (combination of aquifer and river rights), have been trading for around $20K/acre-foot. These rights may be even more valuable in and around Santa Paula, where, in 2016, the city council passed an ordinance requiring developers to purchase water rights at a price of $26K/acre-foot.

Limoneira does face a host of risks, some of which are unique to agricultural companies and could lead to devastating consequences; a few are: drought, disease, wildfires, earthquakes, restrictive labor/migration legislation, and restrictive trade policies. For those interested in a somewhat dated, but in-depth analysis of Limoneira, you may enjoy an article on Limoneira I wrote a couple of years ago.

I find Limoneira to be one of the most undervalued stocks in the market and believe their land and water rights, Harvest development, and growing agricultural business puts shares in a good position to outperform the broader market if given enough time.

Lockheed Martin: Lockheed Martin (LMT), a large-cap ($92.8B) defense contractor, may be the most recognizable name on this list, while simultaneously being the most perplexing. Lockheed Martin is of course known as a leading manufacturer of a broad spectrum of aerospace, maritime, missile, and cyber defense products. Lockheed breaks these segments into four categories: Aeronautics, Missiles and Fire Control (MFC), Rotary and Mission Systems (RMS), and Space. Sales and net income totaled $53.7B and $5B, respectively, amounting to a profit margin of 9.3%.

LMT shares currently trade at $328.33, the PE is 16.9, the forward PE is 16.2, and the yield is 2.7%. Over the past 15 years LMT shares have returned 959.3%, and LMT has a net debt position of $13.4B.

While Lockheed is, undoubtedly, a defense company, they also can be considered an engineering firm. More recently, Lockheed Martin has begun branching out into other industries in a bid to leverage their experience in engineering and materials science to make breakthroughs with disruptive technologies-in some respects, it mirrors Google's (GOOG) moonshot strategy. LMT's most known "moonshot" project is their endeavor to bring nuclear fusion to life.

Another such project is Lockheed's graphene, or "Perforene", membranes. The benefit of these membranes is that they are exceedingly thin, making them more energy efficient than more traditional membranes. The real potential for these graphene membranes is to apply them to desalinate water. While micro and ultrafiltration membranes rely on a sieve-like mechanism (think of a pasta strainer that allows water to pass but filters out the pasta), current desalination membranes rely on the diffusion of water. Without getting bogged down by specifics, diffusion is a much more energy intensive way of treating water than sieve-like membranes. The problem with desalination is that salt particles are so small that no sieve-like membranes are capable of efficiently rejecting salts. However, graphene has shown promise as a way to potentially create a sieve-like membrane with pores small enough to reject salts but allow for the passage of water, and thus to be employed as an energy efficient membrane for desalinating water. Based on what I've seen on Lockheed's membrane page, they would need to reduce the pore size by a factor of 10 (from ~50 nm to ~5 nm). There are technical challenges to doing this, but should Lockheed succeed, it would truly shift the paradigm of membrane desalination. Not only would this likely provide a massive boost to LMT's revenues, but it would also likely bring fresh, clean water to water-stressed regions around the world.

Source

One risk to LMT is if their F-35 program does not perform as expected. I am far from qualified to judge the combat readiness of a fighter jet, but it does appear there are some questions around the F-35's performance. Another possible concern would be if military budgets come under pressure. While this is always a concern during election cycles, it appears likely to me the defense industry will be in good shape, at least for the intermediate term. Things can certainly change but the way I look at it is that Republicans, even President Trump, who has challenged military budgets in the past, tend to be a positive for the defense industry. Democrats have, by in large, actually been a positive for defense contractors as well (hence the sector's great performance, they seem to make money no matter which party is in control). I will admit that some of the candidates on the Democratic side would be a negative for the industry. However, Joe Biden appears to be the front runner, with Bernie Sanders and Pete Buttigieg as dark horse candidates. While I would label Sanders as a negative for the industry, I would categorize Biden and Buttigieg as positives. Things can certainly change-I never thought President Trump would become president-but it does seem reasonable that a defense-friendly President will remain in office for the foreseeable future. The Senate and House are much tougher to predict so I won't venture guesses, but overall I am cautiously optimistic that the defense cycle still has longer to run than many believe-and this all comes on the backdrop of what I view as an increasingly capable and confident group of military rivals, including China, Russia, Iran, and North Korea.

Roper Technologies: As mentioned, Roper (ROP), a large-cap conglomerate ($36.5B), is a runner up to Danaher as a top choice from this list. Revenues were $5.2B (71% domestic, 29% international) and net income was $944.4M, for a robust profit margin of 18.2%. Roper is about as diversified of a conglomerate as exists, with the following business segments: Radio Frequency (RF) Technology (42% of sales), Medical and Scientific Imaging (29%), Industrial Technology (17%), and Energy Systems & Controls (12%).

Roper is a dividend aristocrat. With shares currently trading at $352.48, ROP has a PE of 33.9, a forward PE of 27.8, and a dividend yield of 0.5%. Over the past 15 years shares have returned 1,476.9%. Roper holds $4.9B in debt, a sizable amount, but manageable for a company of their size and profitability.

Source: 10-K

Roper's water products fall under their Industry Technology segment and, to some degree, the RF Technology segment. The Industrial Technology segment produces pumps and meters (as well as materials analysis equipment), while the RF Technology segment offers products in metering and remote monitoring (among other offerings). Roper is a leader in the smart meter market and, like Badger Meter and several other companies on this list, is in good position to benefit from more intelligent water infrastructure. I won't reiterate my reasons for being bullish here as I already touched on these under the Badger Meter section, but needless to say, I think the market has a long runway for growth.

Due to Roper's acquisition-heavy business model, their other market segments are quite unrelated to water. In addition to their metering products, the RF Technology segment sells software, software-as-a-service, card systems/electronic security, toll and traffic systems, and RFID card reading solutions. These are growing, high margin businesses, and in recent years Roper has seemed to target bolt-on acquisitions that fit into this segment. Roper has also favored acquisitions in its Medical and Scientific Imaging arm, which is focused on medical hardware (primarily imaging) that is paired with software. This is also a growing field. Roper's Energy Systems & Controls, which is their smallest segment, is actually the legacy business of Roper. It isn't especially high margin, but it is profitable. The business manufactures control systems, fluid management systems, and instruments used in inspection and measurement at industrial sites. Given the broad range of products offered, I recommend prospective investors visit Roper's website to get a better idea of their businesses.

Roper is a company that I sadly do not own shares in (a couple buy orders came so close to being triggered!), but that I admire. They, like Danaher, have mastered the art of bolt-on acquisitions. This can be a dangerous game to play, but Roper's track record is admirable, and from an investor's standpoint, I expect them to continue to grow by a combination of acquisitions and organic growth.

Despite my confidence in Roper's ability to grow by acquisition, the risk of overpaying for a company, or failing to properly integrate a company, is inherent to Roper's business model. Additionally, I have heard (but not experienced first-hand) that Roper can be overzealous when it comes to cutting costs, at times jeopardizing the quality (or at least perceived quality) of the products made by Roper's subsidiaries. I hesitate to put this in my analysis because I do not have first-hand experience with this, but it is worth considering from an investment standpoint-even the most well-intentioned cost cuts can come at a, well, cost.

Nevertheless, I think Roper is a very well-run company and an even better one to invest in. It remains extremely high on my watch list, and I hope to initiate a position sooner rather than later-but at its current valuation, I remain on the sidelines.

San Jose Water: San Jose Water (SJW) is a small-cap ($1.7B) water utility based in San Jose, California. Revenue was $397.7M, while net income came to $38.8M, for a profit margin of 9.8%. Nearly all of SJW's revenues come from water (~99%), though it is worth noting that SJW has a modest land business, which owns a small amount of real estate in California and Tennessee. In terms of SJW's water business, over 90% of income is derived from California (Santa Clara county), while around 10% is from Texas (outside of Austin). These two regions are among the most prosperous in the US; SJW's service area in Santa Clara hits on some of the most affluent cities in the US, including San Jose, Cupertino, Saratoga, Monte Sereno, and Los Gatos.

San Jose Water is a dividend king, having raised the dividend for 51 consecutive years. With shares currently trading at $60.47, SJW has a PE of 30.6, a forward PE of 29.1, and a dividend yield of 2%. Over the past 15 years shares have returned 384.2%. SJW holds $431.4M in debt.

There is a large potential catalyst on San Jose Water's horizon: a merger with Connecticut Water Services (CTWS), a publicly traded water utility with operations in Connecticut and Maine. The deal, which was initially announced over a year ago, has been rife with drama and twists and turns: a competing bid from Eversource Energy (ES) for CTWS, followed by a bid for SJW from California Water Service Group (CWT). Both SJW and CTWS have, to date, fought off the unsolicited advances and labored to see the merger to completion (the current offer is $70/share of CTWS). However, the Connecticut Public Utilities Regulatory Authority has resisted the link up. SJW and CTWS had to withdraw their original application for regulatory approval; they recently resubmitted an amended merger application in early April.

I was initially skeptical about the deal between SJW and CTWS, but after spending time studying the merger, I have come to the conclusion that SJW would emerge a stronger and better company should the deal come to fruition. It will buffer SJW's exposure to certain risks (especially drought and earthquakes), while also boosting SJW's scale, which should give them more leverage over suppliers, the ability to expand margins by streamlining redundancies across the two organizations, and more financial flexibility to execute future M&A in the water utilities space, which is ripe for further consolidation.

Source

I like SJW as an investment and think it is currently trading around fair value. That said, due to the merger risk, SJW is somewhat of a less safe investment at the moment, especially for a water utility, though I believe this risk is justified by the potential payoff. A few merger specific risks include: the price paid for CTWS, further regulatory scrutiny resulting in no merger or a merger at unfavorable terms, and the fact that SJW already did a large share sale to raise funds for the deal. Several non-merger related risks include water quality problems, as well as natural disasters, such as earthquakes or droughts. In terms of droughts, SJW is somewhat buffered by their own water rights and sources, though they typically purchase around 50% of their water volumes from other sources, so droughts are a legitimate concern. Droughts also increase operational costs, as pumping and treatment expenses typically rise.

I'd say SJW shares are trading at the upper range of its fair value, which, for a water utility is a rarity. For those looking to put in money into a water utility, SJW is one of the few I think is worth a close look at current prices.

Texas Pacific Land Trust: Texas Pacific Land Trust (TPL) is a mid-cap ($6.5B) real estate and energy company based in Texas. Revenues ($300.2M) generated a net income of $209.7M for an eye-catching profit margin of 70%. The vast majority of TPL's top and bottom line come from energy.

With shares currently trading at $843.55, TPL has a PE of 31.3 and a dividend yield of 0.2%. Over the past 15 years shares have returned 6,729.6%. TPL has no debt and a net cash position of around $200M.

TPL is perhaps the most unique stock I have ever come across. Founded in 1888 out of the bankruptcy of the Texas and Pacific Railway, TPL is a self-liquidating trust, meaning it sells off the land that the railroad owns and uses the proceeds to buy back shares. However, with the recent shale revolution, TPL found itself in an advantageous position, as it still owns ~900,000 acres in Texas, much of it in the Permian Basin. TPL has seen its top and bottom line skyrocket higher due to royalties from oil and gas wells drilled on their property, as well as from easement rights, as pipeline operators build out takeaway infrastructure in West Texas.

As a part of this drilling activity on their land, TPL has also started a water business, both sourcing water for fracking and disposing of produced water (around 4 barrels of produced water are extracted per barrel of oil). Water is expensive to transport, especially without pipelines, so TPL's water business has the potential to add yet another catalyst to their top and bottom line, as their land holdings put them in prime position to continue sourcing and treating water. TPL has also invested in water recycling, and has indicated this will be a focus moving forward, as this would allow TPL to potentially make money three times with the same customer by a) providing frack water, b) treating produced water, and then c) reselling the recycled produced water for further fracking.

Source

A top risk to TPL is a drop in energy prices and drilling activity in West Texas, though the company did weather the recent downturn well. Another risk is corporate governance. The company is run by three trustees. While the stock has performed exceptionally well under their watch, they are not held to the same governance standards that leaders of most corporations are held to, and some investors are arguing that the performance of TPL is not due to exceptional management, but to the exceptionally fortunate land holdings the trust happens to own in West Texas. A battle is currently being waged between the board and an activist investor, Horizon Kinetics, which owns 23% of TPL and would like to nominate an outsider to the board. The drama is continuing to unfold and will not be settled until May 22nd, when shareholders will vote on the open board seat.

Anyone who has invested heavily in TPL has done exceedingly well for themselves, however, given the unconventional nature of the company, I view it more as a stock to hold as an ancillary position rather than a core one. With shares touching all-time highs, I wouldn't call it a buy now, but should oil prices fall and pull TPL down within them, I'd look to add to my position and suggest other investors consider doing the same.

Thermo Fisher Scientific: Thermo Fisher (TMO) is a large-cap manufacturer of life-sciences equipment. It generated $24.4B in revenue and earned $2.9B in net income, leading to a profit margin of 11.9%. Thermo Fisher breaks down their business segments in four categories: Laboratory Products and Services (40% of sales), Life Sciences Solutions (25%), Analytical Instruments (22%), and Specialty Diagnostics (15%).

With shares currently trading at $273.22, TMO has a PE of 34.9, a forward PE of 22.4, and a dividend yield of 0.3%. Over the past 15 years shares have returned 874.9%. TMO has used debt to fuel its impressive growth and currently holds $19B in debt on its balance sheet.

In the life sciences industry Thermo Fisher is the clear heavyweight, with meaningful positions in just about every aspect of life science equipment and solutions. In some respects, TMO can be thought of as a combination of three companies on this list: Danaher, Bruker, and Waters. I don't want to bore readers with a laundry list of all the products and services TMO offers, so I'll leave a link here to TMO's webpage, which I suggest prospective investors visit to get a better feel for Thermo Fisher's business lines.

Speaking from personal experience, Thermo Fisher equipment is throughout the lab I work in, and I think it would be a challenge to find a modern life science lab without a notable amount of TMO products. The ubiquity of Thermo equipment in labs is largely due to Thermo Fisher's aggressive debt-fueled acquisition strategy, which they appear to have executed quite successfully, as the top and bottom line have grown nicely without stressing the company's finances.

Source: 10-K

TMO's relation to water comes through their analytical chemistry equipment, which is used to test water quality. In a looser way, their general lab equipment can also be related to water, as their products are used in environmental research conducted by both the private and public sectors.

I don't see many chinks in TMO's armor other than generic risks such as the health of the economy or deterioration in quality of TMO's products, though their debt is worth keeping an eye on. However, from what I can tell, their debt seems manageable, provided they don't continue to increase leverage.

Overall, TMO is one of my favorite growth stocks and is near the top of my list of companies I'd like to initiate a position in.

3M: 3M (MMM) is, along with Lockheed Martin, probably the most recognizable stock on this list. MMM is an industrial giant, with a market cap of $110.4B. Sales totaled $32.8B and net income was $5.3B, leading to an impressive 16.3% profit margin. 3M breaks their revenues into 4 categories: Safety & Industrial (36% of sales), Transportation & Electronics (30%), Health Care (21%), and Consumer (15%). These are all attractive end markets, and 3M expects to achieve low to mid-single digit organic currency constant growth in the intermediate term-though 3M did recently miss badly on earnings and essentially called for flat revenue in FY 2019. 3M is a true international powerhouse, with 39% of sales coming domestically and 61% coming from abroad.

3M's connection to water comes through the membranes and filters they manufacture and sell, which are used in the healthcare and pharmaceutical industries, as well as laboratory work-though 3M's water sales are a tiny fraction of their overall revenues.

Source

3M is a dividend king, having raised their dividend for 61 consecutive years. The company holds $13.4B in long-term debt. With shares currently trading at $191.67, MMM has a PE of 20.5, a forward PE of 19.4, and a dividend yield of 3%. Over the past 15 years, shares have returned 221.8%.

When weighing performance and consistency, 3M is tough to beat. They have an enviable track record in terms of management and product performance. As an industrial company, 3M is certainly exposed to economic risks, but their financial power and diverse business lines mean they should be able to weather an economic slowdown. This said, 3M did just miss badly on earnings. Whether these issues are indicative of a broader slowdown or are unique to 3M remains to be seen (though both scenarios would be bearish, at least in the near-term). It is also worth noting that Stephen Tusa, the analyst who called GE's massive meltdown, has come out as a bear against 3M. Another potential headwind is lawsuits, as 3M's industrial operations led to a number of polluted sites, including, ironically, aquifers. I personally still believe 3M to be a stock worth investing in, particularly if the share price falls the mid $100s, which may have seemed a pipe dream not long ago, but now appears to be a possibility. Overall I consider 3M a safe vehicle to steadily compound investment money over time, and a worthy core holding in just about any stock portfolio.

The Toro Company: Toro (TTC) is a mid-cap ($7.8B) firm that manufactures turf and land management equipment. Sales came in at $2.6B, which drove net income of $271.9M for a profit margin of 10.5%. Three quarters of Toro's revenues were domestic, while one quarter came from abroad.

With shares changing hands at $73.12, TTC has a PE of 25.7, a forward PE of 24.5, and a dividend yield of 1.2%. Over the past 15 years shares have returned 1,100.5%. TTC has $312.5M in debt, a manageable amount for a company of their size and profitability.

Toro is best known for their lawn care products, especially their namesake Toro lawnmowers. That said, Toro owns a variety of brands that can be used in lawn care and modest construction projects, ranging from lawnmowers, to small excavators, to snow blowers. For a more detailed view of what Toro sells, I again suggest prospective investors visit the company site.

Around 16% of Toro's sales come from irrigation systems. Some of these are turf irrigation systems (think sprinklers), while others are drip irrigation systems. I am particularly intrigued by Toro's drip irrigation products, which deliver water to crops and plants more efficiently than any other irrigation product. Though they only account for ~5% of Toro's sales, I see great growth potential for these products as water becomes more scarce and high-value non-traditional farming practices, such as urban farming and warehouse marijuana grow operations, become more common. While I am less bullish on their turf irrigation products, I do still like the business, as Toro's irrigation systems appear to be well-regarded and commonly used by professional operations, such as athletic fields and golf courses.

Aside from their water products, Toro is simply a well-managed company. Their returns on invested capital and equity are impressively high, and management does well to balance growth with conservative management of the balance sheet and returns to shareholders. Even though it is a water stock of sorts, Toro is unlikely to ever generate much excitement in the investment community. That said, I expect them to continue to deliver steady growth for the foreseeable future.

Source

Toro is dependent on the health of the housing market, and like many companies on this list, the health of the greater economy, so downturns are prone to have an outsized impact on their products. Also, a move away from lawns, whether it is because of water restrictions or migration from the suburbs to cities, could also prove to be a long-term headwind. For a more detailed look into Toro, readers may find an article I wrote last summer useful.

Waters: Waters (WAT) is a mid-cap ($15.2B) manufacturer of life science tools and analytical equipment. Their primary products are liquid chromatography (analysis of liquid mixtures) and mass spectrometry (chemical analysis) equipment; this equipment falls under the Waters brand. They also sell other equipment used in thermal analysis (measuring impact of temperature on materials), rheometry (measuring impact of forces on materials), and calorimetry (for measuring heat transfer); this equipment falls under the TA Instruments brand. Total sales for the company were $2.4B and net income was $593.8M, for an impressive 24.7% profit margin.

As of writing, shares are trading for $214.23, leading to a PE of 28.3 and a forward PE of 23.3. WAT does not pay a dividend. Over the past 15 years shares have risen 414.7 %. WAT has a net cash position of $100M.

Waters is a well-run company that makes high-quality, expensive products used in a variety of growing industries. They also have a high installed base, meaning they can rely on consumables to deliver steady sales (consumables accounted for 17% of revenues). Most of Waters' customers (~2/3) are in the medical field. Waters' connection to water (aside from their name) comes primarily through the Food & Environment sales, which include products used to test water quality. As with some of the other scientific instrument manufacturers on this list, Waters' focus on materials science and life sciences also puts them in a position to tangentially benefit from water due to lab work and research in the field.

Waters drives ~2/3 of their sales from abroad, which can be a good thing, but currently, with the US appearing to fare better than the global economy, it could become a headwind. Waters recently missed badly on quarterly results and lowered the outlook for the year. Should the global economy continue to weaken, it would likely hit Waters harder than some of their peers. Another risk to Waters is that Thermo Fisher, a company nearly 10x larger by EV, is a direct competitor. Waters has fared extremely well on its own, but it can expect TMO to remain a formidable challenger. I have a faith Waters will continue to deliver innovative and high-quality products, but it is worth considering that TMO, as a much larger company, may be able to steal market share from the smaller WAT. Relatedly, I actually wouldn't be surprised to see Danaher one day make a bid for Waters, which, in my eyes could be mutually beneficial under the right circumstances.

Source

Overall, I like Waters a great deal. Up until their earnings miss, shares were trading in the mid $200 range and at a rich valuation, in part due to M&A hopes. Following their guidance, shares are now in the low $200s. I wouldn't say they are back in the buy zone, but they are closer than many companies on this list; I'd say ~$180 is a reasonable price to target entry (~20x forward EPS).

Xylem: Last, but certainly not least, is Xylem. In fact, I am very bullish on Xylem, hence its inclusion as an honorable mention stock. Xylem is a mid-cap ($14.9B) manufacturer of water treatment equipment and is essentially a pure-play manufacturer of water treatment equipment. Revenues totaled $5.2B, resulting in net income of $549M (10.6% operating margin). Xylem breaks their sales into four segments: Utilities (50% of sales), Industrial (35%), Commercial (10%), and Residential (5%).

With shares currently trading at $83.11, XYL has a PE of 27, a forward PE of 25.2, and a dividend yield of 1.2%. Since it was spun off in 2011, shares have returned 282.1%. XYL has a net debt position of $2B on its balance sheet, a meaningful but manageable amount given their size and profitability. It is worth noting that while management has shown a willingness to use debt to fund acquisitions, they have also shown a commitment to paying down debt, often suspending share repurchases until debt levels have come down.

Source

Xylem is one of my favorite stocks on this list because it has a leading position in many of the most rapidly growing components of water and wastewater treatment and distribution, and it has developed this position in a deliberate and profitable way. Xylem's products touch on essentially every part of water and wastewater treatment, from pumps to membrane systems, to smart flow meters. To get an idea of the different products Xylem manufactures and sells, prospective investors should visit the Xylem website.

I see Xylem's wide range of offerings giving the company three distinct advantages over other equipment manufacturers. One is that Xylem can provide comprehensive, turnkey solutions to utilities. As water treatment and distribution systems become connected to the internet, Xylem's comprehensive offerings could evolve into a technological moat of sorts, as equipment could be designed to work together - for example, a flow meter could feed back to a pump to govern pumping rates. Undoubtedly, some of this will (and can) be achieved with parts from different manufacturers, but it isn't difficult for me to imagine ways that Xylem could develop an integrated network that simplifies this sort of communication between machines.

Another area of importance that Xylem excels in is exploitation of non-traditional water sources, which largely amounts to water reuse and desalination. As freshwater sources continue to, sadly, be overexploited and polluted, utilities are increasingly turning to wastewater and seawater as sources for water. Xylem manufactures all sorts of equipment that is used in treatment of non-traditional water sources, so I expect them to benefit from a long runway of sales growth as these sources become an increasingly important portion of utilities' water resource portfolio.

Lastly, I like Xylem's focus on industrial customers, which account for ~35% of Xylem's sales. While utilities often have stable, slowly growing budgets, commercial firms often have more volatile, but faster growing budgets. This is because companies are not beholden to tax revenue allocations made by politicians, but rather how management sees money best spent. Firms are increasingly aware of their water footprints, whether it be for image or because water is vital to a company's operations (semiconductor and beverage manufacturing are but two examples). Because of this, many companies are investing heavily in water reuse, and I expect this investment to continue to grow, perhaps at a rate notably higher than municipal spending on water infrastructure.

The main risks to Xylem that I see are pretty generic: a downturn in the global economy, or a failure in to produce high-quality equipment would pose problems. However, from what I can gather, Xylem is the undisputed leader in water equipment, and I expect them to maintain, or even grow, their leading position over the years. Right now I wouldn't call shares a bargain, but they aren't trading at an outrageous level either. I like Xylem better should it pull back to the low $70s or mid to high-$60s.

Conclusion

With that, I conclude my list of top water stocks as of Spring 2019. This is a bit of a marathon of a read, so I'll keep my conclusion brief. One point I'd like to reemphasize that this is not an endorsement to simply run out and buy these stocks but rather a comprehensive list of companies to monitor, research, and, should you decide to do so, invest in when they reach your buy zone. Should you buy, I'd recommend averaging into a full position at different set price points.

Another thought is that while this list may be less "wet" than a water investor may like, the diversification offered through these equities is broad, and there are advantages that come with such diversification. In addition to water, the equities listed here touch on a range of growing sectors, including health care, life sciences, energy, real estate, agriculture, technology, and defense. Moreover, within this list, the risk and growth profiles of companies vary, offering readers a diverse range of investment options to draw from.

I'll also note there are a number of companies I would have liked to include, but due to length, I left them out. In the comment section please do not hesitate to share water companies you believe stand out as exceptional investments but did not make the list. Additionally, please weigh in on the companies listed here-this is an admittedly wide, but shallow, analysis of firms, so additional color is appreciated in the comment section.

Thank you for reading, and good luck with your investments. If you enjoyed the article and would like to be alerted to future articles that I write, please consider clicking the orange "Follow" button at the top of the page.

Disclosure: I am/we are long AOS, CGW, WTR, LMNR, DHR, ECL, CMD, SJW, XYL, MWA, LMT, TPL, TTC, WAT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.