A Compelling Investment Theme

The water industry is comprised of a vast array of companies providing products and services toward the collection, conveyance, treatment and monitoring/analysis of water and wastewater for multiple purposes and end users. As you will see in the table below, investing in this industry has historically worked very well. In today’s unsettled world and the resulting instability of financial markets, we believe that allocating a portion of one’s portfolio to water investing will improve stability without sacrificing returns.

Water is the single most important economic input to the global economy, and more specifically, to individual enterprises. The disparity between supply and demand for clean water is an inexorable problem; yet the relentless demand for its uninterrupted supply makes it by far the most stable of all commodities – unaffected by cyclical influences which constantly badger other more typical input commodities.

This global theme of water insufficiency relative to unrelenting demand, along with all the related trends and problems it has spawned, continues to benefit the prospects of a broad range of publicly traded companies which help to provide solutions. A diverse global universe of investment opportunities exists within this theme; all the while eliminating the typical resistance to sector fund investments, which are far more limited in scope and susceptible to cyclical influences:  Water investing is far too broad and diverse to be considered sector investing.

Water Utilities: The Industry Stalwart

Domestic U.S. water utilities have generally been the largest core investment group for our water investment portfolios, for the simple reason that water utilities have been a leading stock market performer for many years. Moreover, dividends have played as large part in these total return figures, which tends to dampen market volatility for these shares.

*An equally-weighted list of all publicly traded U.S. water utility stocks that existed as of 12/31/03.  Importantly, this is a negatively-selected list, in that many public water utility stocks were acquired during the years depicted above, and the returns on those acquired companies, normally purchased at large premiums to market prices, are not included herein. Thus, if this compilation included the returns of all water utility stocks that were trading at the beginning of these periods, the returns would have been substantially higher.

A striking and very illustrative fact is that we have not found any randomly selected five-year period in the last 25 years (1982-87, 1993-98, 1979-84, etc.) where water utilities were not among a very small group of best performing sectors in the U.S. stock market.  Why?  The simple answer is that water utilities do well in good times and bad. In addition, regular dividend increases tend to keep the stock prices moving ahead on a very consistent and predictable basis. Such regular dividend increases are a hallmark of the water utility sector, and are perhaps the best indicator we know of regarding the quality and stability of any enterprise.  It also says a lot about the cash generated by these businesses.

Aqua America (WTR), formerly known as Philadelphia Suburban Corporation, is presently the largest investor-owned American water utility. Its dividend history is not only impressive, but also quite instructive. In August of 2003, the Company announced a 7.1% cash dividend increase and a five-for-four stock split payable December 1, 2003. That increase represents the twelfth cash dividend increase in 11 years and the fifth stock split in seven years. The company has paid dividends without interruption for 58 consecutive years.

More recently, on November 10, Southwest Water Company (SWWC), another American water utility, announced a 9.2 percent increase in its quarterly common share cash dividend and a 4-for-3 stock split. This is the kind of news that water investors have regularly enjoyed.

The long-term total return of water utilities is indeed impressive.  Three of the best performing stocks over the 20-year period ending 12/31/2002 were water utilities: American Water Works Company (AWK), Philadelphia Suburban Corporation (PSC), and San Jose Water Company (SJW). In early 2003, (AWK) was purchased for cash by a large German utility company. Before its acquisition, AWK was very high on the list of the best-performing stocks on the New York Stock Exchange for the prior 20 years.

The following table illustrates top performing American stocks for the most recent 20-year period (12/31/1983 through 12/31/2003).

There are a number of water utilities that are smaller and newer than those that have been mentioned here, and we have every reason to believe that their dividend history, when viewed in the longer-term future, will be every bit as predictable and productive as that of the larger and older water utilities.  Indeed, there is ample evidence to indicate that water industry investing, while always good, is on the verge of getting much better.

Privatization and Consolidation Furthers the Merits of Water Investing

Clean and cheap water is no longer something we can take for granted.  Our water infrastructure is aging and has become dilapidated due to a lack of effort by municipal governments to properly invest in the necessary replacement and maintenance projects to keep these systems in good shape.  Furthermore, ever increasing population and industrial output continues to strain a finite resource as water supplies are exposed to the degrading effects of pollution.  The result is that water supplies are increasingly at risk to quality deterioration and interruptions in water delivery service are becoming alarmingly common.  This has caused pressure on governments to rehabilitate their water infrastructure systems and raise the stringency standards for quality and enforcement.

The cost of owning and operating a water system is rising at a breakneck pace. The EPA estimates up to $1 trillion will have to be spent upgrading U.S. water infrastructure over the next few years. The Federal Government says that this is the largest single infrastructure-related problem facing our society today.

For the nearly 50,000 or so quasi-municipal or private water systems serving fewer than 3,000 people, their share of the huge $1 trillion price tag is too much for them to pay, as these small and inefficient systems have no access to capital markets.  But for the handful of investor-owned utilities, which together now serve less than 10 percent of the population, it presents a compelling opportunity to acquire these systems in a ‘buyers market’ for prices that provide a very high return on invested capital and allow for significant economies of scale as regional systems expand incrementally.

Unlike the European water industry, which is dominated by a few very large public companies, the ownership of U.S. water utilities remains extremely decentralized and fragmented. The misguided ethos that, “our water should belong to everyone and shouldn't be provided for profit”, has resulted in the fact that  municipalities still own and operate some 80 percent of water systems and 90 percent of wastewater systems. At this point in time, investor-owned public water utilities serve only about 8% of the total U.S. water utility market, although that number is increasing very rapidly, and is one of the primary drivers creating opportunities for investors.

With that said, the issue of water ownership, however, really isn’t even the main point to consider when contemplating the value of the water we receive and utilize on a daily basis. The real value-added comes from those enterprises whose operations are involved in the collection, conveyance, processing, delivery, and recovery of our water, not ownership and/or the value of the actual raw commodity.

As one prominent water industry spokesman often says:

 “If you want free water, you can have all you want by going to the local reservoir or river and filling your own bucket. However, if you want clean, safe, potable water consistently piped into your house, you’re going to have to pay for that convenience.”

The cost crisis in the water market is altering the historic public vs. private ownership balance in a big way. Small systems simply aren't large enough or sufficiently capitalized to pay the cost of upgrading their pipes, expanding their necessary water treatment facilities, and complying with the ever-increasing regulatory standards, all while dealing with today’s increased security concerns post 9/11. Given the cash-strapped state of most municipalities, they're not equipped to meet the challenge of helping local water systems make the necessary improvements.

The investor-owned utilities are the only industry players with the experience and ample access to capital to meet all the requirements necessary to run efficient well-maintained systems. In doing so, investor-owned water utilities are profiting in two major ways: First, they're acquiring outright the smaller systems that can't meet such requirements, and second, they're managing the operations of many large municipal systems through contract-operations agreements.

On the acquisition side, most buyouts are being completed at prices well below the replacement value of the acquired systems, helping to immediately add to the acquiring company's earnings. Systems can often be integrated with the utilities’ existing infrastructure at minimal cost. And regulators, anxious to ensure clean water supplies, have been very supportive, granting speedy approval of takeovers and rate increases to pay for system improvements and integration. As a result, water utilities like Aqua America are able to grow earnings at double-digit rates, simply by making acquisitions to supplement normal system growth.

The contract-operations business, on the other hand, is a more palatable alternative for many municipalities, preserving public ownership while turning over operations to the more adept management found in investor-owned companies. The value of these deals depends on how well the managers can improve productivity as well as the price negotiated for their services, which generally depends on how much competition they have for the contract. By and large, however, these deals are sparking huge increases in profit growth for the better operators such as Southwest Water.

With water use per capita in most regions actually in long-term decline, due to conservation measures, acquisitions and contract operations are the two primary roads to growth for water utilities. And, with the water business being a natural monopoly on a regional retail level, the growth is about as safe and assured as you can get. Throw in an average dividend of about 3 percent and you've got an investment in line for safe and predictable annual total returns of 10 to 15 percent well into the foreseeable future, and despite what may be happening in the rest of the stock market and/or in the operating economy in general.

Shorter-term returns could be even more attractive, thanks to the merger activity that continues among the investor-owned water utilities themselves. Acquirers include other investor-owned companies, as was the case with the 1999 takeover of Consumers Water by Philadelphia Suburban and the 2000 merger between California Water and Dominguez Services. More recently, an increasing number of suitors have come from outside the country.  French conglomerate Suez, for example, bought out United Water Resources, the third largest U.S. water utility at the time. Meanwhile, Britain's Kelda bought Connecticut-based Aquarion and Thames Water bought E-Town Water, only to be acquired by German giant RWE. RWE stepped in again in early 2003 and paid cash for the crown jewel of American water utilities, AWK, as mentioned earlier.

The fact that the price premiums related to acquisitions of the investor-owned utilities have been up to 3 times book value, has been very enriching for those investors who maintained a constant portfolio position in water utility stock. In addition, with the number of takeover candidates shrinking, the remaining companies could go even higher. That adds up to a strong combination of potential longer-term capital gains for selected water utilities, all the while benefiting from a growing and significant stream of dividend income.

The Water Industry -  An Extensive and Diverse Universe of Companies

We have spent a great amount of time discussing water utilities up to this point, but it must be strongly emphasized that water utilities are actually only a small part of our investment universe of global water industry stocks. Our emphasis in discussing water utilities up to this point was to illustrate the remarkable stability at the basic delivery point of the industry, and how all companies participating in the industry supply and service chain are very positively influenced by this persistency.

The non-utility majority of companies on our list are basic water industrial stocks: Companies involved with pumps, pipes, valves, filters, testing, instrumentation, engineering, and building of water systems. Water utilities are the highly visible point of the spear in the water industry, but the water industrials are the shaft of that spear, and one cannot be effective without the other.

As we said earlier, only about 8% of the customers in the U.S. are served by an investor-owned utility, and that number is only around 10% on a global basis. However, every water utility, whether owned by a municipality or stockholders, must buy the goods and services necessary to provide uninterrupted service and to provide a safe product. Every water utility is a steady customer of the water industrials, and obviously the services of the utility must remain uninterrupted. Therefore, the business order flow to the industrials also has a stable and non-cyclical quality. Indeed, there is a pronounced “trickle-down” effect in the water industry, and that is not a play on words.

Over the last 25 years, we have found that companies who sell mainly to water utilities have a much more persistent, predictable, and stable business profile than those similar companies who might be selling into more cyclical industries. Thus, a valve maker selling to water utilities is likely to have a much better business than a valve maker selling to the oil industry or to the aircraft industry. Here again, many segments of the water industrial sector are highly localized and fragmented and offer fertile prospects for the benefits of consolidation and privatization.

Water Stocks and the Liquidity Myth

Apparently the majority of investors, to the extent they have ever even thought about water investing, view the industry to be composed only of the short list of remaining investor-owned U.S. water utilities. Thus, we often hear the rejoinder:  “You have a great concept, but one can’t get enough money invested into the idea to make it worthwhile.” That perception is simply untrue, and perhaps arose because of the dearth of research and information available on the industry, which, as value investors, we find to be a good reason to give this investment theme our close attention.

To quantify a response to investors with this view, we recently looked at the 25 largest stocks in our 160-stock universe and found that this short list currently trades in a very liquid manner, and our self-imposed 20% threshold of average volume would amount to about $162 million in daily trading value. In short, we could trade over $150 million in share value on a daily basis and still not have any disturbing affect on market prices. To be noted here is the fact that these 25 names are global in scope, and are not limited only to U.S. markets: Water is a global business.

A Word About Performance

To paraphrase Warren Buffett’s observation about value investing:  Water investing is simple, but it’s not easy. The theme is compelling and the logic is nearly unassailable, but the devil is in the details. As the record shows from others who have tried, one simply cannot “index” the water industry, and accurate evaluation of individual companies is all-important. With persistent applications of analysis and patience, solid low-risk returns are available from water investing and the results have proven to produce a very low market correlation. Given the outlook discussed above, we see no reason why similar, if not improved, returns can be produced in future years.

 

John I. Dickerson
Summit Global Management, Inc.
12230 El Camino Real, Suite 300
San Diego, CA 92130
Tel: (858) 847-0404
www.summitglobal.com
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