The Case for Water Equity Investing

As every investor knows only too well, the last two years have been an exceptionally difficult period in the global financial markets. With the most serious credit crisis in several generations, and the associated deep economic recession from which we still have not managed to extricate ourselves, equity valuations across all industrial sectors have fallen sharply ? even given the recent recovery. We believe that while these circumstances have caused widespread fear and uncertainty, they have also created an unprecedented opportunity for investors interested in the global water industry.

Not only do we still see strong fundamental drivers for sustainable growth and equity appreciation in global ?hydrocommerce,? but investors also have the opportunity today to invest in water companies at more attractive valuations than have been available for a number of years. Despite the negative short-term impact of the financial crisis, water equities are uniquely resistant to external economic cycles ? because of fixed supply and the relentlessly increasing demand for water. We believe water stocks represent an increasingly attractive alternative ?store of value? in an uncertain world ? a good place to store money for a ?rainy day.?

The lure of water investing is not a new idea, but it is one that deserves fresh examination from the perspective of the revised business expectations, and the new economic environment to emerge from the wreckage of 2008. The intention of this article is not to promote a specific investment style or strategy, but rather to present a broad overview of issues relevant to the serious investor in water equities.

The Underlying Drivers of Water Investing

No other industry rivals hydrocommerce in terms of the strong, consistent and fundamental drivers that are propelling its future growth. Each of these underlying factors are worthy of detailed discussion, but are summarized briefly below to provide a basic foundation for further investment analysis and consideration.

1) The Basic Water Situation: Fixed Supply, Exploding Demand

The available supply of fresh water to meet all human needs amounts to only about one-half of 1 percent of all water on earth. Furthermore, surface rivers and lakes make up only a small fraction of this already minute amount; the bulk of the world?s fresh water is currently inaccessible within the polar icecaps.

Fresh water supplies are being effectively destroyed or rendered unusable at an alarming rate by pollution from modern industrial, agricultural and sanitation practices.

Groundwater supplies almost everywhere are being ?mined? beyond their natural rate of replenishment. In northern China, the water table is dropping by up to 3 meters per year, while the critical Ogallala aquifer of the central United States has experienced declines of over 150 feet, and has even started to be exhausted in certain areas. Mexico City now has to pump some of its water from a depth of more than 7,000 feet, and the government has resorted to running ads warning: ?The City May Run Out of Water.? The city is also beginning to experience severe subsidence in certain areas, due to the exhaustion of groundwater aquifers
The potential impacts of global climate change will only intensify and complicate water supply issues in the future. Shifting and more intense weather patterns, unpredictable precipitation levels, earlier snowmelt, and rising temperatures will wreak havoc with our existing water storage and distribution infrastructure.

Perhaps the most significant issue here is simply the exploding demand for water ? driven by the world?s growing population. It took mankind around 10,000 years to reach a total population of 1 billion. One hundred fifty years later (~1950) the population had doubled to 2 billion. In 2000, the global population stood at 6 billion people, and it is estimated to reach 8 billion by 2025. This exponential population growth ? and the accompanying industrial and agricultural expansion ? puts an incessant and accelerating demand on our fixed water supply.

Not only are more people demanding more water, but as standards of living rise and industrialization advances, they are also demanding more of it on a per capita basis. In 1900, the global annual water use per capita was 350 cubic meters per year. By 2000, that number had grown to 633 cubic meters, inclusive of both direct uses as well as the water necessary for the production of agricultural and industrial goods.

To feed the growing population, the world will need almost 50 percent more food by 2030. This translates into an increasing demand for irrigation, which already claims nearly 70 percent of all fresh water currently used on a global basis.

2) Geographic Imbalance Between Sources and Uses

Water is not evenly distributed around the globe. Fewer than 10 countries possess 60 percent of the world?s available fresh water supply. China, for example, makes up 21 percent of the world?s population, but possesses only 7 percent of the renewable water resources. Canada is the world?s most water-rich country but has a relatively small population, while Africa is a water-stressed continent whose population is doubling every 20 years.

Half of humanity currently lives in towns and cities. This number is increasing as more and more people, particularly in less developed countries, migrate from rural areas into growing urban hubs in search of economic livelihood. By 2030, it is expected that nearly two-thirds of the world?s population will live in these expanding urban areas and a handful of mega-cities, resulting in dramatically increased water demand on already over-stressed, or effectively non-existent infrastructure systems.

As water resources become scarcer, tension between competing users may intensify at local, national and even international levels. Over 260 river basins are shared by two or more countries. In the absence of strong political institutions, pacts and agreements, changes within a basin can lead to trans-boundary tensions. When major projects proceed without regional collaboration, they can become a point of conflict that heightens geopolitical instability.

Currently, 20 percent of the world?s population (over one billion people) does not have reliable access to an improved supply of drinking water, and some 2.6 billion people do not have access to basic sanitation. By 2025, it is estimated that as much as one-third of the world?s population will not have adequate access to drinking water. By 2050, more than 4 billion people, nearly half the world?s population, are expected to live in areas that are chronically short of water.

3)? Aging and Insufficient Infrastructure

Developed countries are struggling to maintain their aging infrastructure at a sustainable rate, while many developing countries still need to build the basic infrastructural framework for water and wastewater systems.
In the United States alone, the network of drinking water transmission lines extends to almost a million miles ? more than four times the length of the National Highway System. This aging infrastructure, much of which is more than 100 years old, has long exceeded its useful life and in many areas is in a state of utter disrepair. In some areas, water loss exceeds 50 percent during distribution because of leakage ? a production loss that would not be even remotely tolerated in any other industry. The American Water Works Association (AWWA) estimates that domestic water utilities will need to invest $330 billion over the next 20 years to replace aging pipes and treatment plants. New developments, security upgrades, advanced treatment methods and other needs may raise that bill to $500 billion.? Some estimates put these figures much higher.

In order to meet the United Nation?s Millennium Development Goals ? to ?halve, by 2015, the proportion of people without sustainable access to safe drinking water and basic sanitation? ? an enormous investment in water and wastewater infrastructure will be necessary.

Climate change will likely increase the amount of money necessary for storing and distributing water, and
innovative solutions must emerge as the magnitude of these looming expenditures becomes clearer. From underground aquifer recharge in place of expensive surface impoundments, to in-place rehabilitation of existing piping instead of outright replacement ? expect more dollars to be spent in more creative ways.

4)? Increasing Regulation and Heightened Awareness

Key U.S. legislation such as the Clean Water Act and the Safe Drinking Water Act are forging much tougher regulatory standards. Allowable contaminant levels continue to be lowered, and tougher enforcement seems likely under the Obama administration. These trends contribute to new capital investment requirements and help drive the already strong demand for monitoring and treatment technologies and services.

Most other countries worldwide are also moving in the direction of tougher and more complex regulatory regimes with respect to drinking water protection and wastewater treatment requirements, although some are only now beginning to enforce them. It is these regulations which fundamentally drive the day-to-day activities, spending levels and commercial developments in the water industry.

The popular media is providing historically high levels of attention to water resource issues, and this coverage will only increase as the real problems worsen. Heightened public awareness greatly helps spur regulatory reforms, increase spending and encourage better policymaking at the highest levels.

The financial and business world is also rapidly coming up the learning curve in terms of the economic impact of water. Companies that provide products or services tangential to the core water industry are looking at ways of broadening their exposure to the water industry. Industries whose existence depends on clean water supplies ? sectors like semiconductor, food and beverage, and pharmaceutical ? are increasingly realizing their true dependence on clean water and the business risks to which they may be exposed. Hence, large corporations are becoming far more involved on both the supply and demand sides of the clean water business, and the financial sector is becoming better-prepared to fund these new needs and opportunities.

Industry Performance and Trends

The Investible Water Equity Universe

The global water industry is enormous ? the world?s third biggest in terms of embedded capital,? behind only the oil and gas business, and electrical power. However, it remains ill-defined and poorly understood by the general investing public, when compared to other more traditional and widely followed sectors of the global economy. In fact, the water ?industry? is not really a single industry at all, but is rather a wide spectrum of companies spanning diverse industrial sectors. A more suitable term may be ?hydrocommerce?- denoting the full continuum of companies involved one way or another in the treatment, distribution and management of clean water for economic and social benefit.

Hydrocommerce may be more explicitly characterized as comprised of those companies which provide products and services enabling the flow of usable water from (1) initial raw supply sources, through (2) collection and treatment, to (3) distribution among the various types of end-users, and finally to (4) wastewater treatment . The global market for these products and services is now estimated to be approximately $500 billion per year.

Summit Global Management monitors a proprietary universe of publicly traded hydrocommerce companies, built and screened over the past three decades and currently numbering 394 names.?? Water is a truly global business, with equities traded on numerous exchanges around the world. Although the United States is the largest single water market ? estimated at around $120 billion per year ? only about one-quarter of Summit?s water universe is U.S.-based.

Investible opportunities are emerging rapidly in other worldwide markets ? both developed (Western Europe, Pacific Rim) and rapidly developing (BRIC, Middle East).? In early 2007, Summit?s tracked universe numbered just 319 rather than 394 companies. All growth in the interim came from outside the United States, either through the addition of new companies in existing markets or the inclusion of entirely new, rapidly maturing markets in the group.

Furthermore, Summit?s universe does not include such well-known names as General Electric, United Technologies, Dow Chemical, Siemens, BASF or Mitsubishi Heavy Industries. Although these companies have significant water divisions (some quite large), water does not represent a significant percentage of their respective overall revenues, and therefore is not material to their equity valuations. Nor does our universe include consumer products companies such as Coca-Cola or Nestle, as the impact of their water bottling operations are influenced more by the vagaries of consumer taste and marketing rather than the solid fundamentals of large-scale water distribution.

As described in more detail below, we divide the water investment landscape into two key sectors ? (1) the water utilities themselves, which actually provide drinking water and wastewater services to end-users, and (2) the vast array of supporting companies that provide the technologies, services and products which the utilities need in order to continue operating and delivering that clean water to consumers every day.

Water Utilities ? The Primary Suppliers

Water utilities have long been considered an industrial stalwart by the investment community ?? and rightly so. Water is very much a localized resource, unlike electricity or natural gas that can be widely distributed, so local water provision is one of the world?s only true natural monopolies. Their business is simple ? to provide an uninterrupted supply of clean water and dependable wastewater services to an ever-growing and more demanding public. However, this rather dull business model, plus the fact that water has no economic substitute, has created an enduring industry ? and an investment opportunity that is unequaled in long-term performance and relatively unaffected by cyclical market conditions.

This fundamental strength and consistency has historically translated into strong equity performance for publicly traded water utilities. When compared to a broad range of broader market indices, the performance of U.S water utilities over five-year periods for the past two decades has shown steady equity growth, regardless of wider economic and stock trends. The reason for this is no mystery ? when times get tough, we may all cut back on fancy restaurants, new cars, and other discretionary items, but we generally continue to use the same amount of water. We really have no choice. So, utilities generally produce and sell the same amount of water, and thus generate a reliable revenue stream ? a revenue stream that, in fact, inevitably grows as the result of both population growth and periodic regulatory rate increases. It is often said that what financial markets hate most is uncertainty, so the predictability of water utility stocks goes a long way towards explaining their superior performance throughout the years.

Indeed, compared with almost any other industry, water utilities have a more compelling business model in terms of persistent demand and consistent earnings. This, in turn, leads to another hallmark of the water utility business ? regular dividend increases. In our opinion, this is perhaps the best indicator of the quality and stability of any enterprise, and also underlines the predictability and consistency of the cash-flow generated by these businesses. For example, one of the largest U.S. investor-owned utilities, Aqua America, has paid a dividend for more than 60 consecutive years and has increased it 19 times in the last 18 years. We believe payments like these are a major contributor to the long-term performance of utility equities, and also tend to reduce their market volatility.

Although many non-U.S. water utilities lack comparatively long histories as publicly traded entities, initial evidence suggests that investor appetite is strong for the same solid business fundamentals regardless of location. However, despite their recent stock out-performance, most non-U.S. utilities still typically trade at lower P/E levels than their U.S. counterparts. This suggests there is room for further equity appreciation among these foreign utilities.

Water Industrials ? Essential Providers of Products, Services and Solutions

Although water utilities have attractive fundamentals from an investment perspective, they represent only a small portion of the overall water investment theme. Of the Summit-defined hydrocommerce universe of 394 companies, only 12 percent are water utilities. The vast majority are supporting enterprises that feed the supply chain for water and wastewater utilities ? either (1) basic water industrial stocks: pump, pipe and valve manufacturers, filtration and treatment companies, testing equipment and instrumentation providers, and so on; or (2) service businesses: design-engineering and construction firms, contract operations providers, service and maintenance companies, and analytical testing laboratories.

Every water utility, whether owned by a municipality or private investors, must buy the products and services necessary to provide consistent water supplies in a regulation-compliant manner. By law, they cannot defer maintenance or suspend capital spending due to prevailing economic conditions. Every water utility is hence a relatively steady customer of water industrial companies, and so these companies in turn profit from the consistent buying patterns ? and hence share many of the same revenue stability and recession-resistant characteristics of the water utilities themselves.

Since we began tracking the hydrocommerce universe some 30 years ago, we have found that companies which sell primarily to water utilities have a much more persistent, predictable and stable business profile than similar companies that might be selling into more cyclical industries. As a result, these businesses have tended to outperform other industrial sectors with respect to equity growth.

As an example, a valve manufacturer selling to water utilities is likely to have a steadier and more predictable business than a valve maker selling to the oil or aircraft industry. There is a pronounced ?trickle-down? effect in the water industry, not only with respect to consistency of demand, but also with respect to revenues and resulting equity performance. Many of these industrial companies sell into various end markets, but to the extent that they are more focused on water-related clientele, they tend to have a more consistent and predictable workflow and revenue.

Industrial companies also benefit from additional direct purchase orders from other end-users such as agricultural concerns and thermoelectric providers. Given the strong demand drivers outlined earlier, these markets may account for accelerated future growth beyond the industrials? steady if not particularly exciting ?razor blade? business with water utilities. In addition, much like the utilities, many segments of the water industrial sector tend to be highly localized and fragmented, offering fertile prospects for the benefits of consolidation. Indeed, by one estimate there were 244 water industry acquisitions valued at $49 billion from 1998 to 2008.

Despite all of these attractive investment characteristics, hydrocommerce industrial stocks have yet to become a widely followed economic market sector and are consequently still under-recognized by the larger names on Wall Street.? Fluctuations in the new global economy will undoubtedly impact the volume and rate of investment going into hydrocommerce in the near term. But given water?s the compelling, recession-resistant business model, combined with the urgency of water demand and challenges across the globe, Summit believes that the outlook for water stocks today is much better than it was 25 years ago, or even five years ago.? Hydrocommerce will undoubtedly remain one of the world?s most vital industries, and will continue to offer some of the best risk/reward characteristics to the intelligent long-term investor.

Steve Maxwell is Managing Director of TechKNOWLEDGEy Strategic Group, a Boulder, Colo.-based management consultancy specializing in merger and acquisition advisory services and strategic planning for the water and broader environmental industries. He is also an associate and advisor to Summit Global Management.

Matthew J. Dickerson
is Chief Marketing Officer at Summit Global Management and focuses on business development, client management and fund marketing. He was previously Chief Executive Officer of The Amphion Group, an award-winning advertising and design agency in Denver serving a nationwide roster of clients.

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