Water, Water Everywhere—for Investors

With population growing and water works aging, a range of companies may be in for growth spurts.

By SHARE

Water may be the most basic—and valuable—commodity. Although it's a renewable resource, the 2½ percent of water on Earth that's not salty or trapped in ice is steady decreasing as the world population continues to rise.

Meanwhile, water systems are widely in disrepair. Much of the existing water infrastructure in the United States was built in the period following World War II. The American Water Works Association estimates that it will take at least $250 billion to replace thousands of miles of leaky water lines and aging filtration plants over the next 30 years.

The situation in developing countries is even worse. In China, where a third of the population drinks substandard water, the government is investing $125 billion over the next few years to improve water supply and waste-water treatment. "With many developing countries now flush with capital, infrastructure spending in the emerging economies is set to skyrocket, and water should capture a healthy portion of the share," says Les Satlow of Cabot Money Management.

Many companies stand to benefit from massive spending on infrastructure. In fact, many already are: On average, stocks in the water sector gained 22 percent in 2007, compared with a 4 percent increase for the S&P 500, according to the Boenning & Scattergood Water Digest. While the report says these companies "are positioned to sustain their streak of robust relative performance," shares haven't been exactly cheap. But some of that froth has dissolved during recent market pullbacks, and many water stocks are currently trading near the bottom of their historical valuations. "By and large, this group is looking pretty good at the moment," says Michael Gaugler, an analyst with Brean Murray, Carret & Co.

Because the industry is vast, there are many ways to invest in water infrastructure. The simplest way to get broad exposure to the sector is through an exchange-traded fund such as PowerShares Water Resources (symbol PHO). This fund holds a portfolio of 35 water-connected stocks, including treatment companies, pipe and valve makers, metering outfits, utilities, and industrial conglomerates. Otherwise, here are a few individual stocks for consideration:

Pumps, pipes, and valves. According to the Environmental Protection Agency, half of the water pipes in the nation will be in poor, very poor, or "elapsed status" by 2020. That spells profits for Mueller Water Products, the big dog of the U.S. pipe and valve market (and maker of half of the country's fire hydrants.) Because 40 percent of Mueller's business in 2007 was tied to new housing construction—through sales of residential water systems—the company's revenues and profits have suffered. The stock, recently $8 a share, is down significantly from its high of $19 last summer. But residential construction, which now accounts for 30 percent of sales, is becoming a smaller piece of the pie. "At some point in the near future, the effects of new housing on Mueller's business model will no longer be a hindrance to bottom-line earnings growth," writes Gaugler in a recent note to clients. The shares, which trade at 15 times analysts' earnings expectations for the fiscal 2008 year, might appeal to long-term investors.

Playing defense with utilities. Water utilities aren't a bad place to park your money during uncertain economic times. "The sector's reputation as a defensive haven is justified: In the last two recessions, water utilities maintained solid financial performance despite the challenging economic climate," according to Boenning & Scattergood. That's not surprising, since customers don't tend to curb their water usage during tough times as they might with heat or air conditioning.

The largest of the publicly traded U.S. water utilities is Aqua America. Although based in Bryn Mawr, Pa., Aqua (WTR) is aggressively growing its empire by buying up smaller rivals at the rate of 25 to 30 per year. These are generally small, mom-and-pop outfits that can't afford to upgrade their systems in the face of ever-tightening federal water-quality standards. Aqua's goal is to increase its customer base by 4 percent annually, earnings by 10 percent a year; and dividend by 5 percent. The company earned 72 cents a share last year, just two pennies more than in 2006. That sluggish growth is partially due to what those in the industry call "regulatory lag," the time after a utility's costs go up but before it's allowed to raise the rate it charges to customers. At $20 recently, Aqua's stock is down from $26 in early August.