WE FORGET, IT'S THE
GLOBAL WATER INDUSTRY
by John Dickerson, President & CEO
Summit Global Management, Inc.
March 20, 2006
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 the U.S.-based utility component of this industry has historically worked very well, but the time has come for much broader global exposure in water stocks, as this group in the U.S. has generally become overvalued.
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 demographic demand for its uninterrupted supply makes water 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 opportunities it has spawned, continues to benefit the prospects of a broad range of publicly traded companies which help to provide solutions to this supply/demand dilemma. A diverse global universe of investment opportunities exists within the theme of water investing; 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 a broad and deep global theme, (the global factor being a subject that U.S. investors are presently not giving sufficient weight), and is far too diverse to be considered sector investing.
Water Utilities: The Industry Stalwart
U.S. water utilities have generally been the largest core investment group for most water investment portfolios, for the simple reason that U.S. water utilities have been a leading stock market performer for many years. Moreover, dividends have played a large part in these total return figures, which tends to dampen market volatility for these shares.
5Year Summary-12/31/00 to 12/31/05
|S&P500 Index TR||2.74%||0.54%|
|DowJones Industrial Average TR||10.42%||2.00%|
10 Year Summary-12/31/95 to 12/31/05
|S&P500 Index TR||138.29%||9.06%|
|DowJones Industrial Average TR||154.69%||9.79%|
Source: Bloomberg Analytics
*An equally-weighted list of all publicly traded U.S. water utility stocks that existed as of 12/31/05. Importantly, this is a negatively-selected list, in that some 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 found that in any randomly selected five-year period over the last 25 years (1982-87, 1993-98, 1979-84, etc.) water utilities dominated the list of the best performing industry groups in the U.S. stock market on a total return basis. Why? The simple answer is that water utilities have always done very well in good times and bad. When compared to any other industry, water utilities have a more obvious and compelling business model with most persistent demand and probably the most predictable future.
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 group, and are perhaps the best indicator of 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 in the US. Its dividend history is not only impressive, but also quite instructive. In November of 2005, the company announced a 10% dividend increase and a 4 for 3 stock split, which represents the 15th increase in 14 years. The company has paid dividends since 1945. The March 1, 2005, payment began the 60th consecutive year of shareholder dividend payments. This stellar record led the company to the number one spot in the performance list below.
Similarly, late in 2005, Southwest Water Company (SWWC), another American water utility, announced a 10% increase in its quarterly dividend and a 5% stock dividend payable in January of 2006. This is the kind of news that Southwest Water investors have regularly enjoyed, and helps to explain why Southwest is second in the 10-year performance list below.
The long-term total return of water utilities continued to be a leader in the U.S. stock market through 2005. Below is a list comparing the ten remaining investor-owned water utilities in the U.S. as compared to a list of popular investment icons. With a record like this, it is not hard to understand why U.S. water utilities now carry such remarkably high market valuations. The question investors now need to ask themselves is: �How high is too high?�
Keep in mind that this utility list used to be much longer, but many companies beyond the ten now remaining were bought by water-savvy foreign investors over the last ten years, and the list is now much reduced. Thus, the current list is somewhat negatively selected, in that many of the better-performing companies are no longer part of the group and some of the laggards remain.
The following table illustrates a list of widely held American stocks for the most recent 10-year period (12/31/1995 through 12/31/2005).
|INDU||DowJones Indus Avg.||154.69%||9.79%|
|Source:Bloomberg Analytics - All returns are with dividends reinvested.|
The Water Industry - An Extensive and Diverse Global Universe of Companies
We have discussed 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. Indeed, the Summit-defined water stock universe stood at 359 companies on 12/31/05, and only a small percentage of the list was water utilities. Our emphasis in discussing water utilities was intended to illustrate the remarkable stability at the basic delivery point of the industry, and how all companies participating in the industry�s supply and service chain are very positively influenced by this persistency and stability.
Summary by Region � December 31, 2005
|Asia& Pacific Rim||$84,912,970,957||143||18.71||
|LatinAmerica & Canada||$21,954,702,028||18||13.51||
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 construction 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.
Notice that only 103 of the 359 companies in the chart above are U.S. companies: This is truly a global industry, although it still does not seem to be perceived as such by most investors. The over-emphasis on U.S. companies is pointed out by the statistics within the above summary: Note that the valuation numbers for U.S. water equities are generally above, while the dividends are well below, those of the rest of the world. We believe that these wide disparities will be removed in due course by a �reversion to the mean� adjustment process that we expect to take place in international markets.
A Comparison of International Water Utility Valuations
In comparing typical water utility valuations around the world, one can see quite clearly that investors have taken U.S. water utilities to what seems to us to be an unsustainable level. Utilities have always tended to be the bell-weather stocks for regional and country-specific water stocks and for this reason, much can be gleaned from these comparisons.
The table below compares the 1/30/06 valuation of Aqua America, Inc., the largest investor-owned water utility in the U.S., versus three water utilities based in Brazil, Spain and Britain. Many more could have been selected from around the world with similar results, but this short list gets the point across.
Aqua-America is a very well managed company with a superlative record. This is a company that has historically justified a premium market valuation. Nevertheless, we now wonder if the quality of Aqua America justifies the wide valuation disparities that are outlined below.
If nothing else, this data should serve to remind investors that any incremental assets being deployed in the water sector would probably be better served by investing in selections chosen from international markets.
|Aqua America Inc (WTR)||US||40.35||7.40||4.69||19.18||13.79||1.74%|
|Cia de Saneamento Basico do Estado de Sao Paulo||BRAZIL||5.68||1.08||0.61||3.61||2.48||2.87%|
|Sociedad General de Aguas de Barcelona SA||SPAIN||15.21||1.17||2.40||NA||7.49||2.65%|
|Northumbrian Water Group PL||BRITAIN||11.84||2.16||5.04||6.98||4.19||4.27%|
|Average of 3 Companies||10.91||1.47||2.68||5.30||4.72||3.26%|
|WTR as a Percent of Average||369.84%||503.40%||174.78%||362.23%|| |
|All Information from Bloomberg Analytics - 1/30/06 P/E- Price to Earnings; P/S- Price to Sales; P/B- Price to Book Value; P/CF- Price to Cash Flow; P/Ebitda- Price to Earnings before income tax, depreciation and amortization; Div Yld- Dividend Yield|
Clearly, Aqua America is valued very much higher than the average of the other three companies in every category above. While the company may deserve a higher valuation than the others, in our opinion these comparisons are way out of line.
The Key Drivers for Global Water Investing
No other industry rivals the global water industry in the amount of key drivers propelling the growth of the industry. Indeed, the manifest drivers are each compelling and inexorable, and a full discussion of these factors would require many pages of information. Thus, in the interest of brevity, we have labored below to reduce the discussion of the drivers to an outline form that we hope succeeds in giving the reader a good basis for understanding why we believe the global water industry will be an investment leader for decades to come.
Large Industry Undergoing Dynamic Change:
The Water Industry is one of the three largest industries in the world (along with Oil & Gas and Electricity) in terms of assets deployed; however, it still is not well understood by investors, and still has a minority of investor ownership. This �under-owned� factor creates more investor opportunity than is present with other very large, but already investor-dominated, industries. It has been said by some that the global water industry today resembles the world petroleum industry in 1920.
- On 12/31/05, the Summit Water Universe was composed of 359 companies with $661 Billion of market value. These are the companies that will benefit from the drivers discussed here and these are the companies which will help solve and/or alleviate the world�s water problems. In our view, every serious investment portfolio should own a core group of these stocks over the years to come.
- Although hard data is sparse, it is clear that the fastest growing industry in the world today, in terms of new public equity capitalization coming into investor hands, is the global water industry. This trend is not slowing and is expected to accelerate and persist for many years to come. �The number of people served globally by investor-owned water companies is expected to rise 500% over the next 10 years.� � Lehman Brothers.
- Global water utilities currently have the lowest percentage of investor ownership of all forms of utilities, but municipal and/or private ownership is steadily declining as privatization and consolidation advances.
Fixed Supply, Exploding Demand: The supply of fresh water on our planet is no larger today than when humans first walked the Earth. However, there are now more than six billion people globally competing for this finite resource, which is becoming increasingly scarce by means of pollution.
- Available fresh water is well less than 1% of all water on earth. Amazingly, the actual usable/accessible water supply is less than 1/100th of this already minute amount.
- Running water is available to only 20% of the world�s population. Major health problems persist in part due to the fact that 50% utilize unclean water and have no basic sanitary facilities.
- A third of all nations are suffering from water stress. Since 1950 world population doubled, but water use tripled. Technological advancements have yet to reduce human dependence on water.
Special Features Of Water Stocks: When compared to any other industry, water has a more obvious and compelling business model with the most persistent demand and probably the most predictable future.
- There is no substitute for water and users cannot postpone purchases; price-inelastic demand.
- Conveyance system to the end user creates a natural monopoly with huge barriers to entry.
- Demand is unaffected by inflation, recession, interest rates, changing preferences, or inventory loss.
- A history of strong and consistent growth under all market or economic conditions.
- Price does not yet reflect real economic value: Huge room/need exists for asset price expansion.
Privatization And Consolidation Gains Momentum: Dilapidated water infrastructure is a key driver forcing a trend toward privatization and consolidation of water utilities around the world. With governments around the world being squeezed for funds, the monetization of their water utility makes good sense and removes a serious burden from municipal funding. Buyers, in turn, acquire hard assets at a fraction of replacement value; assets which provide excellent cash returns.
- Municipal and private utility operators often do not have the resources to maintain their water systems up to regulatory standards. Politicians and regulators want to �get rid� of the problem that nobody wants to pay for.
- Need to reduce municipal burden encourages water systems to privatize at values favoring the buyer, which, in turn, is most often an investor-owned company. Privatization very much favors the buyer, and this trend is gathering momentum at an accelerating pace.
- Companies involved in consolidation see good revenue growth within a slower-growing market, and pricing allows attractive returns on capital to the buyer; all while significant cash flow streams are created.
- Water systems �roll-up� offers growing economies of scale and enhanced prospects of return for investors.
Water Problems in China are Creating a New Opportunity:
While markets have avidly bid most "China plays" to premiums, little attention has been paid to the most basic and compelling requirement for the sustained growth of the Chinese economy: Adequate water and sanitation facilities.
- China's per capita water reserves are only about 1/4 the global average, and are only slightly above the water assets of India. Of the 669 cities in the country, 440 suffer water shortages, and 110 of these cities are considered to have reached the critical level.
- Companies that can help solve the massive water problems in China are looking at strong demand for years to come.
- Beyond China, immense potential exists in India and other undeveloped, but emerging, areas of the world.
The Essential Investment Thesis of Water Investing
The global water industry combines an excellent underlying business model with probably the most inexorable demand future of any existent industry, and this fundamental fact is not likely to change. Indeed, we believe that the water industry has more wind in its sails than any other global industry, period. Choosing the best stocks from within this select universe further enhances return potential. But, in choosing the best stocks available, one must be willing to look beyond the shores of America. Water investments should be selected on the basis of the best values available, but company selections should not be made by location.
In our view, if one concentrates wholly on a stock universe that represents the highest quality and most dominant investor-owned water stocks in the world (our stock universe of 359 companies), and if one constantly monitors this universe for the best values, the chances for investment success are very good and the odds for unsatisfactory performance are quite low.
We have spent 25 years of assiduous labor assembling our global universe, and we have been closely watching the water industry evolve for a quite some time. We have seen valuations rise and fall, while market interest has revolved among countries and currencies. In all that time, however, we have not seen the kind of valuation disparities that we are seeing today between U.S. and international water stocks, and we urge all investors to be aware of the dangers that lurk in these sharp valuation differences.
We have been water investors for a very long time, and in all these years we have never seen an investment theme that comes remotely close to providing the risk-reward characteristics of the global water industry. The industry has certainly evolved over the last 25 years, and the changes are virtually all positive: The outlook for water stocks today is much better than it was 25 years ago, and we have never been as optimistic as we are today about the future of our chosen investment arena.
If water investors begin to think global, not local, they will have a wonderful future ahead of them.
© 2006 John Dickerson