Water world

Most people assume there is an infinite supply of water but the truth is that over a third of the world’s population live in water-stressed countries and this problem is particularly acute in emerging markets

With a stigma still attached to ethical funds, many groups now emphasise the growth drivers behind the sector rather than restrictive dark green investing.

Broadly speaking, this side of ethical investing includes renewable energy production (comprising solar, wind, geothermal, hydro, tidal and bio-energy), plus energy efficiency, water and waste management and pollution control.

At the core, the growth is coming from twin factors of fast-rising populations on the one hand and ever-increasing demand for finite natural resources on the other.

Taking water as an example, both are clearly in evidence, with urban migration and rising living standards putting pressure on what most people assume is an infinite supply.  Furthermore, an expanding and more affluent middle class with a preference for a higher protein/meat diet in many emerging economies is exacerbating agricultural water demand.

Understanding water scarcity – at least in the Western world – is a difficult concept to grasp. But as a formal definition, it is simply where agricultural, domestic and industrial consumption, and the water required for maintaining ecosystems, has approached or exceeded the total available supply.

Back in 2010, the UN Secretary General Ban Ki-moon outlined the problem, citing the potential impact of water stress on global economic growth and putting it on a level with climate change.

At present, over a third of the world’s population live in so-called water stressed countries. As might be expected, this is a particular concern in emerging markets, with Asia having 60 per cent of the world’s population but only 36 per cent of the world’s fresh water supply (see box below).

Some figures put the challenge into context: of 336,000,000 cubic miles of water on earth, the vast majority is salt water, with only 2.5 per cent  of the total considered fresh.

Distribution around the world is another problem, with huge imbalances from country to country. Figures from Impax reveal that in Malaysia for example, every 100 people share 35 million cubic feet of water. In India, this same volume must supply 350 people while in Israel, the figure rockets to 4,000.

Overall, the situation comes down to a single fact: only 0.01 per cent of the world’s total water resources is readily available so any technology promoting efficient use for domestic, agricultural or industrial production is highly valued.

Highlighting the opportunity in this area, 2011 research from ethical specialist Eiris shows just a fraction of companies are currently managing the risks they face from water shortages, drought and pollution.

Lead author Randeep Sanghera wrote: “Under a current business-as-usual scenario, water demand is set to outstrip supply by 40% by 2030, which has the potential to put $63tn of global GDP at risk by 2050.

“Many business supply chains can be heavily reliant on water as a raw material, which means risks from scarcity are spread across the value chain. The era of cheap and easy access to water for companies is coming to an end, posing a potentially greater threat to business than the loss of any other natural resource, including oil.”

Eiris has identified several sectors at high risk owing to their water usage profile, with agriculture predictably singled out as the most in danger. Figures show the sector is the dominant water user globally, accounting for 70 per cent on average and up to 90 per cent in some developing nations.

In addition, Sanghera says agriculture is key to the supply chains of a variety of other sectors such as food and beverages, supermarkets, fast-food chains, apparel manufacturers and retailers. Elsewhere, power generators are also heavily reliant on water for energy production and many nuclear and coal-fired plants cannot operate without it.

Looking forward, Sanghera claims the financial impacts of water scarcity will become fully apparent.

“The price of water, which has previously been undervalued and kept artificially low through subsidies, will rise globally,” he adds.

Bio-fuels may help ease demand but its expansion is eating up land

“Water issues are also inherently political and scarcity could become a potential cause of tension between nations or competing domestic jurisdictions. Additionally, companies could seek to gain a competitive advantage by moving to water-rich nations in the same way that certain industries have moved to countries with cheap labour.”

Advocates for water investment include no less an industry figure than Jim Rogers – co-founder of the Quantum Fund with George Soros – who highlights scarcity in countries ranging from India to the US.

According to Rogers, finding ways to invest in water can make people extremely rich and he has previously revealed a holding in Singaporean water treatment business Hyflux.

However while the various facts and figures on the water problem are undeniably interesting, they provide little insight on how to make money from this area.

Matt Sheldon, co-portfolio manager of the Kleinwort Benson Investors Water Strategy, says at outset, it is important for potential investors to get past various myths about the sector. First, and perhaps, most important, is the idea water is uninvestable and ‘impure’, with few companies sufficiently focused on the sector.

“While there are a limited number of global stocks sufficiently levered to the theme, and most are mid- to small-cap, there is plenty of capacity to achieve a diversified water portfolio,” he adds.

“Not all water companies are 100 per cent water-focused and many also partake in waste businesses, energy markets, healthcare, technology, general industrial, and other non-water markets. The key is to optimise a portfolio’s ‘water’ purity to ensure sufficient tie-in to the long-term drivers while understanding and analysing the non-water businesses at company level in the stock selection process.  

“That means combining stocks with 20 per cent water exposure (say, US meter company Itron) with 50 per cent (French utility Suez Environment) and 100 per cent water-focused businesses (Japanese ultrapure water specialist Kurita Water).”

Sheldon also highlights the myth that water investing is naturally defensive, with municipal demand not varying too much but more cyclical for commercial and industrial uses.

“Capital spending on water equipment and construction services is deferrable, at least for a time,” he adds. “In the 2008-09 downturn, water companies saw a broad range of sales changes, from up a bit to down more than 15 per cent. Equities were even more cyclical, as money left the markets and multiples compressed drastically on depressed earnings.

“While there are defensive elements of water investing, you can also access growth or create a more balanced portfolio through the market cycles.”

Finally, Sheldon also stresses a large performance dispersion between water stocks. “They do not trade as a tight-knit group, so there are risk-reward opportunities to rotate from the out- to the underperformers,” he adds.

Among other specialists in the sector, Pictet’s Hans-Peter Portner, who runs the group’s dedicated Water fund, notes massive supply/demand issues as the key driver for companies, with the world needing 50 per cent more water, energy and food to deal with the expected population in 2050.

”This means individuals, businesses and governments will have to make some profound changes to their behaviour if the world is to avert a natural resources crisis,” he adds.

“There are major obstacles to securing the future of the world’s resources. The first is the dire state of public finances among advanced economies with areas such as renewable energy and water infrastructure certain to fall down the list of priorities.

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“The second is the intimate relationship that exists between the world’s resource systems. The interconnections – known as the food-energy water nexus – are such that solutions aiming to safeguard the future of one can sometimes imperil another.”

Portner highlights the development of bio-fuels as a striking example of the damage caused by ignoring the nexus.

“Bio-fuels may help ease demand and supply imbalances in energy but its expansion is eating up land that was once used to produce food crops, causing volatility in grain prices,” he adds.

While government will be key in driving through change, Portner says the private sector also has a role to play, with ingenuity in plentiful supply in the water, timber, energy and agricultural industries.

“There are many firms that possess the management expertise, products and services that can help ease the strain on the world’s natural resources,” he adds.

“In the area of water recycling, an activity crucial in reversing the global water shortage, the private sector is deploying its skills to particularly good effect. The world currently recycles just 20 per cent of its used water – an unsustainably low level if it is ever to bring demand and supply into equilibrium. There is, however, evidence to suggest the water treatment technologies developed by firms can have a significant impact on re-use rates, with more efficient irrigation techniques another field where such firms are leading the way.”

While ongoing austerity is clearly a concern, Portner says the water sits at the intersection of longer-term megatrends such as urbanisation, commercialisation and sustainability.

“The fundamentals linked to the commercialisation trend is likely to accelerate in light of austerity programmes, as more municipalities eventually delegate activities that require significant investments and/or state-of-the-art know-how to the private sector,” he adds.

“In such a context, the global water industry is poised to outperform the broader market as value drivers remain valid irrespective of economic environment.”

Elsewhere, Simon Gottelier, investment manager, listed equities, at ethical specialist Impax, agrees the growing gap between supply and demand will require substantial capital investment in water treatment and distribution infrastructure to reduce imbalances.

“This opens the door to a number of investment opportunities into companies providing new ways to supply, distribute, conserve and treat water,” he adds.

“Investing in the water sector can be complex and requires a deep knowledge of current legislation and technological developments. To date, the water sector has provided strong risk-adjusted returns and we believe it will continue to develop into a dynamic sector within global equities, with significant long-term investment potential.”

In recent years, the water sector has outperformed global markets, with improvements in science and technology contributing to an influx of new products and services for equipment and water service companies.

“We believe that such advances will lead to enhancements in efficiency, distribution and filtration,” adds Gottelier.

“Scientific research is also providing a greater understanding of water properties, which can be applied at a commercial level for ultra-filtration, desalination and wastewater treatment.”

Apart from the obvious population growth, Gottelier also highlights a serious problem – and therefore opportunity – with the aging water supply and sanitation infrastructure.

“Much of the existing infrastructure was designed and built at a time of significantly different resource availability and water use,” he adds.

“Upgrading and/or expanding infrastructure is therefore an urgent need in many places in developing and developed regions.”

Again, a look at some figures puts this situation into context. In China for example, the urban population more than doubled from 254 million to 691 million between 1990 and 2011 and now exceeds the rural population.  A further 400 million people are expected to move to urban areas by 2025, increasing the total number living in Chinese cities to approximately one billion.

According to Gottelier, there are similarly ominous supply and demand imbalances in other emerging economies such as India and Brazil.

“In developed nations, there has been significant underinvestment in repairs and upgrades, especially to urban infrastructure, much of which was built in the late nineteenth and early twentieth centuries,” he adds.

“The useful life of these systems is considered to be around 60 to 80 years and due to damage and inefficiencies, an estimated 30-40 per cent of water is lost to leakage in such systems.

“Water infrastructure, and particularly treatment, has moved sharply up government agendas, not least because governments and their regulators dictate the quality of water, the quality of service, and the price.”

Looking at opportunities for investment, Gottelier says many expect defensive utilities to dominate but – like Sheldon – he stresses it is possible to access growth and create a balanced portfolio through the market cycles.

“Water investments with strong growth potential have business models that are addressing supply-demand imbalances,” he adds.

“It is possible to construct a balanced portfolio of water investments with exposure to early cycle, late cycle and defensive business models, with opportunities across infrastructure, treatment and utility companies” (see box below).

Over the next five years, Gottelier says investment in water infrastructure, wastewater treatment, desalination and water recycling is expected to rise steadily.

“Looking at the evolution of water prices relative to headline inflation from 1986 to 2011, real prices have risen similarly to those of oil, highlighting the scarcity of the resource,” he adds. “Should this trend continue, the sector is likely to offer further strong risk-adjusted returns for equity investors.”

Looking at other ways to access the water theme, Premier’s James Smith is an advocate of the utility route, seeing these stocks as a better way of playing the theme than technology-oriented businesses.

“Our view is that it is usually better to own the wind farms than the wind turbine suppliers – if you look at airports as a comparison for example, the vast majority have outperformed the airlines that fly in and out of them,” he adds.

A veteran of the utilities space, Smith runs the group’s Global Power and Water fund and Energy and Water investment trust, and argues against the market perception of utilities as ex-growth, underperforming and full of political risk.

He highlights that the FTSE Utilities sector has produced a total return of slightly over 386 per cent in the decade to end May, more than doubling the 164 per cent from the FTSE All-Share.

Smith says the myth about underperforming utilities comes from headlines about government interference in what are largely regulated businesses, where he admits it remains easy for political point scoring.

“That said, regulated entities have major advantages in that they can pass through inflation to customers, whereas most other businesses will see their profits squeezed,” he adds.

Smith outlines a compelling case for utility outperformance, with their regulated status mitigating against the adverse impact of movements in commodity prices, demand, competition, interest rates and inflation.

While the portfolio is geographically diversified, with more than a third in emerging markets, he says it is increasingly possible to look at utilities as a ‘global’ industry, with many countries adopting the UK’s regulated model.

While the team largely takes a bottom-up approach, Smith says China is a clear example of a country with a dynamic utility sector, which justifies the portfolio’s 20 per cent position.

China is also something of an exception to this broad skew away from water and energy technology, with the country exemplifying many of the major scarcity and pollution themes.
With its water for example, most of the country’s resources are in the south and massive desalination plants are required to supply to northern provinces.

Smith says it is still difficult to invest in attractive businesses in these areas but highlights China Everbright International as one holding involved in the sewage treatment and water recycling industry.

Most of the fund’s Chinese positions – which also include China Power International and China Resources Power – have produced strong returns in recent months. Smith notes China Power International as particularly strong as a result of record high levels of hydropower generation, with the peak season for this approaching.

“It should also coincide with further positive news from the Chinese government regarding reform to the hydropower tariff,” adds the manager.

The scale of the problem

Water scarcity was broadly limited to a small number of countries in Africa and the Middle East in the mid-1970s but Eiris data shows it had spread to many large and densely populated parts of Asia by 2000.

By 2025, the UN predicts it will affect two-thirds of the world, including the US and Australia as well as China and India. Once again, this is not just a warning for the future and water risk has already started to impact on country growth.

In the 2011 Eiris report, Sanghera wrote: “As one of the worlds leading crop producers, the value of agricultural exports in India currently accounts for $18.1bn and demand for crops is expected to increase by 26 per cent by 2050.

“The majority of food crops in India constitute rice, wheat and sugarcane, which are extremely water intensive. Predicted groundwater depletion rates of 75 per cent in a large portion of states will severely constrain the country’s ability to meet agricultural demands.”
As for China – seen as the gorging demon when it comes to many commodities – external costs of water scarcity and pollution have already amounted to 2.3 per cent of GDP.

Its current five-year plan includes the most ambitious energy-saving, water-conserving and emission-reducing targets the country has ever set.

 

The investment universe

1. Infrastructure:

Pumps, pipes and valves – Relatively commoditised products, with some early cyclical exposures to the construction and general industrial capital expenditure cycles.

Water reuse, conservation and irrigation equipment – Attractive global growth rates of 6-12 per cent, with up to 16 per cent achievable in emerging markets and Asia.

Demand reduction products and metering infrastructure – Predominantly a developed market technology, with potentially double-digit market growth potential. Construction market exposure implies a degree of early cyclicality.

2. Treatment:

Chemical – Water chemicals tend to be an operating expenditure item and are often characterised as having relatively low monetary value but high importance in the treatment process. Rather than relying on new capital investment for growth, water chemical companies tend to have clear earnings visibility due to the importance of their product in existing processes.

Filtration, membrane technology, desalination – As a rule, these businesses are less cyclical than infrastructure companies but are exposed to industrial and utility applications. Filters wear out and need replacing hence all ‘membrane’ or filtration-based businesses offer investors above-average earnings visibility

Physical water treatment – Technologies with highly specialised, niche applications, such as ozone and ultraviolet water treatment are used in a number of utility and industrial applications.

Pollution monitoring and testing – Companies involved in the manufacture of machinery for water sample testing, as well as the laboratories involved in sample analysis. These focus on fulfilling increasingly strict global water purity regulations and are active in both the industrial and utility fields.

3. Utilities

Regional regulatory regimes are key to understanding global water utilities. The UK, for example, runs on five-year investment cycles, with inflation passed on to the consumer and contributing to the regulatory asset value of the company.  

Source: Impax Asset Management