More valuable than oil

That bottle of water on your desk likely cost many times more than its equivalent in gasoline. No wonder investments in water have outperformed global indexes by a sizable margin. But first, a little background.

Almost all of the water on earth is salt water with only about 2.5% considered “fresh.” Of this, less than 1% is accessible surface water. In many areas, the water is polluted, exacerbating the supply constraint. Additionally, while fresh water supplies are relatively static, global populations are expected to increase from less than 7 billion to 9 billion by 2050. And much of this population growth is occurring in developing economies where access to fresh water is much more limited.

Under a current “business as usual” scenario, by 2030 water demand will outstrip supply by 40%. By 2050, this fresh water deficit has the potential to put $63 trillion or 22% of global gross domestic product at risk. In response to this unsustainable trend, governments and businesses must plan and implement long-term solutions to address water scarcity and quality issues through improved water conservation, treatment, re-use and desalination facilities.

The investment opportunity surrounding this growing global supply/demand imbalance is underpinned by four drivers.

• In developed markets, substantial investment is needed to upgrade aging infrastructure, and the costs of doing so are rising steeply. Cumulative water infrastructure spending requirements are expected to exceed $23 trillion by 2030.

• Water demand is rapidly increasing in developing economies where rising population and urbanization is requiring massive investment in water infrastructure.

• Stricter water quality regulations to address pollution are driving investment in water treatment facilities, particularly in China and India.

• Changing weather patterns are making it rain harder where and when it does rain, requiring significant investment in storm water systems and pumping stations.

As a result, companies active in the global water market are approaching $500 billion in revenues growing at a rate of approximately 7% per year. Not surprisingly, merger-and-acquisition activity has been robust and much of that activity has been dominated by global companies looking to expand their businesses through bolt-on acquisitions of innovative technologies. Siemens AG, 3M Co. and General Electric Co. have acquired companies in the water market, with GE's acquisition spree including BetzDearborn Inc. and Osmonics Inc. (water treatment), Ionics Inc. (desalination) and Zenon Environmental Inc. (membranes) as part of its move into the sector. M&A activity should continue, as large-cap companies with access to low-cost capital seek companies with niche water technologies such as advanced treatment and filtration applications.

Investors can select from a wide range of opportunities across three main sectors of the water value chain:

• Water infrastructure companies provide steady growth on a global basis and up to 20% in some developing markets. Businesses range from pumps, pipes and valve manufacturers to companies supplying equipment for irrigation and infrastructure projects.

• Water treatment companies typically offer high levels of profitability and steady growth profiles. High value-added products, such as desalination membranes or advanced treatment technologies command higher margins and offer a greater degree of earnings visibility because of steady demand for critical products in existing processes. With increasing demand requirements from growing coastal communities, desalination is a key area of growth.

• Water utilities are defensive in nature because of stable cash flows and attractive dividends.

Investing in companies across the water value chain can provide investors with a diversified and balanced portfolio regardless of the point in the economic cycle. For instance, a portfolio weighted toward water utilities, with their stable cash flows and high dividends, offers protection against volatile markets. Alternatively, water infrastructure companies are highly correlated to the cyclical construction markets. Water treatment companies provide attractive growth opportunities in developing markets where growth exceeds global averages.

Investing in water has rewarded investors with strong returns. For the 10 year period through June 30, the S&P Water index has outperformed the MSCI World index by 3.4% annualized, with comparable levels of absolute risk.

Historically, investors have targeted resource demand opportunities by allocating private equity capital to real assets and infrastructure projects or by investing in commodities. This is familiar territory. However, investing in listed equities across the global water value chain presents several benefits to investors:

• Listed equities provide greater liquidity and transparency than private equity or commodities.

• The investible universe, representing approximately 300 public companies globally, is wide and deep, allowing investors to build diversified portfolios.

• Listed equities provide access to early cycle, late cycle and defensive positions across the water infrastructure, treatment and utilities sectors, and across a range of regions and countries.

• Assessing the intrinsic value of specific stocks is not nearly as complex or onerous as the due diligence required to value specific private assets.

• Share prices of companies active in the water market remain attractively priced on average given their above market earnings growth rate and high enterprise value compared to invested capital.

Like the oil boom last century, there are many rich investment opportunities in this century's water boom. The global availability of accessible, clean water is finite and under considerable strain, and the growing gap between supply and demand will continue to fuel the need for more efficient technologies in water infrastructure, treatment, and utilities. The growing supply/demand imbalance is creating demand for a variety of solutions, and the water sector will need substantial capital investment across all subsectors, presenting investors with a numerous attractive long-term, global opportunities.

David W. Richardson is a managing director at Impax Asset Management based in New York.