Water
Industry Funds Less
Exposed To Economic Cycles
by Stephen Hoffmann
Water Investment Newsletter
The
speculative excesses of Wall Street's recent history have given
way to more traditional approaches to investing. The flood of
easy money that drove massive capital spending in technology
has receded in the advent of severe over-capacity and waning
demand. The definition of low risk and high returns, spawned
by rampant global spending, has shifted back to more fundamental
industries.
With the volatility
in the broad markets reaching unprecedented proportions, many
investors are looking for themes that exhibit more stable growth
prospects. The dynamics of the water industry fit the model,
creating growing interest from investment funds.
The volatility in the
stock market remains extremely high. As measured by indexes that
track volatility, the market hasn't been this unstable for an
extended period since the fall of 1998. Some analysts point to
the extreme volatility as an indication that capitulation is
underway and that the bear market is trying to form a bottom.
Economic data may suggest otherwise.
But no matter what
the technicians believe to be the future direction of equities,
many investors have become more risk averse. In addition, commodity
prices have plummeted to historic lows. While utilities such
as telecoms and energy companies have suffered from stock market
volatility and commodity price swings, growing demand and more
constant prices make the water industry less exposed to economic
cycles.
In recent months a
handful of funds dedicated to the water theme have emerged, investing
in utilities, waste disposal companies, specialized equipment
manufacturers and bottled water. Because of their focus, these
funds function like sector funds, which seek to target growth
opportunities in a specific industry.
The WIN hypothetical
portfolio follows this approach. Within a fund, investment professionals
commonly classify stocks as growth or value, depending on their
characteristics. Some mutual funds tend to favor one style over
another. Other mutual funds are designed to be flexible and allow
the portfolio manager the latitude to favor a style given the
present market conditions. And current market conditions favor
the fundamental outlook for companies within the water industry.
During any interval
of time, the growth and value investment styles demonstrate very
different levels of volatility and investment returns. Investors
in growth stocks expect the long-term earnings potential of the
companies in which they are invested will outpace the market's
expectations. Value stocks tend to have slower and more stable
earnings growth rates but carry the expectation that at some
point in the future, the value will be recognized.
One of the major attractions
with the water industry is that at this juncture many water stocks
represent a unique combination of value and growth characteristics.
Value is derived from the essential nature and demand characteristics
of water consumption. And growth is a function of accelerating
earnings as the global water industry transitions to market-based
solutions.
And with the bulk of the highly fragmented industry (about 56,000 utilities spread across the U.S. alone) in municipal hands, industry observers predict much of that demand will be met with private investment. It is not surprising, then, that a number of water funds have been established to take advantage of the economics of privatization.
According to the water fund managers, the companies best positioned to ride the wave of new investment are specialist equipment makers and the world's top three water companies: Vivendi Environment and Suez, both of France, and Germany's RWE. Since 1999, these European flagships have spent $22 billion snapping up the largest publicly listed utilities, equipment suppliers, and treatment and chemical processing companies in the U.S.
Vivendi's water unit relies on its U.S. operations for nearly 25 percent of its cash flow, making it the best place to benefit from an upturn in the U.S. economy. And, Unlike Suez and RWE, which have focused on buying traditional water utilities, Vivendi has tended to shy away from regulated assets, which are more vulnerable to rigid rate conditions and political pressures.
Outside of the acquisition of U.S. Filter, Vivendi has focused on providing service contracts and has pursued the public-private ventures market. This model enables the company to participate in the upside potential in the provision of water without the commensurate risk of full ownership. Again, a model that fund managers like.
The downside to the large multi-national utilities is that the global acquisition of customers comes with a heavy debt load. Over-investing can, and has, caused free cash flow to lag. Thus, while the water utilities offer attractive share prices and steady annual growth of about 6 percent, fund managers have cut their utility weighting by as much as half to make room for more dynamic, higher-growth specialty equipment companies.
In particular, they have focused on a handful of mid-sized companies that have developed proprietary technologies for water treatment. This is the same logic that has long been the investment focus of the WIN hypothetical portfolio and continues to represent what is believed to be the path to greater capital gains.
The main advantage of larger water funds is that, because of trading logistics, many are able to easily invest in global companies traded on foreign exchanges such as Germany's Wedeco and BWT of Austria. Where practical, the Win portfolio selects foreign stocks, such as Trojan Technologies listed on the Toronto Exchange, and will continue to do so.
But it is often difficult, and costly, for individual investors to purchase water stocks on a foreign exchange. For those managers wary of smaller, less liquid players, dedicated funds have widened the net to include bottled water companies such as Groupe Danone, the French company, which derives 25 percent of its $12.6 billion top-line sales from bottled water.
Private equity funds have been interested in the water industry for some time. Aqua International Partners, L.P., a member of Texas Pacific Group, was established in 1997 to provide water and water-related products and services to emerging market economies. The fund was created by William Reilly (former EPA head) with support from Texas Pacific Group and the U.S. Overseas Private Investment Corporation. Several other small funds include Summit Water Partners, L.P., in La Jolla, which is available to accredited investors and The ATC Aquarion Fund (a series of The Declaration Fund) out of Santa Fe.
Only recently has there been a publicly traded fund that focused entirely on the water industry as opposed to a broader environmental theme. The North American mutual funds units of Swiss banker Pictet & Cie has an offering for U.S. investors, the Pictet Global Water Fund. The portfolio is modeled after a similar fund launched in 2000 in Europe. The fund is available in both retail (PGWRX) and institutional (PGWIX) shares. The fund is marketed to retail investors directly from Pictet or through select mutual fund supermarkets with a minimum investment of $2,500. And Swiss-based SAM Sustainable Asset Management has a water fund.
There is little doubt that water funds (public and private) will continue to proliferate in response to the growth prospects of the global water industry. Associated with this visibility is the danger that water funds will over-promise on returns that, while attractive, may take some time to materialize.
The water industry is ill defined, comprised of firms classified as cottage businesses to diversified global behemoths. As such, it is a challenge to manage a fund of `water' stocks. And the arena for public water companies is somewhat limited in number. Having said that, the opportunity is compelling. The potential is based upon a fragmented market and the prospect of higher technology being applied to a rapidly growing worldwide demand for quality drinking water.
Editor's Note: Stephen Hoffmann is a contributing editor to Water Investment Newsletter, 230 Main St., Halstead, KS 67056, 1 year, 12 issues, $140. Hoffmann & Associates has provided advisory services to the water industry for over 20 years.
