Walking on water

From the perspective of someone living in northern Europe, where rain has been particularly prevalent this summer, it’s difficult to believe there could be any value from investing in water. You might ask, doesn’t the stuff literally fall from the sky?

Of course, the problem is water doesn’t fall everywhere – and it’s expensive and difficult to transport from the places where it does fall to the places where it doesn’t. Despite the abundant supply of seawater and rain, global water shortages are becoming more acute. Then there’s that one indisputable fact about water: we can’t live without it. The relative scarcity of water moved Goldman Sachs to describe the commodity a few years back as “petroleum for the next century”. To this end, the World Bank forecasts that investment in water infrastructure this decade will grow around 10 times as fast as in the transport sector.

Bank Sarasin, in its report Water – Elixir of Life and Investment Theme, published earlier this year, said demand for water is growing at 2% a year – faster than the world’s population. Burkhard Varnholt, chief investment officer at Sarasin, which launched the Sarasin Sustainable Water Fund in December 2007, says: “Because the technological, political and environmental challenges are so complex, this investment theme has not only great market potential but also outstanding margin potential. Specialised, sustainably managed investments in the water market are a must for any long-term portfolio.” But you might expect him to say that given that Sarasin has a water fund to promote.

But it’s fair to say water has proven to be a better bet than other equities since 2007, although not by any staggering measure. Standard & Poor’s global water index was up 36.95% over the past three years (from the dark days of the stock market trough in 2009), while equity markets rose 34.59% over the same period as measured by the MSCI World index. Between June 2011 and June 2012, S&P’s water stocks were down 3.26% compared with a 4.98% fall in global markets, while over the last five years – from June 2007 – water was up 8.48%, against a 1.35% fall in world markets.

Family offices appear to be keeping an eye on the theme, although many say they are not yet motivated to invest directly in water-related businesses or the small handful of actively managed specialist water funds that have proliferated in the past decade. “I agree with the premise, water is interesting from a number of different perspectives,” says Dan Briggs, chief investment officer at the UK multi family office Fleming Family & Partners. “We’ve looked at a number of different things quite close to home. Water companies, for example. They aren’t cyclical, they offer a steady return and the water regulator is keen that water companies invest, so that makes the asset base attractive. Take Thames Water for example, owned by Macquarie Bank and a number of different sovereign wealth funds. I’d make a lot from the fact that sovereign wealth funds are interested.”

But Briggs adds the valuations on funds and stocks are not yet compelling enough for FF&P to make a concerted investment in water-themed companies. “I’m very excited for investors to go in, but are we going to build a whole portfolio around it? I don’t think it’s sufficiently homogenous sector for us right now. We are waiting for a good entry point. If there’s a big sell off, then potentially [we will buy in]. Water’s going to be with us forever in a way that motorcars and oil will not be. It is an interesting place to be, provided the price is right.”

William Drake, director at London-based MFO Lord North Street, agrees. “We have looked at it a bit, it’s obviously a vitally important sector. It has enormous geopolitical significance. I’m interested to learn more. We haven’t invested yet as we haven’t seen any funds that appeal, but we might well do in the future.” So is it a suitable theme for sophisticated investors? “It depends on the overall circumstances of the investor, and the nature and structure of the fund,” says Drake.

Jonathan Fry, private wealth director at Fry Family Office, points out that water belongs in the 5% of an adventurous portfolio devoted to “adventurous” investments and no more. But Jonathan Bell, chief investment officer at Stanhope Capital in London, sees wisdom in accessing water. He has introduced some clients to Summit Global Management, a San Diego-based investment adviser that specialises in acquiring water rights – the entitlements to access water for farm irrigation – mostly in the US and Australia. “There are areas which are excellent for agriculture – hot, sunny with erratic water supply,” says Bell.

“I think that’s an interesting area, you’re directly investing in water where it’s scarce, and it’s a play on global demand and growth for agricultural products.” Bell says although there was some concern about the liquidity of investments such as water rights, it provides diversification that other water equities, which are correlated to the rest of the stock market’s performance, can’t provide.

Bell is not alone. Investing in agriculture as an indirect play on water is gathering favour among advisers, along with general infrastructure and emerging market funds. This happened as pure water funds proved not to be the uncorrelated asset class it was once said to be. Indeed, some advisers who dipped a toe into water in 2008 ran scared when markets fell and are yet to return.

It should be noted that specialist water funds have outperformed global markets and the S&P’s benchmark in recent years – just. By far the largest, with more than €2 billion in funds under management, and one of the best performers over the past three years is the Luxembourg-based Pictet Water Fund. But it has a higher than average 1.6% management fee and it stretches the water theme somewhat. The Sarasin Sustainable Water Fund (€232 million in assets) takes a different approach.

As the name suggests, it concentrates on companies that use water sustainably. Sarasin eschews the likes of Nestlé, focusing on waste water treatment and technology companies that supply utilities. The Sarasin fund has returned 43.8% over the past three years – between 30 June 2009 and 29 June 2012 – lagging the Pictet fund at 48.2% over the same period.

A cheaper way to buy in is to track the index through an exchange traded fund, which is traded like stocks and can be bought and sold through stockbrokers – for instance, the iShares S&P Global Water ETF, which holds €150 million in assets, according to data from Lipper, and tracks the S&P’s index. The biggest holding in the index is the Swiss industrial company Geberit, which makes high-tech WCs, shower elements and piping. ETFs are also a more cost-effective way to buy a basket of water-themed businesses. The charge on the S&P ETF is 0.65%.
So what is the best way to tap in?

Treatment
Wealth manager Kleinwort Benson says worldwide regulations to improve water quality will drive spending on advanced treatment technologies and testing equipment. For example, American industrials giant Danaher Corporation, which develops instruments and materials to purify, disinfect and analyse industrial and drinking water, is a leading ultraviolet treatment provider. Danaher has said the International Maritime Organization’s ballast water treatment regulations, which forces ships to minimise the harm caused by transferring bacteria through ballast water, will boost the market for treatment and analysis to $5 billion (€4 billion) by 2017, from $200 million today.

As a huge conglomerate, Danaher’s fortunes do not rest on its water business. Its share price has had a rocky 12 months to July 2012, ending the year virtually flat, but has been impressive over two years, rising 41%. Danaher is the second biggest holding in the Pictet Water Fund (4.7% of the fund’s total assets). Sarasin doesn’t hold the stock on the basis of its military contracts and nuclear energy businesses, and instead holds New York-listed Calgon Carbon Corporation, which specialises in carbon as well as UV-based water and air purification.

Another much-talked about stock in the space is the Singapore listed Hyflux, which treats potable water and waste water, has built desalination plants in China and has operated in India, Algeria, Asia and the Middle East. Hyflux has also been volatile, but for more diversified exposure, Hyflux is the biggest holding in the Powershares Palisades Global Water Fund ETF (5.57% of its assets). Managed by Invesco, the ETF aims to replicate the Palisades Global Water Index, a rival to S&P’s index. The ETF is down 4.1% over one year, up 26.9% over three years and down 7% over five years, to 29 June 2012.

Utilities
Water as an underlying resource is not tradable like gold or copper – so historically, water rights and utilities were the way to profit. Western world water mains don’t offer exposure to the racier side of the water story but do serve a purpose, particularly for income seekers.

Severn Trent, the UK water company, is predicting a yield of 4.7% over the next year and earlier this year issued a retail inflation-linked bond. Its share price isn’t particularly exciting. More interesting is Pennon Group, which owns United Utilities and South West Water alongside Viridor, one of the leading UK recycling, renewable energy and waste management businesses. Pennon’s share price, at £7.62 (€9.10), is up 13.3% over the past year.

Most of Pictet Water Fund’s biggest holdings are in utilities: 5.4% in American Water Works and a 4.3% investment in Pennon. The S&P global water index is also weighted heavily in utilities including United Utilities, Severn Trent, American Water Works and Pennon. However, the water story in emerging markets is far more exciting, where companies are tackling persistent problems with leakage. As emerging markets utilities upgrade their facilities, returns in these markets grow.

In a note earlier this year, Kleinwort Benson said: “As developed market spending on water infrastructure slows or declines, it is rapidly being offset and surpassed by emerging markets.” In the first five years of the millennium, the combined spending on water infrastructure, including irrigation by China and India, was only one-third of the spending in the US. However, the projected spend in the countries’ current five-year plans will be more than twice the spending in the US, according to Kleinwort Benson.

Mick Gilligan, head of research at Killik & Co, the UK broker and adviser, is recommending Utilico Emerging Markets investment trust as a water play. While its largest holding is concerned with container terminals, 8.8% of its assets are invested in Eastern Water Resources, a Bangkok company which develops and maintains water pipeline systems in Thailand. In doing so, it produces and supplies tap water, treats waste water and supplies raw water to industrial estates, factories and water works. The Utilico fund is up 68% over three years to 13 July 2012 and 22.3% over five years to 13 July this year, according to Killik & Co.
Utilities suppliers are a subset of water utilities. Sarasin says that utilities spend 44% of their sales on components such as pipes, pumps, filters and construction services. For example, Elster Group, headquartered in Germany, makes meters to measure and improve the flow of natural gas, electricity and water in more than 130 counties – important technology for utilities. Elster is the biggest holding in the Sarasin Sustainable Water Fund at 3.24%.

Agriculture
Farmers undoubtedly have a vested interest in water and as such, agriculture is usually at the forefront of developing new methods of irrigation and reducing wastage.

Kristof Bulkai, co-manager at the Thames River Water and Agriculture Fund, says: “Food and water are two sides of the same coin. Demand for water is demand for food – 70% of all the water we use is used by farmers to irrigate land. So far, we have been meeting this requirement from ground water. The problem is there’s not much of it left. In California, this is a big problem.”

The Thames River fund has a wide mandate and its holdings range from a bet on the US housing recovery to manufacturers of water cleaning equipment, residential water pumps and pipes. It also holds water rights in Chile, Australia and America.

The fund has underperformed the benchmark but, says Bulkai, its time will come. “The real breakthrough eventually will come from some sort of technological innovation. The person who is able to develop the right enzyme that is able to convert non-food waste into fuel is going to make a lot of money. However, we have invested a lot in these companies and somehow none of them have been able to do it economically.”

Thomas Becket, chief investment officer at PSigma Investment Management, sold the Pictet Water Fund this year and bought into the First State Global Agribusiness Fund, launched in March 2010, which holds seed businesses Monsanto and Syngenta. “We wanted to realise some profits from the Pictet investment, and exploit water through a purer agriculture play,” says Becket. The fund was cheap as “soft commodity prices have been hit hard over the last 12 months and agricultural companies are now trading at what we believe are reasonable valuations”, he adds.

Renewables
Alternative energy is another natural fit for the water theme. While hydroelectric plants are generally excluded from specialist water funds, Ecofin Water & Power Opportunities investment trust has a stake (2.39% of its assets) in Origo, a Chinese private equity firm, which backs an alternative energy player, China Cleantech partners. The businesses also focus on water and energy storage and distribution, and desalination.

The Ecofin fund is trading at around a 30% discount to its net asset value – that is to say, investors so far have lost a chunk of their capital – but it pays a yield of around 5.5% so at least provides a respectable income. It might be cause for a confidence boost that Ecofin also holds Pennon alongside Siemens and General Electric, leaders in the clean- tech water race. GE was a pioneer in the reverse osmosis filtration systems that went on to become the norm in the business. Ecofin directors also tend to have six-figure stakes in the trust, another cause for comfort.

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