Commodities: Water, water everywhere…
…any way to invest? Martin Steward ponders how to turn H2O into EUR, GBP and USD
"Greene isn't after the oil," James Bond realises midway through Quantum of Solace, stumbling on the villain's underground dam. "He wants the water."
And no wonder: it is a precious commodity. Only 0.5% of the earth's water is fresh, and we are using it faster each year. Today, 1.2bn people lack potable water and more than twice that have inadequate sanitation, causing 5m deaths and wiping nearly $600trn from global GDP each year. The UN's goal of halving those numbers by 2015 will cost $12bn per year beyond current spending, according to Summit Global Management, a San Diego, California-based water investment specialist. Infrastructure needs an annual investment of $180bn for the next 20 years, according to the World Bank.
Water remains under-priced for a reason: no-one other than Bond villains wants to hit the poor with the price hike that would make this capex economically viable. But work is being funded - China's twelfth Five Year Plan alone has earmarked $160bn - and in theory you shouldn't need to be a villain to make money from this opportunity. For example, tiered pricing allows everyone their 50 litres per day at very low prices, while charging more for excess use. Common in Australia and Israel, global adoption would be spectacular for smart metering companies like US firm Itron. And if water's value rises, a vicious circle has the potential to become a virtuous one: utilities would be able to expand their capex on efficiency-creating opportunities for manufacturers of pipes, pumps and valves like Germany's KSB and providers of pipe monitoring technology like Canada's Pure Technologies.
And this is before we even get into the 20% of water used by industry (opportunities for those valve makers and wastewater treatment specialists like Japan's Organo) and the 65% used in agriculture (benefiting firms like India's Jain Irrigation Systems).
"Individual consumers will riot at price rises," observes Nathalie Han, manager of the Renewable, Alternative and Sustainable Resources fund at Craton Capital Management. "Mining companies will pay and pass the cost on. That means a big difference in potential returns." In the words of Burkhard Varnholt, CIO at Sarasin & Partners: "Water is one of the most powerful investment themes this decade is likely to see."
But you don't have to go far to encounter sceptics. You might think thematic managers would be all over this. Not Catherine Wood, CIO on thematic portfolios AllianceBernstein Investments: "There's no real publicly investable opportunity unless you want to be full of utilities and conglomerates." Khiem Le, manager of the Global Environment fund at AXA Investment Managers, has 13% allocated to water but would like twice that: "That reflects a lack of investable opportunities." Claire Burgess, manager of Premier Asset Management's Environmental Power and Water fund, says it is stuck at 20% and "actively seeking" more. And Valerie Daoud Henderson at Fourwinds Capital Management reveals that before launching its private equity Aqua Resources fund the firm abandoned its original plan for a fund of public water equity funds: "Most were invested in large water incumbents or, at worst, companies like Nestlé."
The bottled water peddlers have gone from most portfolios now, but one can still find managers holding emerging market manufacturers of sanitary ware, anticipating a wave of Chinese fitting their homes with new taps and basins. Is that really the global water theme, rather than the emerging consumer theme? No wonder we find significant sector concentration in these funds: the PowerShares Water Resource Portfolio, a big water-themed ETF, has 34% in utilities and 50% in industrials; the Sarasin Sustainable Water is similarly allocated; Amundi's Aqua Global fund is currently 47%/39%.
When water utilities are privatised - and just 11 of the US's 54,000 are - they are great: Summit notes that Aqua America has paid a dividend for six decades; the average UK utility will deliver a 2-3% yield above its cost of capital. Pension funds love them. But are these really water theme investments? "The regulator always intermediates the price signals coming from water, so the investment case is really around cash flows generated by regulation," reasons Hugo Rogers, portfolio manager on the Thames River Water and Agriculture Absolute Return fund.
Indeed, water fund managers really deploy utilities as a risk management tool to set against their pro-cyclical industrial stocks. "They are a very good way of reducing portfolio volatility," says Simon Gottelier, manager of listed equities at Impax Asset Management. Or as Nicolas Fragneau, manager of Amundi's Aqua Global fund, puts it: "If we want to be defensive we might go 50% utilities; if we want to be more aggressive we might go 20% utilities."
Jens Peers, head of environmental strategies at Kleinwort Benson, points out that regulated utilities can be balanced by "non-regulated utilities like Suez and Veolia" - but that only leads us to our next problem. Only about one-third of Veolia Environnement's revenues come from Veolia Water (other business areas vary from waste management to running buses); and 45% of Suez Evironnement's revenues are water-related.
Even pure plays can be difficult to justify as part of the global water shortage story. Germany's Geberit features in many portfolios: are its cisterns part of the water efficiency story in the same way that Pure's pipe monitoring technology clearly is? And pure-plays are the exceptions. Water-related revenues have been fragmented through a combination of acquisitions and the very fact that water is the lifeblood of virtually every industry. As Summit Global puts it: "There is really no such thing as the water industry."
Take a closer look at the Powershares ETF: among its industrials only Organo, Wavin, Geberit and Kurita Water Industries are pure-plays - and Kurita aims to ‘develop new energy-related business'. Then we have Pentair (60% of revenues from water); GLV (60%); Nalco (43%); Valmont Industries (22% from irrigation); ARCADIS (35% from ‘environment'); Stantec (40% from ‘environment'); Ebara Corp (7% from its Fluid Machinery & Systems Company); Uponor (plumbing and heating); Tetra Tech (architecture and engineering with a water industry focus); KSB (pumps and valves for a variety of industries); and ITT (a mix of water and defence).
"There are a whole bunch of companies in dedicated water funds where the water business is just too diluted for me to consider," says Le on AXA's Global Environment fund. Suez is about as diluted as I can go." Le's fund has a lower limit of 25% of revenues from environmental business, and that reflects practice at most dedicated water funds, too. Amundi's Fragneau says that a 25% limit results in a universe of 200 stocks, 150 of which are "easily tradable".
There are signs of change, however. ITT recently decided to separate its water and defence businesses after years of lobbying from investors. "The defence multiples are typically lower than the water multiples, so the entire company was undervalued," says Marc-Olivier Buffle, senior analyst in industrials and water at Sustainable Asset Management (SAM). Recognising that water is a growing business and capital is looking for pure-play opportunities if revenues can be purified - might lead investment banks to get behind a trend in water-specific spin-outs. "We've noticed GE becoming quite active presenting to water investors," says Peers.
"We do expect more companies to spin off their water related activities. Investors are paying more attention to this sector and conglomerates might find it value-creating to make this business area more visible," says Øystein Sjølie, communications adviser at Norges Bank, which pursues water investments for Norway's Pension Fund Global both internally and with external specialists, but also collects data on water risk management from hundreds of its portfolio companies. "The pure water universe is smaller than other areas in the public utilities. This is primarily a sign of immaturity of the sector. This could change fast over the coming years and we already see a rising attention and activity, both from investors and companies. As a long-term investor, we should be ready to take part and not look just at the investible universe now, rather at what will become."
Still, water-business divestment certainly isn't a trend yet, and in the meantime another wave of M&A continues to tie water specialists like Dionex into diversified businesses like Thermo Fisher. "Across the environmental space generally we've seen large, diversified companies with low cost of capital buying up high-growth businesses," says Gottelier. "Water is one of the areas where this is most pronounced."
What if you follow the corporate buyers down the market-cap scale? Water funds are often overweight mid-caps. "There are several mid-cap companies specialised in the water space, particularly in the upstream part of the water business," says Sjølie at Norges Bank. The micro irrigation specialists Jain and Netafim are both about $1.5bn. Pure Technologies is on the cusp of micro-cap at $220m, as is, for example, Energy Recovery Systems (ERI), which sells energy efficiency technology to the desalination industry.
So perhaps the way to play water would be via private equity? But private equity is not falling over itself to launch dedicated water funds: there are few beyond Fourwinds' fund, Toronto's XPV Capital (a GE spin-off) and the odd business like the UK's Modern Water, which develops patented water technologies. David Lloyd Owen, founder of the water business consultancy Envisager and an adviser to XPV, recalls surveying the private equity field a few years ago and finding that, while 90% of funds held one recognisable water business, less than 10% had more than one, only 1% more than two. "VC is very much biased towards the energy side of cleantech," he says.
Unfortunately, the cleantech playbook doesn't help in a sector without public subsidies, where technologies take years to be adopted. "We invested in Bluewater Bio, which owns a [waste water treatment] technology called HYBACS and a successful pilot plant with Severn Trent," says Henderson at Fourwinds. "But it took a while for Severn Trent to go with it. You are often dealing with public health issues, so it's very difficult for a utility to spend a lot of money on unproven technology." Neil McDougall, co-founder of Modern Water, tells a similar story: "Some of our technologies are being tried out by UK water companies now, but until just a year or two ago it was virtually impossible."
But perhaps the key reason why water venture capital is difficult is also the reason for the fragmentation at conglomerate level: as a theme it is less about individual technologies that about improving processes than employ a range of disparate technologies. "A lot of what goes on in water is incremental, and about solutions that re-align processes so that they work with and not against each other," says Lloyd Owen.
Is water an investable theme, or a vital factor running through numerous other investable themes? It seems easier to pursue it with a diversified portfolio of environmental, agricultural and energy stocks. After all, many of the conglomerates with water businesses take their other revenues from precisely those sectors. As Varnholt at Sarasin puts it: "Water, food and power are really three parts of the same story."
This is true from the ridiculous (the same firm's pumps often pump both water and oil on the same worksite) to the sublime (desalination is economically viable only with improved energy efficiency). "The wedding of renewable energy and desalination as an economic package would be truly fascinating," says Lloyd Owen.
It's already happening: the Perth Seawater Deslaination Plant, built by Suez, uses ERI's energy recovery technology and gets its power from a wind farm. AXA's Global Environment fund has exposure to all three but, as Le puts it, "I could never create a dedicated water fund." Han, on the Renewable, Alternative and Sustainable Resources fund at Craton Capital, agrees: "The water theme falls into the part of the portfolio which is about improving efficiency in any resource. We like desalination as a key support industry to mining in Chile, for example; and waste water treatment can limit the environmental impact of oil sands extraction."
So perhaps it's best to leave the water fixation to Bond villains. It's undeniably a mega theme, but looking at the bigger picture is the best way to make it impact your investment portfolio.