Water’s Slippery Seduction: Investors Flood Sector

by (author unknown), Blue Gold, European Water Partnership Blog on Mar 29, 2008

By CAROLYN CUI and ANN DAVIS. The Wall Street Journal


Water may be the world’s most critical commodity. But it has been a tough market for many investors to tap profitably lately.


Since last summer, a flood of investment vehicles have hit the market, seeking to capitalize on the rising global need for clean water. But many of these investments have proved disappointing in the past few months, just as Wall Street has piled into the sector. For one, water-oriented stocks—from big conglomerates like General Electric Co. to water utilities to equipment suppliers like Mueller Water Products Inc.—also are exposed to broader economic problems, including the housing slowdown.


The economics of water treatment and delivery itself look compelling. An acute shortage of clean water in many regions has been worsened by population growth and by competition from industry and agriculture.


More than one in six people lack access to safe drinking water, according to the World Water Council. Global spending to treat and purify water, and to improve the often-dilapidated infrastructure that stores and distributes it, amounts to hundreds of billions of dollars a year, and rising.


Investors can’t trade water like other commodities, because it isn’t priced on a global market. It is heavy and the cost of transporting it is many times its value, so it lends itself to regional markets.


Some of the best water stocks already are expensive, because investors have been forced to pour into a relatively small set of opportunities.


Many investors in the initial public offering of Mueller Water Products in 2006 expected demand for the company’s valves, hydrants and pipes to hold up as long as water systems needed improvements. But since last June, amid a downturn in housing construction, Mueller’s stock has plunged by roughly half. Still, it trades at a relatively pricey 32 times last year’s earnings.


“What you’re buying is essentially a supplier to residential construction companies,” said Rod Parsley, portfolio manager of the Perella Weinberg Partners Oasis Fund, an approximately $500 million hedge fund focused on water, clean technologies and alternative energy. Mueller also sells to municipalities.


Water use drops in a recession: 40% of fresh water in the U.S. is consumed in industrial applications. That is why many water utilities have fallen recently on recession fears.


Two of three exchange-traded funds that track water-related stocks have sunk since their mid-2007 debuts. The third, First Trust ISE Water Index, is up 4.1% since its May 11 launch. But measured since June 13, after all three began trading, it has posted a gain of 1.9%. Over that period, Claymore S&P Global Water ETF has lost 6.3% and PowerShares Global Water Portfolio dropped 11.9%, compared with the S&P 500-stock index’s loss of 13.2%.


This year, only PowerShares Global Water is underperforming the S&P 500. First Trust and PowerShares Water Resources Portfolio, an ETF launched in 2005, are leading the group, although both have fallen in value.


Actively managed funds focused on the water sector have fared slightly better. The Kinetics Water Infrastructure Fund is down 1.8% since its July 2 launch. Its drop of 3.5% this year is well ahead of the S&P and other water ETFs.


A publicly traded portfolio of water hedge-fund investments organized in July, Australia’s 20 million Australian dollars ($18.4 million) MFS Water Fund has beaten the MSCI World Index by about five percentage points from inception through January, the last month for which performance is available, though in January it didn’t outperform the index by much.


Other scarce commodities have soared: the Dow Jones-AIG Commodity Index has risen about 16% since mid-June.


“There’s a lot of money to be made in water, but it’s a lot trickier than just picking a basket of companies ostensibly participating in the sector,” said Mr. Parsley. Oasis doesn’t disclose returns. But MFS, which invests in Oasis, calls it one of its best performers.


“Just because something calls itself a water company or ostensibly makes something associated with water, are you really buying a water play?” he said.


Over the longer run, it is a better story. Water-focused investing was a niche in 1999, when John Dickerson started San Diego-based Summit Water Equity Fund. The hedge fund now has $600 million in assets. The fund has more than tripled in value during that time, according to Mr. Dickerson.


The United Nations Population Fund sees global consumption of water doubling every 20 years. In 2005, the Environmental Protection Agency estimated that aging systems in the U.S. will require $277 billion in investments just to upgrade and maintain drinking-water quality over the next 20 years.


The power industry is one of many big users; water is critical in hydroelectric dams, cooling processes at fossil-fuel and nuclear-power plants. So is the food industry. It takes 260 gallons of water to produce 2.2 pounds of wheat and 3,380 gallons of water to produce 2.2 pounds of beef, according to the World Water Council.


Of the hundreds of large municipal U.S. water utilities, only about 10 are publicly traded. Water utilities are natural monopolies, tend to show steady growth and returned 383% from 1996 through 2006, beating the Dow Jones Industrial Average’s return of 135%. This year, water utilities have lost 7%, while the S&P 500 lost 10%, according to Smith, Moore & Co., a brokerage firm.


Only a trickle of other water-related companies have recently gone public. Among the next IPOs: American Water Works Co., which could become the biggest publicly traded water utility in the U.S., and Energy Recovery Inc., a desalination-technology firm.


Many big companies in water treatment and distribution are conglomerates whose stocks move on many other factors. General Electric and Siemens AG are two of the holdings in PowerShares’ water portfolios.


William Brennan, portfolio manager of the Kinetics fund and former adviser to Summit, the hedge fund, said investment dollars dedicated to the water business surged to nearly $20 billion in 2007 from $1.5 billion in 2005. He contends that has made water stocks more volatile and reduced chances of finding new gems.