Investing in water: demographics, market access and political risk

Room 151 takes a look at a hot investment topic: water.

There is lots of it, but water is becoming scarce.

Interest in the sector has been piqued by the film version of Michael Lewis’s best-seller The Big Short, which ended with a laconic message: “Burry is focusing all his trading in one commodity: water”.

Michael Burry, one of the main characters in the film, is famous for his bet against the subprime market.

More than 1bn people live in ‘water-stressed’ areas where supply is inadequate for demand, according to Word Resources Institute, and it thinks this number could rise to 3.5bn by 2025.

The United Nations says: “Water scarcity affects more than 40% of the global population and is projected to rise.

“Over 1.7bn are currently living in river basins where water use exceeds recharge”.

The world’s population is increasing.

In 1960 the total number was around 3bn; today it is 7.7bn.

Agriculture is the largest source of demand for water, taking nearly 70% of withdrawals.

According to the Institute of Mechanical Engineers it takes between 500 and 4,000 litres to produce 1kg of wheat.

Once you start producing protein, water consumption rises dramatically, with 1kg of meat requiring between 5,000 and 20,000 litres.

Growing middle classes in emerging markets are increasing demand as they move upmarket in their food consumption.

One way their increasing wealth expresses itself is in increasing demand for beef, and it takes nearly four times as much water to produce 1kg of beef as it does 1kg of chicken.

Apart from agriculture, demand for water comes from industrial and domestic activities, accounting for 22% and 8% of withdrawals, respectively, with both of these growing much faster than agriculture. 

Within industrial, an especially large consumer is power generation, with much of electricity output dependent on stream-driven turbines.

Rising domestic consumption is fed not just by an increase in the population, but by increased urbanization, which leads to increased use per head and creates huge demand for infrastructure.

The supply side of water is by its nature largely fixed.

Just 2.5% of the planet’s water is fresh water, and 70% of that is frozen.

The remaining proportion is ‘stored’ in rivers, lakes and reservoirs, or lies in aquifers (large underground wells), which are being steadily emptied.

According to the United States Geological Survey groundwater depletion during the 20th century was ‘large’, totalling about 800 cubic kilometres (km³), and then increased by another quarter to 1000km³ in just the five years from 2001 to 2008.

A further threat to supply comes from pollution which can render fresh water unfit for human use.

There are ways to increase supply, and these could prove important to investors in spotting growth areas.

However, their effect on increasing overall supply will remain limited.

One problem in the western world is leaks due to ageing infrastructure, and a relatively simple way to address them is to stop the losses by upgrading the water mains.

Exploration can lead to the discovery of new acquifers, desalination can turn desert into farmland, though so far this is not economical, and smart meters can help reduce demand.

Institutional investors can invest in water in many ways.

There are three areas of direct equity investment: the water utilities; the water technology companies that make pipes, meters, filters and infrastructure; and the environmental services companies that treat water and distribute it.

Water utilities are an obvious target in the sense that they are large, relatively transparent, and liquid.

They constitute a large part of the water benchmarks, such as the S&P Global Water Index, of which they make up nearly half (48.4% as of December 2018).

There are three big listed UK water companies: Pennon, United Utilities and Severn Trent.

They are regulated and so their prices are controlled, but the efficiencies they make are shared over time between their customers and their shareholders.

They are currently subject to a degree of political risk, with Labour promising to nationalise them, and with the uncertainties of Brexit.

They are also subject to regulatory risk, and Ofwat has talked of a ‘tough new regime’ for the next five-year regulatory period, starting in April this year.

France’s Veolia Environnement SA and Suez are diversified global companies acting as water utilities and providing waste management services.

In the US, American Water Works, one of the largest water utilities, has benefited from strict water regulations encouraging municipalities to outsource their water supplies.

The American water system also needs investment to address ageing and leaky infrastructure.

In addition, there are the water-related stocks such as Polypipe Group, which makes pipes and water management products, and which is listed on the FTSE 250.

Pentair is a water treatment company, incorporated in Ireland but with its main listing is on the NYSE.

Its products reduce water consumption, clean water for consumption, and clean waste water before it is returned to the environment.

Xylem, spun out of ITT inc. is listed on the NYSE and is a leader in smart water solutions.

There are two main ETFs in the sector.

iShares Global Water ETF tracks 50 of the largest global companies active in water-related businesses, and which tracks the S&P GlobalWater Index, while the Lyxor World Water ETF aims to track 20 of the largest utilities and companies engaged in water infrastructure and treatment.

Two actively managed funds are run by Pictet and Fidelity.

Pictet’s Water Fund invests in global water-related stocks, i.e. companies providing water supply and processing services, water technology companies, and environmental services.

Fidelity International launched its Sustainable Water and Waste Fund in November 2018.

This is managed by Bertrand Lecourt, who told Room 151 that over the long term the water and waste sector “has delivered good earnings momentum, with 10% earnings growth and an average dividend yield of 3%, plus some ‘decorrelation’, making a compelling investment strategy.”

Lecourt says that the water indices, such as the S&P Global Water Index are by no means perfect, but that they still demonstrate quite clearly the out-performance of the sector against the MSCI World Index. 

He likes direct investment in equities, because investors, he says, often have to pay a premium to go down the direct route of investing in private equity, or buying real assets, and that the investible universe of water and waste-related shares has become much more interesting.

“The spectrum of equities has increased a lot.

“Over the past 30 years the number of stocks has grown from under 50 to more than 330”.

He notes that even the largest of these are not mega stocks, and are consequently not always well-covered by analysts, leaving room for stock-picking.

One notable practitioner of the direct investment approach has been Harvard University, whose endowment fund has been busy buying up vineyards in California.

The university’s interest does not lie so much directly in grapes, but rather in the water they contain.

In 2011 to 2017 the state was hit by one of the worst droughts in its history, and Harvard’s vineyards confer prime access to groundwater underneath them.

Harvard Management Co. owns around 10,000 areas of vineyards through a shell company, Bordiaea Inc.

According to the Wall Street Journal, this land is now worth around $305m, about three times what it was worth in 2013.

The Californian vineyards sit within a wider investment strategy, of which Harvard and Yale have been prominent exponents, of investing half of their endowment funds in assets other than bonds and equities.

This is Michael Burry’s investment idea too: to buy water-rich farmland, grow a crop which requires a lot of water, like almonds, and transport it to water-poor areas.

Direct investment can have disadvantages, however, in addition to its illiquidity.

In May 2018 environmentalist Kat Taylor resigned from Harvard’s board of overseers, saying she had concerns over “water holdings that threaten the human right to water”.

LGPS investors, with a watchful eye on the broader ethical considerations of how their assets are deployed, will certainly be mindful of any such implications.

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