I’m referring to the precious commodity ‘water’, which commentators have dubbed ‘blue gold’. The structural case for this essential commodity is easy to make, and indeed very compelling.
The reality is that global demand for water is growing, driven by population growth, urbanisation and industrialisation (primarily in the emerging economies).
For example, the world population today is currently nearly 7bn; rising to approximately 9bn by 2050. Furthermore, the bulging middle classes in India and China are increasing demand for water intensive foods like dairy and meat.
According to The Economist, the number of people living in countries chronically short of water stood at 8% at the beginning of the 21st century, this is predicted to rise to 45% by 2050.
Moreover, the supply of water is finite; you cannot produce any more of it. Of the world’s ocean, only 2.5% is fresh water. From that 2.5%, around 70% is frozen, therefore all living things have just 0.75% to live on. As for the other 97.5% of the world ocean, the salt can be removed, but desalination is expensive and consumes substantial amounts of energy
Whenever there is a scarcity of resources, price rises will soon follow. From an investment perspective, I believe this presents a tantalizing opportunity.
And, what makes water particularly attractive is that there is no substitute, because it is absolutely essential for life. Consumers will never give it up; water will always be in demand.
Unlike other commodities, investors cannot gain direct exposure through buying it or by investing in futures contracts.
Perhaps the two best know methods would be to invest in either a collective investment vehicle (OEIC and Investment Trust) or a public water utility company.
Two of the best know funds currently on the market are the ‘Pictet Water Fund’, an offshore fund domiciled in Luxembourg, and the ‘Ecofin Water & Power Opportunities’, a British investment trust.
The Pictet Water Fund aims to invest in companies operating in water supply, treatment, environmental services and water technology. Its three year cumulative share price performance stands at solid 47% as of 3/9/2012, beating the MSCI World index and its sector benchmark.
The investment Trust ‘Ecofin Water & Power Opportunities’ on the other hand, invests chiefly in global water and power utility shares in the developed markets.
As for equities, the most straightforward method would be to invest directly in water utilities. In the UK, investors have an excellent opportunity to invest pick up the last three remaining public water utilities businesses – United Utilities, Pennon and Severn Trent.
The water sectors key attraction is that it guarantees investors low business risk, good visibility of earnings, low volatility, strong fundamentals and inflation-proof dividends.
As a regulated monopoly, the key drivers are the political and regulatory outlook. Ofwat (UK’s regulator of water and sewage industry in England and Wales), sets the limits on which the water companies can charge their customers every five years. They essentially guarantee a return on an agreed capital expenditure programme; enabling them to lock in above inflation dividend growth targets for the next five years.
Ofwat’s present pricing regime runs from 2010 to 2015. Until that time, United Utilities is able to offer shareholders dividend payouts of Retail Price Index (RPI) plus 2%, plus 4% for Pennon Group and plus 3% for Severn Trent.
Being halfway through the pricing regime puts the sector in sound regulatory waters; this is in stark contrast to its energy counterparts, which are facing political and regulatory onslaught by populist politicians.
Energy and water utilities together, the UK only has seven left. Where as in the post privatisation period, there were 29 listed utilities companies!
The key reason for this is that the UK has traditionally been very open to foreign investment and has a legal structure and a government which are very keen to encourage investment.
The British government has no state control over the utilities; these strategic holdings (particularly in France) have traditionally proved major blockades to foreign takeovers.
This year, the French Utility Giant Veolia sold its UK assets to Rift acquisition, the price paid was a 30% premium to the Regulatory Capital Value (RCV). RCV is the value of reservoirs and treatment plants.
If we applied this premium to the three remaining water utilities, they would trade at above 900p for Pennon, 2,200 for Severn Trent and 920p for United Utilities – a substantial premium to current prices.
In my view, foreign investor’s interests in UK utilities will continue, because they offer safe, asset-backed investments with secure dependable revenues.
The ultimate defensive investment
John Ficenec, writer for the investor’s chronicles magazine described utilities as ‘better than gold’ and urged investors to hurry up and purchase these defensive gems before potential foreign investors snap them up.
Whilst they are certainly not overvalued, they are neither cheap either. With the exception of pennon Group, they trade at a hefty premium to their 10 year P/E averages. Investors are clearly willing to pay a higher price for stability and inflation proof income streams.
||Market Value (£m)
||PE 10yr average
||RPI + Dividends increase
But, will investors continue to pay a high price for a cheery consensus? Or does the macroeconomic and political storm in the energy utilities sector create an excellent buying opportunity?
In this economic climate of uncertainty, a sector which boasts strong fundamentals, robust cash flow generation and an inflation-linked income is certainly a very attractive location to park ones scarce capital.
Goldilocks economic scenario
Finally, if governments were to resume another burst of Quantitative Easing (which looks increasingly likely), then higher inflation and prevailing low borrowing cost would be tailor made for utilities to prosper.
The Federal Reserve bank has promised to keep interest rates low until 2014, the UK’s business cycle is 6 months behind the US and likely to follow suit with interest rates in 2014 as well.
When combined with cost-import inflation through high energy and food prices, the ‘inflation busting’ characteristics of water shares look phenomenally enticing.