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Profiting on Water

Water is not a globally traded commodity. In fact, unless you’re talking about the bottled stuff, it’s barely a commodity at all. You rarely if ever hear consumers grumble about higher water bills the way they gripe about gas prices. And while many people do take steps to save water...

Water is not a globally traded commodity. In fact, unless you’re talking about the bottled stuff, it’s barely a commodity at all. You rarely if ever hear consumers grumble about higher water bills the way they gripe about gas prices. And while many people do take steps to save water by taking shorter showers and turning the tap off while they brush, their primary reasons are usually environmental, not fiscal.

In short, in our world, water is cheap. It’s not really traded, it’s rarely transported far and you can’t really make that much money from it. However, a growing contingent of observers is now saying it may not be that way much longer. They say water—specifically the clean, non-salty variety—is going to get scarcer. And with scarcity will come commoditization. So that thing about not being able to make much money from water? That might be about to change.

Of course, where there’s a money-making opportunity, there are investors. So as you’d expect, a small but growing number of people in the investing world—including several of our Digest contributors—are looking for ways to make money off of water. Today, I’d like to share a couple of ideas from recent Dick Davis Digests.

Our first recommendation comes from Gregory Spear, who recently wrote about the water situation at length in Spear’s ETF Analyst. He recommended buying a water-themed ETF. Here’s part of his recommendation, from the June 20 Investment Digest:

“About 70% of the earth’s surface is covered in water, and 97% of it is saltwater. Saltwater can’t be used for drinking, crop irrigation or most industrial uses, so only the remaining 3% is suitable for most human uses. Of that supply, two-thirds is locked in glaciers and ice caps, which results in less than 1% of the world’s fresh water being available for human use. Most of that water is found in lakes, rivers, reservoirs and underground sources shallow enough to be accessed cheaply. But, much of that supply is polluted or otherwise unsuitable for consumption. That’s why analysts, like those at Fidelity, predict that water is the new oil and will be traded and transported in the future similarly to how oil and natural gas are traded and transported today. …

“It’s a compelling story, but what are the risks of investing in this trend? First, it’s a hard trade to execute because so few companies are pure water plays. … The second risk is that even though it appears that we are heading toward a severe water shortage, such a shortage may not happen. In fact, most of these situations have a way of taking care of themselves. Many, many such predictions have proven to be much overblown in the past. Just 30 years ago, the idea that the world could sustain the population that it has today without severe shortages of basic commodities, including food, was unthinkable. And how many times have we heard that Peak Oil has already occurred, only to discover massive new sources? The list goes on and on, with new technology, or new exploration solving ‘inevitable’ worldwide shortages before they even happen.

“How could this occur in the water situation? Well, if it was possible to tell with any certainty, then there would be no speculation about massive shortages, but even a quick think can provide some clear possibilities. One is that like oil, extraction from sources that are difficult now could become much easier and more economical in the future. The most glaring example of this is desalinization, removing the salt from salt-water. A new technology for accomplishing this inexpensively would completely eliminate all speculation of fresh-water shortages. Tapping glaciers and icebergs is another example, and converting to hydrogen fuel is another. (Water is the only ‘emission’ from hydrogen-fueled engines.) Inexpensive water-purification techniques could also free up large quantities of water that are now too polluted to use, and a new political will to impose pollution controls could reclaim enormous sources that are now unavailable. This is already in progress in many places, like the Great Lakes in the U.S. and some of the world’s greatest rivers.

“Keeping solutions like these in mind can help us find investments that can grow with the development of these solutions, rather than be threatened by them. … And of course, with all of the risks of investing in individual companies in a rapidly changing industry, this is an ideal area in which to use ETFs. … Of the two global water ETFs, our pick is the Claymore S&P Global Water Index ETF (CGW). It has substantially outperformed the PowerShares Global Water Portfolio (PIO) on a long-term basis and in the last several weeks of market turmoil. We are adding CGW to our Model Portfolio at this time with a half position and recommend accumulating on dips.”—Gregory Spear, Spear’s ETF Analyst, June 7, 2012

I like that Spear’s suggested play on the water theme considers that the spread of new technology that averts scarcity is just as likely to be profitable as betting directly on increased scarcity. His historical perspective is spot on: resource scarcity rarely plays out as predicted. My favorite example is the prediction of Thomas Malthus, who wrote around 1800 that the limits of agriculture would soon force a decline in Britain’s population, giving us the term Malthusian. A contemporary investor who responded by hoarding food would have lived to regret it. One who invested in the tools of the ongoing agricultural and industrial revolutions—like fertilizer and steel plows—or in the ships and trains that imported massive quantities of food to Britain over the next century would have seen an excellent return on his investment. Britain’s population wound up nearly doubling between 1800 and 1850.

Another analyst who’s looking for profits in water is Jason Kelly, editor of The Kelly Letter. Kelly wrote about the potential for water to become commoditized earlier this year, and his play on the theme was recommended in the May 9 Dividend Digest. Here’s some of what he wrote.

“Rising demand for water is depleting the easy sources of clean water, which makes water more precious as demand grows further. It’s the same price-elevating cycle we see in oil over the long term, and has even led to analysts using similar language to describe both. … Yet, there’s a difference. When oil is used, it’s gone. When water is used, it’s just moved around.

“Earth is a closed water system. The water we use to brush our teeth and take showers and drink is the same water that rained on the dinosaurs and provided a home for fish caught by ancient Romans. Thus, the challenges humanity faces on the water front are ones of distribution and transformation, not disappearing supply. [When looking for the solutions to these challenges,] one quickly runs into the desalinization and purification sectors and learns about reverse osmosis systems and distillation.

“A little beyond that, however, one finds a lack of profit.

“The water business has been lousy for years. For all the obviousness of it, there’s not much money moving from the world’s emerging markets into the coffers of water companies. Somewhere in mid head-scratch, one notices an interesting factoid. The United States is the largest water market in the world, but most revenues in water indexes originate in emerging markets with a clear focus on Asia.

“That makes sense, as China is home to 21% of the world’s population but only 7% of the planet’s renewable water resources. There are two takeaways from that. The developed world, represented here by the U.S. water market, uses a lot of water but doesn’t pay much for the privilege. The emerging world pays for water, but it’s not yet a very big business compared with other commodities such as oil.

“This presents a conundrum for water investors. The thesis for increased demand from emerging markets is that they’ll become more developed and need more water. Yet doing so apparently labels water a basic right and therefore societies become less willing to pay up for it. There may, therefore, be a cap on the price appreciation of water caused by growing populations in emerging markets. They’ll want more, but will pay less for it as their societies emerge. … which makes the great water opportunity sound a lot like utilities.

“Wait a minute. Excitement around the future of the water business is such that we expect it to be a growth industry, and not just a middling amount of growth but super growth. The millions demanding it, the need to clean it and deliver it, maybe a few patents to protect methods of making natural water potable. Instead, we find that as societies emerge they get their water systems up to par and do so in a way that exposes the companies involved to utilities regulations, and utilities are known for steady dividends rather than explosive growth. … Does that mean there’s no future in water?

“No, but we need to temper our expectations and approach the industry wisely. In my view, the best goal is a fat dividend check from a business that will never suffer a lack of demand or damage from a disruptive technology. … Artesian Resources Corp. (ARTNA – yield 3.8%) provides water, wastewater, and engineering services to customers in Delaware, Maryland, and Pennsylvania. At the end of last year, it served almost 80,000 customers.

“It raised its dividend twice last year. It’s increased the dividend every year for the past 14 years, and made a payout every quarter for 19 years.

“Last year’s revenue came in at $65 million, with water sales rising 1.6% to $57.6 million. How did it grow? By increasing customers served by 2.8%, the whole name of this game. It acquired Cecil County-owned water systems in December for $2.2 million to acquire 1,500 customers in a high-growth area. This is one way it hopes to boost revenue and dividends, with access to the county’s growth corridor.

“Artesian is the stereotypical safe stock, good for conservative investors. Its share price grows steadily over time, as does its dividend payout. It jumps around quite a lot in the short term, however, tracing out a jagged line higher. The price has risen just 17% in the past four years, from $15.75 in May 2008 to Friday’s close at $18.43. Plotting its cost structure changes and revenue growth against the share price appreciation in that time, then projecting the relationship forward based on the company’s forecasts, gives me a four-year share-price projection of $36.

“I assume that the dividend will continue rising, too, making this a compelling buy with about 100% price appreciation potential and cash payments along the way. I added it to our extended Watch List with an initial target buy price of $17. In the sell-off last summer and fall, it bottomed at around $16.”—Jason Kelly, The Kelly Letter, May 6, 2012

Again, I like that Kelly is looking at the unique facts of the water market, and recognizing that higher demand doesn’t necessarily translate to higher prices. His solution is different from Spear’s, but just as acceptable—especially if you like getting regular income from your portfolio holdings.

On that note, there are a few other water investments from recent Digests that I could mention, but they’re not really plays on the theme of water scarcity. They’re un-exciting, consistent, income-generating water utilities. One of them, recommended by Vita Nelson of the Moneypaper in a recent Dividend Digest, has been paying dividends every year since 1816. As I said, I can’t go into them here, but if that sounds like the type of sturdy income-generating investment you’d like in your portfolio, I’d encourage you to try a trial subscription to the Dick Davis Dividend Digest, which is full of just those kinds of ideas. (Plus, for the price of your subscription, you get daily emails that present new dividend-paying investments with yields up to 20%, every weekday.)

That’s it for today; if you have any thoughts on the likelihood of water becoming a commodity, feel free to share them with me at chloe@dickdavis.com, and perhaps I’ll publish them in a future Investment of the Week.

Wishing you success in your investing and beyond,

Chloe Lutts

Editor of Dick Davis Investment of the Week

Chloe Lutts Jensen is the third generation of the Lutts family to join the family business. Prior to joining Cabot, Chloe worked as a financial reporter covering fixed income markets at Debtwire, a division of the Financial Times, and at Institutional Investor. At Cabot, she is a contributor to Cabot Wealth Daily.