Water Stocks: Time to Gulp or Sip Shares?

People often take water for granted, though humans can’t exist without it. Most of us turn on the tap, take showers or water our lawns without thinking about the viability and dependability of that water.

That thinking may not reflect reality. Yes, 71% of our planet is covered by water, but only 0.3% of that water can be used by people, animals and plants, according to the National Ground Water Association (NGWA). The organization explains that much of the usable 0.3% can’t easily be tapped or extracted, while the majority of water used by humans is sourced from rivers. The visible bodies of water are known as surface water, while most fresh water is found underground as soil moisture and aquifers.

As a result, the global water and wastewater treatment market is projected to grow from $323.32 billion in 2023 to $536.41 billion by 2030 at a compound annual growth rate (CAGR) of 7.5%, according to Fortune Business Insight. The company explains that water and wastewater treatment are needed to quench the growing demand for clean water resources for municipal and agricultural uses and manufacturing.

Countries like Saudi Arabia face severe water shortages and have invested in desalination. In the U.S., California has experienced drought for three consecutive years. Four other western U.S. states—Nevada, New Mexico, Utah and Arizona—also cope with drought and water shortages.

Along with the favorable supply/demand trends, the industry also benefits from federal investments. The Infrastructure Investment and Jobs Act of 2021 pledged $55 billion for federal drinking water programs and to improve water infrastructure. Water infrastructure is a complex system that treats and moves water from its source to homes and businesses. The infrastructure comprises wells, reservoirs, tanks, dams, and an extensive network of pipelines.

The U.S. water system is not in top shape and a water main breaks every two minutes (250,000 to 300,000 breaks per year), according to the American Society of Civil Engineers. Those breaks result in the loss of 6 billion gallons of treated water daily. The ASCE reported that it noticed signs of progress in upgrading pipes and other structures as federal financing programs expanded and U.S. water utilities raised rates to reinvest in their networks. ASCE estimates that U.S. water utilities replaced more than 12,000 miles of water pipes in 2020.

About $15 billion of the act's funding is earmarked for replacing lead water pipes to prevent another Flint, MI, catastrophe.

Investing in water companies means choosing from companies in four different sub-sectors: Utilities, Water Testing and Metering, Desalination, and Infrastructure.

Utilities

American Water Works

American Water Works Co. Inc. (AWK)  is the largest publicly traded U.S. water and wastewater utility and provides services to over 14 million customers in 24 states. There are about 14 publicly traded water utilities. The company is not a stodgy utility.

It has consistently increased revenues and income by raising rates and acquisitions that have expanded its base. Recent acquisitions include the $27 million purchase of Jefferson Utilities and Audubon Water Co. for $8 million. Audubon has 2,900 customers.

Argus analyst Kristina Ruggeri is confident that the company will continue to benefit from additional rate hikes and acquisitions in the fragmented water utility industry. She rates it a buy. The EPA estimates that there are about 50,000 U.S. drinking water utilities, which will have to invest more than $470 billion over the next 20 years to repair and replace drinking water infrastructure.

These costs are passed on to customers through water rates. States regulate the rates charged by privately owned water utilities. Ruggeri believes AWK should benefit from a proposed EPA regulation that would enact strict quality standards for drinking water and penalties for not complying.

AWK's management believes that many municipalities may be unable to shoulder these expenses, leading them to sell their water assets to larger companies such as AWK. Ruggeri writes, "we like the company's acquisition pipeline, prospects for additional rate hikes and focus on dividend growth."

The quarterly dividend is $0.7075 for a yield of 2.36%. She also likes the company's strong balance sheet, which should allow the company to continue to make acquisitions. Her target price is $166.

In the past 52 weeks, it has traded between $115.39 and $162.59. Since 2018, the company has increased its annual revenues from $3.4 billion to $3.7 billion in 2022, and net income has risen from $587 million to $820 million last year.

On July 26, the company announced second-quarter 2023 results that topped analyst expectations. EPS rose to $1.44 from $1.20 a year earlier and surpassed the consensus of $1.31. Net sales rose 17% to $1.1 billion, above forecasts, and the operating margin increased by 450 basis points to 39.4%.

Management also affirmed that it is targeting earnings growth of 7-9% in its 2023 to 2027 plan, along with 7-9% dividend growth in the same period. The annual dividend has grown a whopping 56% from $1.78 in 2018 to an estimated $2.78 for the full-year 2023.

The stock has been slightly disappointed lately; for the year-to-date and 12-month periods, the stock has retreated 24.65% and 13.58%. However, it has returned 30.4% for the five-year period, still below the S&P 500 performance during the same period.

However, the most compelling reason to buy the stock is to benefit from the company's aggressive M&A strategy because it is a good bet that the company can expand its margins by purchasing smaller, less efficient utilities. AWK has $555 million in acquisitions under agreement (32 acquisitions in 10 states), including two wastewater systems that should receive regulatory approvals in 2023.

These purchases include more than 48,000 new customers. Plus, the company provides a generous dividend for shareholders. Argus analyst Ruggeri wrote that with her target share price of $166, a shareholder may receive a potential return of 15% when combined with the dividend.

Water Testing and Metering

Badger Meter

The water technology sector is booming due to advanced water-metering infrastructure and water-conversation efforts. As I mentioned earlier, 6 billion gallons of treated water is lost daily due to water main breaks, and these days, companies realize that water is too valuable to waste.

An example of these water technology companies is Badger Meter (BMI). Though not the kind of company like Nvidia that is often debated on CNBC, its products are crucial for water companies because they help conserve water and detect leaks. The company's products include meters, flow instrumentation and pressure-monitoring products. It generates most of its revenues in the U.S.

Just like AWK, the company should benefit from greater demand for water-measurement products thanks to higher federal funds for water infrastructure products. The high demand for these products is the main reason to invest in this subsector. The smart water metering market was estimated to be $5.9 billion in 2019 and projected to reach $9.6 billion by 2024, at a CAGR of 10.3% during the period, according to Research and Markets.

Badger has a $4.16 billion market cap, and its stock shot up from $88.16 a year ago to $170.86 on August 15. Since then, the shares have cooled down to about $142. The stock is now expensive at 55 times Ruggeri’s 2023 EPS estimate. Ruggeri continues to rate the stock a buy with a target price of $182 due to “increased demand for remote water metering and monitoring capabilities, as well as the company's market share gains, expanding margins, and strong balance sheet.”

Water ETFs

Invesco Water Resources ETF

Since the water industry includes many subsectors, an intelligent way to play it is to purchase shares of top water ETFs such as Invesco Water Resources ETF (NASDAQ (PHO), which includes 40-45 water-related stocks in its portfolio. This ETF invests in companies that manufacture products that conserve and purify water for individual homes, businesses and industries. The ETF's fifth largest holding, AWK, is a pure-play water utility company. The other holdings are more diversified, with operations in different sectors besides water.

The fund has a five-star rating from Morningstar, which writes in a report that the fund’s "portfolio maintains a cost advantage over competitors, priced within the second-cheapest fee quintile among peers." The ETF seeks to track the investment results (before fees and expenses) of the NASDAQ OMX U.S. Water IndexSM (the "underlying index"). The fund generally invests at least 90% of its total assets in the underlying index's securities.

First Trust Water ETF

First Trust Water ETF (FIW)  also has a five-star rating from Morningstar, but its expense ratio is 0.53%, compared to 0.6% for PHO. According to Morningstar, the fund’s "portfolio maintains a cost advantage over competitors, priced within the cheapest fee quintile among peers.” It tracks an index of companies that generate a significant percentage of their sales from the potable and wastewater industries. The portfolio of 37 companies includes well-known names from a number of water subsectors, such as Roper, AWK, Ecolab, Xylem, Valmont and Badger Meter.

Ilir Salihi is the founder and senior editor of IncomeInsider.org. You can read more of his content on the IncomeInsider blog.