A Buyer's Market in Water Utilities

The Daily Reckoning PRESENTS: Our country is made up of over 53,000 water systems – and many of them are in dire need of repair. While this could be viewed as a multibillion-dollar crisis, Chris Mayer sees a major opportunity to profit. Read on…


The Roosevelt Hotel is one of the great old hotels in New York. It opened its doors in 1924. It’s in a prime location, on Madison Avenue and 45th Street in Midtown. A vintage bronze relief of Teddy Roosevelt stands watch over the main lobby, as he has for over 80 years.

The hotel also illustrates the seen and unseen in the architecture of our physical economy. What we see is a grand old hotel. What we don’t see is behind the walls and underground – all the pipes, pumps, valves and more. These things get old. And they need replacements and repairs. Now imagine that entire unseen infrastructure on a national scale.

What you have is a multibillion-dollar crisis… or is it an opportunity? It’s a bit of both. For us, it’s an opportunity. In fact, it may be the next great investment theme.

I was at The Roosevelt Hotel attending Gabelli & Co.’s First Annual Water Infrastructure Conference. Here, 11 executives told their story to a small group of investors – including famed billionaire Mario Gabelli himself. All of these companies are involved in water infrastructure in some way.

What struck me was the consistency of their stories. They all see the same thing -a whole lot of work that needs to be done. And estimates for the amount of work just keeping going up. It’s like tapping into a keg that just gets bigger and fuller the more partygoers drink. For investors in their shares, it’s also going to be a long stretch of good years.

Surprisingly, there were no more than two dozen or so attendees at this conference – fewer in the morning hours. But one day soon, conferences like this will be standing room only. The foam is on the lager. There is no going back in the keg. Only most investors haven’t caught on yet.

When you think of the water industry, what kind of business do you think of? Most people think of water utilities – for good reason. Water utilities are the big slice of the pie in the water industry. They have the potential to be an even bigger slice. That’s because most of our water still comes from government-owned water utilities. Investor-owned utilities have only 15% of the market.

However, investor ownership of water utilities is on the rise. I’ll tell you why in a moment. But first, I want to show you what a good investment water utilities have been over the years. I’m betting the results will surprise most investors.

Water utilities have crushed the markets – even in the slow markets we’ve had over the last five years. Water utilities chugged along at an 18% annual clip, while the rest of the market barely eked out a positive return (and the Nasdaq, in fact, posted a negative return).

John Dickerson of Summit Global Management has long made the case for water stocks. And lest you think the last 10 years represent some special circumstance, Dickerson has gone back further. He looked at data going back 25 years. He found that “Water utilities usually topped the list of the best-performing industry groups in the U.S. stock market on a total return basis.”

It’s even better than it looks. As Dickerson points out, these tables understate the results. Merger and acquisition activity over the years has thinned the ranks. The indexes drop the acquired utilities. They are not included in the foregoing tables. “Many of the better-performing companies are no longer part of the group,” Dickerson wrote, “and some of the laggards remain.”

Perhaps some of this surprises you. After all, these are just utilities, aren’t they? Well, when you think about the business it’s not hard to see all the good things that go into making those stellar returns. Water utilities are unlike other utilities – or any other business, for that matter.

For one thing, demand for water is as steady as she comes. Demand is immune to the larger macro forces that so bedevil other investments at times. Demand is unmoved by recession, inflation or fickle consumers. There are no substitutes for water. Then, too, water utilities are monopolies in the regions they serve. More than the big fish in the pond, water utilities, in fact, own the pond.

There are other issues that make water unique. Electricity can move over the grid so that cooler northern cities can help meet demand on hot days in Baltimore. Likewise, gas from St. Louis can move through the pipeline system to provide heating oil in Boston.

In the world of water, such shifts are uneconomical. No one transports water from the Mississippi region to alleviate drought in California. Water is prohibitively expensive to move over any significant distance. Why? Basically, water is too cheap. You can ship coal or iron ore because you can sell it for more than your transportation costs. Not so with water – at least not yet. As a result, water is an intensely local issue.

In fact, there are over 53,000 water systems in America. The great bulk of these are tiny, serving fewer than 4,000 homes. It’s in these smaller systems, though, where there are looming problems. Most are under the purview of local politicians. Typical of government-run enterprises, they are poorly maintained and inefficient.

We lose 60 billion gallons of water every day through old, leaky pipes and mains. That’s enough water to serve the state of California. There are lots of stories about breakdowns in aging pipes leading to interruption of service – or worse, leading to dangerous contaminants in the water itself.

The Environmental Protection Agency estimates our water systems need hundreds of billions of dollars in upgrades and repairs. By its estimates, water is the single largest expenditure in our entire economy – behind only defense spending and Social Security.

Many water systems are beyond the ability of local municipalities to finance repairs – even if they wanted to. They have two options. They can merge their systems with others. Or they can sell them to the investor-owned utilities.

Not surprisingly, the investor-owned businesses are efficient and well financed. They are buying up these assets at cheap prices from cash-strapped municipalities. It is a buyer’s market with prices so low that even accounting for the substantial investments needed, the buyer is looking at good, persistent long-term returns.

One of the steady acquirers over the years has been Aqua America. It made 26 acquisitions in 2004 and 30 in 2005. Over the last 10 years, Aqua America purchased 175 water utilities. There is a lot more to go. We are just at the beginning of this trend. Thousands of water systems remain for the investor-owned companies to collect. The privatization of America’s water systems is still in its toddler years.

The larger companies are consolidating, too. There were once 23 publicly traded utilities. Now there are only 11. As consolidation continues, a further shortening of this list would not surprise me.

In a big-picture sense, water utilities look like a great place to be. The conditions that helped produce those great returns in the past look only more favorable going forward. The basics of the business have not changed – supplying water is as important as ever. And we have many small decrepit water utilities, which provide a rich source of new growth and returns for the existing utilities.


Chris Mayer
for The Daily Reckoning
July 18, 2006

P.S. If history is any guide, these stocks should do well even if the overall market struggles. Best of all, though the returns from this sector have been great, you hardly ever hear anyone talking about them. Somehow, despite the great track record, these stocks have largely flown under Wall Street’s radar. Long-term-thinking investors should look to add water utilities to their portfolios.

I’ve spent the last year researching just these three opportunities in this sector. And out of the 103 publicly traded water companies in the U.S… not to mention the 359 water-related companies traded worldwide… I’m absolutely convinced these three “special situation” stocks will make you the most money as this trend explodes over the years ahead.

Editor’s Note: Christopher Mayer is the editor of Capital and Crisis and Mayer’s Special Situations. Chris began his career in corporate banking after earning an MBA with a concentration in finance. He later started Capital & Crisis, a monthly newsletter that gave Chris’ unique brand of financial commentary a more regular and expanded format.

War and rumors of war moved the markets yesterday.

Prices for oil and gold shot up in the morning, as traders watched TV monitors for news from Lebanon. Then came a rumor that Israel would pull out in a couple of days. The Israelis denied it immediately, but the markets seemed ready for some good news and oil and gold sold off in the afternoon. The dollar rose; worried money must still see it as a safe-haven.

Some people fiercely defend Israel. Others take the Palestinians’ part. We have no opinion. What surprises us is that other people have so many of them. And what amuses us is how pointless they all are.

But this is the world of endless public spectacles we live in. There is the news on TV and in the newspaper. There is commentary running on the World Wide Web 24 hours a day. Even something as distant, complex, and intractable as Israel’s relationships with its neighbors – a story that began in the Old Testament and continues into the New Era – is something people in Des Moines and Butte feel they need to think about. That…and Britney Spears’ pregnancy. With so much going on in public life, there is little time or energy left for the private, marginal details that make so much difference in a person’s life. Conversations are never had. Proper meals are not cooked…or eaten. Work is left undone. Worse, there is no evidence of any deep reflection about anything.

We have no proof for this assertion. It is not even a theory, but a feeling that wells up in us when we read today’s headlines. It’s not that the headlines are so much ado about nothing. It’s that they nothing one can do much about.

Take the matter of war in the Levant. Anyone who has bothered to blow the dust off a history book knows that people in the region cut each other’s throats from time to time. What you learn from this history is that when that happens, you’re better off being somewhere else. There is little that the news today can add to that lesson.

But, this morning, European and English newspapers are having some fun out of the whole business. One of their lead stories attempts to show that the president of the United States of America is a moron. The evidence they present for this is an off-the-record exchange between George W. Bush and Tony Blair, in which the American addresses the British prime minister by his last name, as if he were a gunnery sergeant talking to a new recruit. “Yo, Blair. How are ya doing,” is the headline in the Daily Mail, accompanied by a series of unflattering photos. The president then gives his opinion of how the trouble in Lebanon could be put to rest – a view untainted by history or reflection. It too might more likely have come out of the guardhouse on Pennsylvania Avenue rather than the Oval Office itself: “They need…to get Syria to get Hezbollah to stop doing this sh** and it’s over.”

Yes, and Thomas Friedman’s recipe for ending terrorism in Iraq was just as puerile: Get the Islamic community leaders to delegitimize terrorism.

Life is simple when you are not handicapped by too much reflection. Just get someone on the phone for goodness sake. Get him to do something.

“I felt like telling Kofi to call, to get on the phone to Assad and make something happen,” Bush continued. This is the very same president who greeted the Lebanese prime minister three months ago, saying, “Lebanon can serve as a great example of what is possible in the Middle East.”

He was right about that, though not as he intended. Lebanon does serve as an example of what is possible – the phony war on terrorism could become a real war. Instead of reducing oil to $20 a barrel (“The greatest thing to come out of this [war in Iraq] for the world economy…would be $20 a barrel for oil,”” we recall Rupert Murdoch announcing in February of 2003), the price could easily go much higher. Think the U.S. consumer’s back is breaking now? Just wait to see what happens with oil over $100.

We do not blame the president. He is what he is; he is no moron. He has a role to play, just as we all do. On the whole, he does a pretty good job of it. His role is to destroy America’s commanding lead in the world. Nature cannot abide a monopoly for long. Great empires, which monopolize military power, must be brought down…if not from the outside, then from the inside. Mr. Bush is merely an unwitting instrument of history.

In this role, the president is fortunate in having a whole coterie of barmy advisors and intellectual scalawags to assist him. William Kristol, Mr. Murdoch’s man in Washington, for example, urges the president to get further involved in the Near East, the Middle East, and everywhere else east of Eden. “Weakness,” he writes as if he were advising the Emperor Commodus, “is provocative.” He suggests a tighter connection between the United States and Israel, and a show of force, including an immediate strike against Iranian nuclear facilities. We don’t know whether that would be good or bad, in the big scheme of things, but if it’s provocation Mr. Kristol worries about, we can hardly think of a worse one.

More news from our team at The Rude Awakening…


Justice Litle, reporting from Reno, Nevada:

“Getting a nuclear reaction from coffee grinds and banana peels seems a bit of a stretch. In fact, turning the contents of your garbage can into any form of clean energy sounds like a pipe dream…not so.”

For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening.


And more miscellanies…

*** In October of 2003, Fortune magazine ran an article by Warren Buffett titled, “Squanderville versus Thriftville”. As the story goes, the citizens of the “fictitious” Squanderville found that by trading their Squanderbonds (denominated in Squanderbucks) for Thriftvilles’ hard-earned products, they could get the “Thrifts” to do all their work for them.

You know how the story goes: The Thrifts start getting nervous about the Squanders ability to pay off the debt that they’ve accumulated, so while “they continue to hold some bonds, they sell most of them to Squanderville residents for Squanderbucks and use the proceeds to buy Squanderville land. And eventually the Thrifts own all of Squanderville.”

Buffett’s Dr. Seussian tale wasn’t too far from the truth: we’ve known for a while that foreign companies are slowly buying America – and now they’ve started in on the roads and bridges.

“On a single day in June, an Australian-Spanish partnership paid $3.8 billion to lease the Indiana Toll Road,” reports the AP. “An Australian company bought a 99-year lease on Virginia’s Pocahontas Parkway, and Texas officials decided to let a Spanish-American partnership build and run a toll road from Austin to Seguin for 50 years.”

Unlike the uproar that was heard over the possibility of selling U.S. ports to a foreign-run company back in February, most are seeing the sell-off of our transportation infrastructure as a good thing – after all, the federal highway fund will have a balance of $16 billion by the end of the year, and the fund will most likely run out by 2009 or 2010.

We turn back to Squanderville and Thriftville to help explain this further:

“Sooner or later the Squanderville government, facing ever greater payments to service debt, would decide to embrace highly inflationary policies – that is, issue more Squanderbucks to dilute the value of each. After all, the government would reason, those irritating Squanderbonds are simply claims on specific numbers of Squanderbucks, not on bucks of specific value. In short, making Squanderbucks less valuable would ease the island’s fiscal pain.

“That prospect is why I, were I a resident of Thriftville, would opt for direct ownership of Squanderville land rather than bonds of the island’s government. Most governments find it much harder morally to seize foreign-owned property than they do to dilute the purchasing power of claim checks foreigners hold. Theft by stealth is preferred to theft by force.”

We think that says it all…

*** If the neocons – who urged the United States into the war on terror and the attack on Iraq – prevail, the price of gold will really fly. But for now, it has bounced back so strongly and quickly from its last correction, it looks to us as though another correction is needed.

*** How ’bout those homebuilders? They almost look like bargains. Pulte is down 31% this year. Centex is down 36%. KB has fallen 45%. And the Ryland Group has almost been cut in half. Ryland is down so far that its stock trades at below four times earnings. Is it time to buy…or sell? We don’t know, but we don’t expect an easy time for the companies who put up houses. They’ve put up so many of them in the last few years that it will take some time to get people moved in. Besides, who hasn’t bought a new house by now? And with consumers struggling to keep up with gasoline prices, we doubt that many more will want to buy.

The homebuilders are being forced to provide incentives to try to move the stock. Some are giving away free country club memberships, appliances or helping with closing costs.

Meanwhile, the retailers are falling – including the group regarded as “discretionary spending” retailers – such as Home Depot, McDonalds and Viacom, as well as Wal-Mart and the other core suppliers to middle America.

*** “San Diego home prices dip,” says a report from the West Coast. Over on the East Coast, “Home sellers push their prices down,” says the Boston Globe.

*** Another friend writes to say that she’s having trouble selling her house in Virginia. We know the place. It is a gem, built in the early 19th century. It’s a brick colonial, with large plantation-style columns overlooking the Rockfish River near Charlottesville. It should have sold easily and quickly. Instead, it has been on the market for nearly a year.

*** And finally, a dear reader sets us straight on our uncharitable reflections on charity:

“I do find Bill Bonner’s editorial piece about charitable giving to be ill informed about the complex problems charities face. Bill and Melinda Gates target their money effectively to bring about the greatest benefit to the most in need. Their methodology is utilitarian and effective, targeting diseases that are preventable, ensuring people can survive to live economically productive lives. Some charities provide micro loans, creating liquidity, which leads to self-sufficiency and growth of local economic infrastructure projects.

“I wholeheartedly agree that ‘wealth, honestly earned by sweat and saving’ is the best way for us all, yet in 2006, over 32,000 children die each day from malnutrition and preventable diseases that we in the west overcame a generation ago. Because of these diseases millions of people who survive their childhoods are often too ill and too incapacitated to work and are of no economic benefit to their families, communities and countries. How will they sweat for their wealth?

“Aid from Western governments has been an unmitigated disaster for Africa and many other nations, yet I would rather your publication refrains from mocking the benevolence of enlightened wealthy individuals prematurely, they might prove you wrong!”

We hope so.