Investing in Water

Investing in Water:Bottoms Up!
A Daily Reckoning White Paper Report
By Dan Denning & Chris Mayer

A “watershed moment” has arrived!…Literally. One of themost dynamic and profitable themes for the rest of thisdecade will be investing in water. Purifying, filtering,transporting, storing and bottling water will becomeincreasingly important global businesses.

Three months ago I wrote to you from Colorado, on the edgeof the Great American Desert. This month, I’m writing toyou from another arid region, Australia. Yes, there’s waterin the tropical north. But most of the Australian landscapeis as dry as Carry Nations.

Investing in Water: Water Is Taken For Granted

Americans seem to believe. We often take it for granted.But most of the world’s residents do not…and for goodreason. 97% of the world’s water is non-potable salt water,which leaves only 3% that could be consumed by humans…andmost of that “water” is trapped in glaciers and icecaps.

Clean, fresh water is not nearly as plentiful as most

In mid-December, the premiers of Quebec and Ontario, alongwith the governors of eight U.S. states, signed a pact thatwill ban all large-scale water diversions from the GreatLakes basin. That will prevent fully 20% of the total freshsurface water of the Earth being exported by pipeline tothirsty states like California, Arizona, or Nevada. Theeight states that border the Great Lakes – Illinois,Indiana, Michigan, Minnesota, New York, Ohio, Pennsylvania,and Wisconsin – have seen the future. And the future isthat fresh surface water is going to be more and morevaluable as it gets more and more scarce.

Investing in Water: EFT’s

Investing in water has never been particularly easy. But itjust got a little easier.

PowerShares has come out with a new exchange-trade fund(ETF) based on water stocks. It’s called the PowerSharesWater Resources Portfolio (PHO). According to theprospectus, “The index seeks to identify a group ofcompanies that focus on the provision of potable water, thetreatment of water, and the technology and service that aredirectly related to water consumption.”

There are a couple of things you should know aboutPowerShares ETFs that make them different from other ETFson the market. But since my friend Dr. Steve Sjuggerud beatme to the punch on the virtues of PowerShares compared withother ETFs, I’ll let him explain:

“PowerShares actually started out by asking, ‘What wouldthe customer want?’

“As the customer, I want broad exposure to a sector (maybe30 stocks). Don’t mess with it too much, please. But if youmust mess with it, please kick out the ‘dogs’ every once ina while, and don’t just passively sit by and watch them goto zero.

“And please don’t load up on overpriced stocks simplybecause the market value of these stocks has gone up. Idon’t want the fund to buy more and more of what’s alreadybecome super expensive. PowerShares fulfill both of theseobjectives…

“Each PowerShares sector ETF actually contains 30 stocks.And most importantly to me, no stock can make up more than5% of the portfolio. So the biotech PowerShares, forexample, couldn’t possibly have two stocks make up two-thirds of the assets. Simple stuff. But great stuff.

“Thankfully, the dogs can also be kicked out… stocks thatappear attractive (based on quantitative measures) can belet in…and the super-expensive stocks will still nevermake it to more than 5% of the portfolio. That’s becauseinstead of holding a fixed portfolio, the PowerSharesportfolio changes quarterly based on dynamic underlyingindexes, called ‘Intellidexes.’

“PowerShares allow me to invest in sectors the way Iwant…where all 30 stocks in the fund actually affect theperformance, which is exactly the diversification I expectfrom investing in exchange-traded funds.”

Steve makes all the important points. You get thediversification of an ETF across a basket of stocks. Butyou also get a little more active management from thechanges that the PowerShares team makes in the index. Thedogs are ditched. And with no stock making up more than 5%of the basket of stocks, you are not vulnerable to an indexcrash prompted by the decline of a single stock.

Investing in Water: Higher Costs But Higher Gains

The only drawback of the PowerShares method is that youwill incur higher brokerage costs and taxable gains becausethe fund is actively managed. But for the betterdiversification and performance, your total return on thefund should be much higher, even after the additionalcosts.

And if there’s a downside to the diversification, it’s thatyou’ll end up owning small pieces of stocks that seem onlyperipherally related to the water theme. For example,General Electric (GE) makes up 0.85% of the index. But afull slate of water utilities are also included among theholdings, with other water treatment and service companiesrounding out the rest of it.

The intrepid investor may prefer to review each of the 35particular holdings and construct a smaller portfolio ofkey water stocks to own for the next 10 years. But for thesimplest way to be “long water” in 2006, this is it. Thestock just launched in mid-December.

By the end of 2006, water will not only be a majorgeopolitical theme, but also a major investment
theme…Drink up!

Dan Denning, Editor Strategic Investment
For The Rude Awakening

Investing in Water:Blue Gold
By Chris Mayer

A gallon of crude oil costs $1.45. A gallon of Evian costs$11.91. This simple observation led one successful investorto assert that oil is undervalued.

We see things a little differently…Oil may beundervalued, but NOT relative to drinking water. In fact,the truth is exactly the opposite.

Investing in Water: An In Demand Resource

For most of the world, clean drinking water is a far moreprecious commodity than oil.

While water largely covers this hardscrabble little planetof ours, less than 3% of it is fresh water. And thepresence of pollution and disease has made much of thatwater undrinkable. Unlike with oil, no amount oftechnological wizardry can replace water.

Water resource enthusiasts, such as money manager JohnDickerson, know these facts well. He is familiar with allof water’s charms – but the biggest is the simple scarcityof clean water.

There are few industrial countries in the world feelingthat scarcity more acutely than China. Its water needs aremore critical than its much ballyhooed power needs. I didnot fully appreciate this until I visited China myself andtalked to Chinese business people. Even Chinese officials –prone to covering up or understating the extent of problems– sound alarmist when it comes to water.

One official recently said China’s problem is “more seriousand urgent than [in] any other country in the world.”China’s rapid industrialization has outpaced its waterinfrastructure, which is on the verge of collapse. AsMinister of Water Resources Wang Shucheng noted, “The priceof China’s economic boom is being paid in water.” Two-thirds of China’s 600 largest cities don’t have enoughwater; half of these cities have polluted groundwater. Lessthan 15% of China’s population has safe drinking water fromtap. The recent spill in the Songhua River, widely coveredin the media, only worsens the problem.

For further perspective, consider this: China has about asmuch water as Canada, but a population 40 times as large.On a per capita basis, China’s water reserves are onlyabout one-quarter of the global average. Worse, thedistribution of people and water creates its own logisticalobstacles. Nearly half of China’s population resides in thenortheastern provinces, where only 14% of the waterresources are located.

These facts provide endless challenges for the Chinese.Water shortages are a serious threat to China’s boomingeconomy. It costs billions each year in lost output. Plus,water efficiency in China is way behind that of developedcountries. As Dickerson says, for an equivalent amount ofwork, “China uses approximately 7-15 times more water thando developed countries, and with usable water suppliessteadily diminishing, will not their competitive positionalso begin to erode?”

The Christian Science Monitor in December 2004 contained aprovocative article suggesting that we could see a cartelof water-exporting countries emerge over the next decade,in a style not unlike the Organization of PetroleumExporting Countries. “Water is blue gold; it’s terriblyprecious,” Maude Barlow, chairwoman of the Council ofCanadians, told the Monitor, “Not too far in the future,we’re going to see a move to surround and commodity theworld’s fresh water. Just as they’ve divvied up the world’soil, in the coming century, there’s going to be a grab.”

Whether or not you choose to believe Barlow, it is clearthat the demand for clean water is real. In an attempt toavert crisis, China plans to build hundreds of new watertreatment plants. But for now, bottled water is thepreferred choice – even among the Chinese, at least amongthose who can afford it. When I was in China, bottled waterwas nearly everywhere. As the Monitor points out,consumption of bottled water nearly quadrupled between1997-2002.

So how to play it?

Investing in Water: Two Companies To Watch

There are several interesting companiesworking on the water crisis in China. I’ll run through twoof them below. These are not the only companies engaged insolving China’s water resource problems, but they were twoof the more interesting stories I found. The largest watercompany in the world is Veolia Environment, of France,and, oddly enough, a spinoff of entertainment giantVivendi. Veolia has a 20-year deal to provide water toTianjin as well as a bundle of other water and wastemanagement contracts throughout China. Veolia currentlyserves over 14 million residents in China.

Another company is Watts Water Technologies, which has beendoing business in China since 1995. The company producedvalves used in China’s Three Gorges Dam project on theYangtze River. In November, the company increased itscommitment to China by acquiring Changsha Valve Works.

According to Watts, Changsha is “a leading manufacturer oflarge-diameter hydraulic-actuated butterfly valves forthermopower and hydropower plants, water distributionprojects and water works projects in China. Thisacquisition strengthens Watts’ position in the fast-growingwater market.”

There are two problems here. First, neither company doesall that much business in China. Veolia’s contracts bringin only a small fraction of its more than $30 billion insales. Watt’s China revenues represent only 3% of sales atthis point. This is a common drawback in looking atpublicly traded water companies (excluding micro-caps).

Ifyou want more concentrated exposure to China’s watercrisis, it seems impossible at this point. The otherproblem is that none of these companies strike me as beingparticularly cheap. Still, they remain interestingcompanies to watch – we may get a chance to own them atexcellent prices down the road. And as the Chinese watercrisis unfolds, it may become clearer as to who and wherethe winners in this struggle will be. One thing seemscertain:

Clean drinking water will remain more precious than oil – especially in China.

Chris Mayer, Editor Capital & Crisis
For The Rude Awakening

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