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

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

Three months ago I wrote to you from Colorado, on the edge of the Great American Desert. This month, I’m writing to you from another arid region, Australia. Yes, there’s water in the tropical north. But most of the Australian landscape is 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 good reason. 97% of the world’s water is non-potable salt water, which leaves only 3% that could be consumed by humans…and most 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, along with the governors of eight U.S. states, signed a pact that will ban all large-scale water diversions from the Great Lakes basin. That will prevent fully 20% of the total fresh surface water of the Earth being exported by pipeline to thirsty states like California, Arizona, or Nevada. The eight states that border the Great Lakes – Illinois, Indiana, Michigan, Minnesota, New York, Ohio, Pennsylvania, and Wisconsin – have seen the future. And the future is that fresh surface water is going to be more and more valuable as it gets more and more scarce.

Investing in Water: EFT’s

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

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

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

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

“As the customer, I want broad exposure to a sector (maybe 30 stocks). Don’t mess with it too much, please. But if you must mess with it, please kick out the ‘dogs’ every once in a while, and don’t just passively sit by and watch them go to zero.

“And please don’t load up on overpriced stocks simply because the market value of these stocks has gone up. I don’t want the fund to buy more and more of what’s already become super expensive. PowerShares fulfill both of these objectives…

“Each PowerShares sector ETF actually contains 30 stocks. And most importantly to me, no stock can make up more than 5% of the portfolio. So the biotech PowerShares, for example, 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 that appear attractive (based on quantitative measures) can be let in…and the super-expensive stocks will still never make it to more than 5% of the portfolio. That’s because instead of holding a fixed portfolio, the PowerShares portfolio changes quarterly based on dynamic underlying indexes, called ‘Intellidexes.’

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

Steve makes all the important points. You get the diversification of an ETF across a basket of stocks. But you also get a little more active management from the changes that the PowerShares team makes in the index. The dogs are ditched. And with no stock making up more than 5% of the basket of stocks, you are not vulnerable to an index crash 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 you will incur higher brokerage costs and taxable gains because the fund is actively managed. But for the better diversification and performance, your total return on the fund should be much higher, even after the additional costs.

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

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

By the end of 2006, water will not only be a major geopolitical 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 investor to assert that oil is undervalued.

We see things a little differently…Oil may be undervalued, 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 more precious commodity than oil.

While water largely covers this hardscrabble little planet of ours, less than 3% of it is fresh water. And the presence of pollution and disease has made much of that water undrinkable. Unlike with oil, no amount of technological wizardry can replace water.

Water resource enthusiasts, such as money manager John Dickerson, know these facts well. He is familiar with all of water’s charms – but the biggest is the simple scarcity of clean water.

There are few industrial countries in the world feeling that scarcity more acutely than China. Its water needs are more critical than its much ballyhooed power needs. I did not fully appreciate this until I visited China myself and talked 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 serious and urgent than [in] any other country in the world.” China’s rapid industrialization has outpaced its water infrastructure, which is on the verge of collapse. As Minister of Water Resources Wang Shucheng noted, “The price of China’s economic boom is being paid in water.” Two-thirds of China’s 600 largest cities don’t have enough water; half of these cities have polluted groundwater. Less than 15% of China’s population has safe drinking water from tap. The recent spill in the Songhua River, widely covered in the media, only worsens the problem.

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

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

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

Whether or not you choose to believe Barlow, it is clear that the demand for clean water is real. In an attempt to avert crisis, China plans to build hundreds of new water treatment plants. But for now, bottled water is the preferred choice – even among the Chinese, at least among those who can afford it. When I was in China, bottled water was nearly everywhere. As the Monitor points out, consumption of bottled water nearly quadrupled between 1997-2002.

So how to play it?

Investing in Water: Two Companies To Watch

There are several interesting companies working on the water crisis in China. I’ll run through two of them below. These are not the only companies engaged in solving China’s water resource problems, but they were two of the more interesting stories I found. The largest water company in the world is Veolia Environment, of France, and, oddly enough, a spinoff of entertainment giant Vivendi. Veolia has a 20-year deal to provide water to Tianjin as well as a bundle of other water and waste management contracts throughout China. Veolia currently serves over 14 million residents in China.

Another company is Watts Water Technologies, which has been doing business in China since 1995. The company produced valves used in China’s Three Gorges Dam project on the Yangtze River. In November, the company increased its commitment to China by acquiring Changsha Valve Works.

According to Watts, Changsha is “a leading manufacturer of large-diameter hydraulic-actuated butterfly valves for thermopower and hydropower plants, water distribution projects and water works projects in China. This acquisition strengthens Watts’ position in the fast-growing water market.”

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

If you want more concentrated exposure to China’s water crisis, it seems impossible at this point. The other problem is that none of these companies strike me as being particularly cheap. Still, they remain interesting companies to watch – we may get a chance to own them at excellent prices down the road. And as the Chinese water crisis unfolds, it may become clearer as to who and where the winners in this struggle will be. One thing seems certain:

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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