Water Utility Equities Could Be Strong Performers Amid Volatile Market

Because the need for clean water is both universal and not close to being solved, publicly traded water utilities can be excellent low-risk investments.

Art by Philip Lindeman

Water utilities have several factors that make them attractive investments: These companies operate in a regulated environment and enjoy few competitors, while generating consistent cash flows and enjoying low volatility, according to a report from Standard & Poor’s.

“Traditionally, this has been viewed as a conservative, low-risk, modest-growth, stable-dividend category of the publicly traded water sector,” says David L. Rose, a co-founder of and partner in Thales Water Advisors. “Returns are largely a function of rate increases and acquisition of other utilities.”

According to Natixis’ Thematic Asset Management, water-focused companies represent an $800-billion-per-year market, which the firm projects to grow between 6% and 8% annually. Combined, these companies have a market cap of more than $3 trillion.

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A 2023 report, “Water as an Investment,” by Arnaud Bisschop and Simon Gottelier of Natixis, identified numerous factors that make water utilities good investments.

“One of the unique points about a diversified water strategy is that outperformance can materialize in both strong and weak markets, providing alpha continuously over the cycle,” said Bisschop in the report.

Water-themed assets are often directly linked to real assets. Because of this, these assets can act as inflation hedges, according to the report.

“We think this is a suitable offering for investors who want to contribute globally to the sustainable use and protection of water resources, while generating long-term growth through an investment process which systematically incorporates ESG,” Bisschop concluded.

Water utilities are also a fragmented industry, ripe for M&A, sats Brian Aronson, equity research analyst at Fidelity and manager of the Fidelity Water Sustainability Fund (FLOWX).

“Water utilities earn a return on the investment required to address these issues by passing it onto the rate base, similarly to their electric utility counterparts. These investments are now well funded through recently approved stimulus. In addition, the industry is more fragmented with over 50k providers in the U.S., allowing the few large, publicly traded utilities ample acquisition opportunities.”

Investment Performance

Many water-related indexes perform similarly to the S&P 500, impressive for a benchmark mostly driven by large-cap tech and growth stocks. While some of are not outperformers, they can provide consistent returns.

The S&P Global Water Index, which tracks 100 global companies that are either water equipment, instruments and materials businesses or water utilities and infrastructure businesses, returned 7.46%, 3.83%, 8.47% and 6.43% for the past one, three, five and 10 years annualized. By comparison, the S&P 500 returned an annualized 27.69%, 9.98%, 12.66% and 10.64%, respectively.

While utilities had underperformed in 2023 and into 2024, earnings growth for these companies have increased substantially, even when their valuations remain low, says Jessica Jouning, portfolio manager at First Sentier Investors, and co-manager of the First Sentier American Listed Infrastructure Fund (FLIAX).

Some equities themselves have consistently outperformed the S&P 500. For example, the York Water Co., a water and wastewater utility based in York, Pennsylvania, has returned more than , while the S&P 500 returned slightly more than 250% during the same period.

However, 2023 was a rough year for utility stocks in general, following a strong defensive performance in 2022, according to investment management firm Duff & Phelps Investment Management Co. However, firm analysts believe utility stocks are undervalued compared to the broader market.

“When measured on a relative price-to-earnings valuation basis against the S&P 500, utility stocks are the cheapest they have been since 2009, indicating they may be undervalued versus the broad market,” wrote Frank Spindler, a client portfolio manager, and Andrew Pon, a research analyst, in a December 2023 report. “Comparing utilities to other income-producing sectors, we think the upside potential in price they offer, and margin of safety included, is hard to match for income-producing assets.”

Assessing Water Stocks

“There are a number of opportunities for institutional investors to participate in the water sector; however, it is important to focus on the strength of the business model, market segment addressed and both product and business model differentiation,” says Thales’ Rose. “As with investing in any company, margin profile and sustainability of growth are important considerations.”

Rose said areas of the market that address longer-term themes are more attractive. He pointed to “resiliency, including water reuse, decentralized water and asset integrity management. While regulation is rarely a reason to invest in any particular company or segment, /destruction has become one of the fastest growing markets in the water sector.”

PFAS treatment refers to the removal of polyfluoroalkyl chemicals from water; these chemicals are hard to break down.

Technology in other industries is often adopted quickly; however, the water sector is notoriously slow at adoption of new technologies.

“Consequently, investing in the latest technology is often very disappointing for investors,” Rose continued. “However, successful investors and companies have been able to leverage technology by transitioning the business model and reducing the risk to the user—providing outcomes, or water treatment as a service. This is by far, the most attractive area of investment.”

According to Eric Navales, a managing director at consulting firm L.E.K. Consulting, companies investing in advanced PFAS substances testing and treatment technologies will benefit the most from new environmental regulations being planned.

“What’s already clear is that such regulations will have wide-ranging implications for the market over the next five to 10 years,” Navales says. “For example, environmental consulting service companies, which are already being asked to develop mitigation strategies for public sector clients and private companies alike, should expect demand for those services to continue to grow. Meanwhile, as new regulations are passed and existing regulations are further tightened, new capital investment and operating spend on water treatment, monitoring and PFAS compliance are expected to further increase. Indeed, environmental consultants have already seen a spike in demand for baseline assessments and site characterization studies.”

Opportunities exist for companies that can address water scarcity and quality issues, according to Brian Aronson, equity research analyst at Fidelity Investments, who manages the Fidelity Water Sustainability Fund (FLOWX).

“When I am researching for the best long term opportunities for the Fidelity Water Sustainability Fund, I am looking for companies that can address issues of water scarcity, water quality and climate resilience. PFAS and other emerging contaminants will drive a significant investment wave as consumers and regulators focus more on water quality than ever before.”

“There are several opportunities to potentially help reduce water consumption, including smart metering, higher quality pumps and filtration technology to increase water re-use. There are also several Engineering and Construction companies that focus on water, and will help governments and companies address commitments related to water quality and consumption.”

Emerging Markets and the Energy Transition

According to BNP Paribas, the world will need to invest more than $1 trillion in water assets in the next decade to ensure that all people have access to clean drinking water, what the firm calls the “trillion-dollar investment gap.”

According to Fidelity, roughly 2 billion people worldwide do not have access to clean drinking water. This demographic is mainly in emerging markets, where there would likely be the most benefit from investments in water utilities in infrastructure. However, utilities investing in these markets could be more complex.

“Investing in emerging markets is more complex,” Rose says. “Success often centers around simple, de-risked solutions and involves companies with partnerships and more established platforms. Most of the opportunities are with the larger companies, such as Xylem or Veolia, that have a presence in these markets, but sales often represent less than 25% of total company sales.”

He points to Mexico-based Rotoplas as “one of the larger pure plays in emerging markets.” The company “has developed a sizable platform addressing commercial, light industrial and residential water treatment and purification.”

Some strong opportunities in emerging markets are companies that can help solve sustainability and scarcity issues, Aronson says.

“Emerging markets are particularly exposed to water scarcity, water quality and climate resilience. Desalination is one way governments around the world are addressing water scarcity. Other opportunities in emerging markets are publicly traded water utilities going through large investment cycles and innovative companies looking for new ways to detect, clean and destroy contaminants.”

Given that wastewater treatment plants and desalination plants are energy intensive, many companies are focusing on increasing the energy efficiency of products used in these facilities. The water sector overall is focusing on decarbonizing as municipalities and governments have net zero ambitions.” Aronson continued.

Significant Water Risk

CDP, a not-for-profit charity (formerly known as the Carbon Disclosure Project) that focuses on environmental issues, found in 2020 that the financial impact of water risks to companies was as high as $301 billion for the year, a figure much greater than the $55 billion needed to address water security issues.

Anni Coonan, a consulting analyst at law firm Bradley Arant Boult Cummings LLP, wrote in an October 2023 report on water scarcity that, “A shortage of water is increasingly putting business operations at risk, as water necessary for manufacturing, heavy industries, construction, and the tech sector runs low.”

“While some sectors are especially vulnerable—food, energy and apparel are the most exposed—the risk is indiscriminate,” Coonan wrote. She added that companies could take several steps to proactively lessen these risks, including: modernizing their equipment, tracking water use, reducing water waste and using recycled water when possible.

Last summer, concerns about water scarcity led Arizona officials to block some new housing construction in the metropolitan Phoenix area due to droughts and groundwater overuse, according to an AP report. Developers have pushed back against the restrictions in reaction to the state’s refusal to approve new construction permits in certain subdivisions.

A report from Arizona Governor Katie Hobbs’ administration last year showed that groundwater in areas around Phoenix is not sufficient to meet projected demand over the next 100 years. In October 2023, Hobbs terminated the ground leases of a company that grows alfalfa in Arizona to feed Saudi Arabia’s cattle because the company used groundwater that could instead be used to supply water to the state’s growing urban areas.

A Montana judge in February stopped a new housing development because a state environmental review about of the new homes’ water usage and its impact on existing homes’ water supply was “abjectly deficient” and “astonishing,” the New York Times reported.

Research from BlackRock Investment Institute predicts that nearly the entire Southwest region of the U.S., including parts of Arizona, California, New Mexico and Utah, will face “extreme water stress issues” by the year 2030.

Water Use Disclosure Is Essential

Michelle Dunstan, chief responsibility officer at Janus Henderson Investors, wrote in an email to CIO that, “Accelerating water scarcity poses a material risk to companies in a number of water-intensive sectors.”

“We are looking for companies to effectively assess and disclose their exposure to areas of high water-stress, and evaluate future impacts of water risk on their operations, production output and costs,” Dunstan wrote. “Similarly to how we would consider any sustainability risk with the potential to impact a company’s performance, we want to see that they are taking steps to effectively address the issue.”

Because water risk is determined by multiple factors, from supply issues determined by rainfall and river basin exposure to demand on shared water resources, investors need in-depth research and engagement to understand how each company’s operations would be impacted by water availability, she explained.

“A key area that we look for is location-based water use disclosures,” Dunstan wrote. “A best practice would include reporting to CDP Water, a reporting initiative that provides investors with valuable granular data on a company’s water use. It enables us to compare river basin exposure, site-level withdrawal volumes, water-related capex, and other data points. We can use this data to drive deeper discussions with companies on water risk mitigation.”

While setting targets around water use can be seen as a “positive” for companies, Dunstan said that Janus Henderson wants to see those targets accompanied by “tangible initiatives” or new technologies that will help firms consume less water and improve their water efficiency.

“Most importantly, water is a resource shared among a number of industry and community actors. Addressing water risk therefore requires collective action. We are interested in how companies are working with the community and their involvement in industry partnerships for watershed management.”

More Expensive to Invest

Aston says Neuberger Berman has had to choose its portfolio of water industry-focused companies more carefully in recent years, as water scarcity and security have become growing issues.

Valuations of firms that provide high-end water filtration and other water treatment or infrastructure needs have significantly increased due to the growing need for their services, Aston explains.

“In the last 10 years or so, there’s been a significant amount of new capital coming into publicly-listed companies looking at solving water issues,” Aston says. “You’ve had this dramatic increase in valuations, which makes it more difficult to invest. It’s become much more expensive [to buy into these companies].”

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