Commodities Corner: Water’s cheap, but water-related stocks have heated up this year

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At about a penny a gallon in many places, water might be difficult to think of as a good investment, but stocks and exchange-traded funds related to it have rallied nicely this year.

As of Thursday, the S&P Global Water Index , which includes 50 water-linked companies worldwide, had climbed nearly 18% in 2019. Many of its components have seen strong year-to-date gains, with utility American Water Works Inc. AWK, -0.91%  up 36%, water-technology provider Xylem Inc. XYL, +3.39% up 17%, and conglomerate Danaher Corp. DHR, +1.14%  up 36% in Friday dealings. The Invesco Water Resources exchange-traded fund PHO, +2.15% trades 29% higher for the year so far.

Water is an “essential part of our daily lives,” observes Christopher Muir, an equity analyst at CFRA Research, pointing out that it’s used in everything from drinking, ice-making, cooking, and cleaning to cooling, firefighting, and electric-power generation. Even so, water is quite cheap—at least in the U.S. The average 2018 residential rate for American Water Works across its various municipalities was $9.62 per 1,000 gallons, while the average commercial rate was $7.46, according to Muir.

However, Deane Dray, a multi-industry analyst at RBC Capital Markets, points out that in certain markets, including some in the U.S., governments “and municipalities are heavily subsidizing the water for consumers.” In other countries, water is “more fairly priced,” adds Dray. For instance, in Switzerland, water prices are about four times those in the U.S.—not because it costs that much more to produce clean water, but because it isn’t heavily subsidized.

Dray says that, even in countries like China, “where consumer and commercial spending is decelerating, you are still seeing healthy investment in water quality and safety.” Improved water quality and availability are among the top mandates in Beijing’s five-year plan for economic growth. “As such, water companies have largely outperformed their industrial peers, and investors are taking notice,” says Dray.

He points to Xylem as the “premier water-sector pure play, with a first- mover advantage in investing in disruptive digital solutions for water utilities.” He cites AquaVenture Holdings Ltd. WAAS, +1.55%, which builds desalination and wastewater-treatment plants, as another leader.

Muir, however, has a Sell rating on American Water Works, based on its valuation. It recently traded at 31.8 times CFRA Research’s 2020 earnings-per-share estimate. That level is too high for the company’s earnings growth rate and 1.6% dividend yield, he says.

In the developed world, we “take access to clean water for granted, but as [the contamination problem in Flint, Mich.] highlights, investments and stringent standards are needed to ensure this,” says Hubert Aarts, co-head of listed equities at Impax Asset Management. “Infrastructure needs to be updated and maintained, and standards need to rise.”

London-based Impax invests in three water-related areas: utilities, infrastructure, and treatment and efficiency, he says. Infrastructure includes companies that produce pumps, pipes, valves, and consultants, while treatment and efficiency includes companies making water meters and helping the industry use water more efficiently and manage waste. “There are a lot of ways to invest in water,” Aarts adds.

“Water investment opportunities keep growing, and innovation is strong.” However, for compliance reasons, he declined to discuss any individual stocks.