A quiet sea of investment potential

Talk about irony. Drinking water – one of nature's most precious resources – is scarce in almost half the world. In the United States, drought conditions, expected to worsen, have already led to restrictions on water use, especially on the East Coast.

Yet, when it comes to the world of investing, water is widely overlooked.

Some analysts who track water believe investors are making a mistake: "Every investor should own not just one, but two water-company stocks, a large company and a smaller company that will likely be taken over in a merger or consolidation," says George C. Fisher, whose book, "The Streetsmart Guide to Overlooked Stocks," is due out in November.

Reasons to own a water stock are not hard to find. For the year to date through early May, the Standard & Poor's water index is up just under 5 percent, compared with a nearly 9 percent drop in the S&P 500 Index.

For the past seven years, the water index's average annual return is roughly 23 percent, compared with 10 percent for the S&P 500.

Investors interested in water stocks, analysts note, should examine three different types of companies:

• Publicly traded water utilities. Companies include Philadelphia Suburban, American States Water, California Water, Middlesex Water, York Water, and Connecticut Water.

• Water-related service firms. Some, such as Southwest Water, provide meter-reading services for other water systems.

Other firms such as Ionics, Cuno, and Tetra Tech deal with water filtration and wastewater treatment. Companies such as Insituform work on sewers and other piping systems. And a few others focus on desalination, converting seawater into drinkable water.

• Companies that bottle and distribute drinking water to consumers. The stakes are high in this $7 billion industry. A gallon of water now sells for more than a gallon of regular unleaded gasoline in many parts of the country.

The two biggest players also happen to be the two biggest soft-drinkmakers, Coca-Cola, which makes Dasani, and PepsiCo, which makes Aquafina.

In terms of numbers of brands offered, the biggest global player is Nestlé. The Swiss food conglomerate markets such brands as Great Bear, Deer Park, Poland Spring, and its flagship product, Perrier. Bottled water is now the second best-selling beverage product in the US, behind soft drinks.

When buying water stocks, particularly a water utility, investors should invest for the long haul – perhaps a decade or more – says Stewart Scharf, who tracks environmental stocks for Standard & Poor's Corp.

For the short term, Mr. Scharf has a "hold" on water stocks. "They are somewhat expensive to own," he says.

The high price of water stocks is partly the result of drought conditions, which have made it difficult for many utilities to meet demand.

Reservoirs, especially along the East Coast, are at about 60 percent of capacity, instead of the 85 percent they should be registering.

But in the long run, water stocks make a good defensive play. "There is a lot of potential in water stocks," Scharf says.

The reasons for looking at water stocks long term stems from two factors. One is simple: Water is a commodity everyone must have to live – a basic human need. It's highly unlikely that demand will ever diminish.

The second factor is the continuing consumer need for clean water. That, in turn, is expected to put pressure on politicians, regulatory agencies, and companies to rebuild antiquated systems used to deliver water in US homes and businesses.

Many systems have pipelines more than a century old, experts say. No doubt selected water stocks will benefit from the need to upgrade aging pipelines and plants, analysts say.

"Some water systems are leaking up to 50 percent of their supply because of old pipes and outdated infrastructure," Mr. Fisher says.

There are some 55,000 water systems in the US. Most of them are municipal systems, but others are run by small, privately held firms.

A number of studies suggest that the total tab to upgrade these systems will run in the hundreds of billions of dollars. The high cost is one of the reasons that some cities are thinking of selling their systems to private companies, or linking them together into large water grids.

Looking at the water-stock universe, Fisher likes Philadelphia Suburban, as well as smaller firms such as Middlesex, York, and Connecticut.

He is wary of the main California systems, such as American States and California Water, given that region's long-running difficulties with supplies and drought.

Another development that could prove profitable for investors: A number of US water utilities have been gobbled up through mergers and consolidations, with major European firms also coming to the US to buy water systems.

Three major European companies – Vivendi Environment and Suez Lyonnaise, both French firms, and RWE, a German utility firm – have already grabbed substantial footholds in the US.

Vivendi has a 17 percent stake in Philadelphia Suburban, and control of US Filter, a wastewater service firm. Suez controls Nalco Chemical, a water-treatment firm, and United Water Resources, a New Jersey utility. RWE has recently acquired American Water Works, the largest publicly traded water company in the US.