Impax’s approach to investing in water infrastructure and technologies, and why it is important to all of us.
by Simon Gottelier, Director and Water Specialist at Impax Asset Management
The ever increasing need for water, but an ever tightening global supply will ensure that companies active in the water sector will benefit from strong growth spanning many decades. At the same time, concern about global water safety and quality is growing. These issues are galvanizing the investment case for the water sector.
Four Key Growth Drivers
We see four key drivers that support our conviction for investing in water:
• The urgent need is to replace and modernize much of the existing water infrastructure in developed countries. Ageing and deteriorating infrastructure is a major issue in the US. The Environment Protection Agency (EPA) has identified an investment requirement approaching $300 billion for the upgrading and maintenance of the U.S. wastewater and storm water infrastructure network [Note 2].
• Governments and their regulators dictate the quality of water, the quality of service and the price. With growing global concerns about pollution and water safety, increasingly strict quality regulations are inevitable.
• The increased number of extreme weather events such as storms, droughts and flooding are aggravating our fresh water supply challenges. Changes in temperature and precipitation patterns are altering the hydrological cycle and are having a significant impact on global water resources and quality.
Robust Growth From Developed and Developing Markets
We expect developing markets, to make a substantial contribution to the earnings of companies in this sector. For example, in China, proposed spending to address the country’s dire water pollution and scarcity issues is likely to exceed the outlays on cleaning up air pollution. Asia’s fight against water pollution will also generate business for developed market companies. Malaysia, Vietnam and in particular India, also require substantial investment in water supply. In our view, companies that can win a share of this business currently present particularly interesting investment opportunities. For example, demand for the pumps, pipes and valves required in water infrastructure construction is rising steadily at two percent to four percent a year globally; while demand in developing markets is rising by 10 percent to 15 percent.
In developed nations there has been significant underinvestment in repairs and upgrades over many years, especially to urban infrastructure, much of which was built in the late 19th and early 20th centuries. The useful life of these systems is considered to be around 60 to 80 years; massive spending on modern replacements is urgently required in many countries.
Diversification Across the Value Chain
To enhance long-term investment performance it is important to hold a broad range of stocks across the different water sectors and industries. We research a large and rapidly expanding universe of water companies, with a combined market capitalization of some $0.7 trillion [Note 3], active in both developed and developing countries and in cyclical markets such as construction and non-cyclical markets such as water treatment.
Water is a highly regulated industry. As water safety regulations intensify it is critical to understand local government policies and their impact on the water sector in making all investment decisions.
Investing Over Economic Cycles
To sustain performance over the long term, it is important to have a diversified, actively managed portfolio of water stocks, each researched in-depth but at same time understanding the macro-economic backdrop, and the impact this can have on performance. The exposure to different parts of the water value chain will vary according to the macro-economic climate and prospects for global and regional growth. For example, water utilities are known as defensive, non-cyclical investments. They are highly regulated, and this gives rise to good earnings visibility and earnings tend to be pretty stable. Their consistent revenues are often considered to be an effective inflation-hedge. Such qualities make utilities attractive when the economic climate is gloomy. In more upbeat times, infrastructure capital expenditure, which is closely linked to activity in the construction market – particularly house building and municipal spending – tends to pick up. As an area that tends to be more cyclical, especially in developed regions, construction would get greater attention in the portfolio in an economic recovery.
Investing in New Technologies
It is our fourth theme of increased incidence of more extreme weather events that is currently giving rise to a number of interesting new investment opportunities. Of particular note are some new technologies that have been developed to counter the severe drought that is being keenly felt in some of the southern states in the US, with California currently suffering its worst drought in forty years. The University of California Davis estimates that there could be a potential cost of $1.7 billion to the local agricultural industry as a function of the drought that they are experiencing.
Brackish water, reverse osmosis, or desalination technologies are beginning to look economically viable and more interesting. The grey water product of this output is used for irrigation within some of the more stricken agricultural regions in California, where many scorched acres are now lying fallow, and for many industrial processes. Reverse osmosis desalination of seawater for potable water looks to become an interesting solution in the longer term. As energy costs have become cheaper, and the technology improved, the cost of desalination (which until recently was prohibited for potable use) has become a lot more palatable. It’s now about twice the price of regular extraction of water source, such as a lake or a river. Secondly we think the crisis in California is becoming so severe that there are in excess of 15 projects that are being scheduled for commissioning up and down the California coast. For example, there is a $1 billion private equity owned facility at Carlsbad, just outside of San Diego, which will be commissioned by early 2016. This technology looks set to have very real potential as a mid- to long-term opportunity.
Furthermore, there are a number of aquifer recharge projects under development in California to replenish depleted aquifers. Wastewater is treated and re-injected back into the aquifer to be reused for potable water processes. Previously this dirty water would have been left untreated and pumped out to sea.
Arguably, the best way for investors to access this growth story is by investing in companies that supply technologically advanced components and also advise these businesses. For example: pump companies, membrane filtration businesses and the environmental consultants that are involved at every point within the construction process of such a facility. As we endure more extreme weather conditions around the globe, we need to find solutions to the issues they produce. We continue to research investments in new technologies, designed to ease water shortages in severely drought stricken regions.
M&A Activity (Mergers & Acquistions)
There is considerable evidence that the attractions of acquiring high-growth, niche-focused water sector businesses remain compelling and recent transactions have underpinned our investment case. We believe that the next couple of years could yield a new round of M&A activity, potentially providing a fresh flush of appealing returns for investors. Companies with specialist technologies such as environmental testing and sensing look to be particularly interesting targets.
In conclusion, the recent outperformance of the water sector has yielded consistent risk-adjusted returns for investors. Furthermore, the broadening gap between water supply and demand will continue to fuel the need for more effective solutions in water utilities, infrastructure and technologies around the world. Significant progress comes at a cost and the sector will need substantial future capital investment, making water a multi-decade investment opportunity that looks set to outperform over the longer term.
by Simon Gottelier, Director and Water Specialist at Impax Asset Management (www.impaxam.com )
Simon joined Impax in 2004 and co-manages the Leaders and Water Strategies, as well as selected clients\’ SRI/ESG products. Simon previously worked at Veolia (formerly Vivendi) Environment, where he was a Financial Analyst. His responsibilities included the analysis and modeling of potential investments and financing issues on the part of the Group\’s water businesses.
Simon began his career in Investment Banking in 1998 at NM Rothschild and subsequently moved to Deutsche Bank where he provided strategic, M&A and financing advice to European and US clients across a broad range of industrial sub-sectors. He has an honours degree in Modern Languages from the University of Bristol.
Article Notes
[1] http://www.overpopulation.org/water.html
[2] http://nepis.epa.gov/Adobe/PDF/P1005TBX.pdf
[3] Impax, Factset
This material has been prepared by Impax Asset Management Limited and Impax Asset Management (AIFM) Limited (“Impax”, authorised and regulated by the Financial Conduct Authority). Both companies are wholly owned subsidiaries of Impax Asset Management Group plc (registered in England & Wales, number 03262305) and are also registered investment advisors with the SEC. Registration does not imply a certain level of skill or training.
