Steven A. Falci explains the value of investing in water equities

The search for consistent alpha generation across global equity allocations is an ongoing challenge. If you were presented with the opportunity to invest in a strategy that could provide a new source of alpha and has delivered nearly 5 per cent excess returns per annum over 12 years while adding value above global equities in 10 of the 12 years, my guess is your interest would be piqued. Equally, I’m sure you would want to know what drove these strong, consistent returns and is this performance repeatable.

The Kleinwort Benson Investors Water Strategy has delivered these returns, and through the continued application of specialist active management to a universe of stocks supported by long term sources of growth, we believe we will be able to continue to have the opportunity to outperform consistently.

Investing in water equities is a multi-year opportunity sustained by multiple persistent drivers that should sustain returns in water for decades. A portfolio of water stocks provides access to a number of persistent global growth themes that investors are keen to access including;

• Natural resource scarcity
• Emerging market growth
• Infrastructure investment

While water investing is sustained by these long term secular drivers, there is opportunity to generate returns consistently through stock selection and portfolio positioning. The opportunity set of stocks providing water solutions have diverse return characteristics - representing companies with diverse business models selling into a variety of end markets and geographic regions. Specialist active management can identify which companies are best positioned across the cycle to generate superior returns across market environments.

The case for an allocation to water equities
The long term case for water has been well documented - water is a finite resource for which there is no substitute and demand for this precious resource continues to grow significantly faster than population. Less than 1 per cent of the world’s water is available for use and this limited supply is increasingly threatened by pollution, particularly in emerging market countries as they grow and industrialise. Historically, water demand has grown at twice the rate of population and is expected to grow by 41 per cent by 2030. Water is essential to sustaining life and critical to global economic wellbeing as an essential input across many industries. Today nearly 800 million people do not have access to clean drinking water and 2.5 billion people lack access to basic sanitation. It has been estimated that unless water provision is adequately addressed, 45 per cent of projected 2050 global GDP (approximately $63 trillion) could be at risk.
In order to address the challenges of water scarcity, an estimated $22 trillion investment will be required from 2005 to 2030, which will be
the largest component of global infrastructure spending over that time period - more than roads, railroads, seaports, and power combined.4 As a specialist manager focused on water equities we see a tremendous opportunity to identify how this capital will be deployed and which companies will provide the winning solutions.

Investing in water
Kleinwort Benson Investors defines water as all manufacturers, service providers and operators across the water cycle. The water cycle describes the flow of water:

• from its origin
• through collection and treatment
• to delivery to end users across residences, industry and agriculture
• through wastewater treatment and remediation back into the environment

We segment companies working across the water cycle into three water sectors:

• Water and Wastewater Utilities
• Water Infrastructure
• Water Technology

Companies across our three water sectors have diverse return characteristics, providing the opportunity for specialist active management to add value across different market environments.

Water utilities are the linchpin for providing water for residential and commercial use and treating waste water for reuse or remediation back into the environment. As such, they are managers of water infrastructure and the users of technology to filter, treat and measure water use. Regulated utilities are the dominant component of this sector, providing a stable, low-beta safe haven during periods of market turbulence.

The sector can also provide the opportunity to participate in growth through non–regulated utilities with more cyclical businesses and emerging market utilities that are facilitating and participating in growth in developing countries.

Water infrastructure companies include manufacturers of pipes, pumps, valves, fluid control systems and irrigation equipment. They also encompass engineering and consulting firms and construction companies that are involved in the design and implementation of large scale projects. It is a high beta, long-term growth sector, and will be volatile due to exposure to cyclical variables related to the economic cycle and capital spending. The need for new infrastructure in the developing world and the replacement of aged infrastructure in the developed world will drive growth in this sector for many years to come.

Water technology consists of a broad array of niche companies providing both established and ground breaking products and services to meet a variety of needs across the water cycle, including filtration, disinfection, metering and testing. While in aggregate the sector has a beta in line with the market, there are a variety of opportunities to earn extraordinary returns in high growth, smaller cap stocks. These returns can be earned through companies that grow organically or through others that are acquired by larger companies looking for leading niche technologies to complement other capabilities.

There are times when valuation disparities between sectors provide the opportunity to add value. This is very much bottom-up driven, and specialist active management can identify clusters of companies within each sector that have become under or over-valued and identify the fundamental reasons for the valuation disparity. For example, during the European economic crisis in the summer of 2011, many water infrastructure stocks were sold off well beyond their intrinsic value. The more defensive regulated utilities outperformed in this sell off, and many were viewed as fairly valued, providing the opportunity to reduce exposure to utilities and access outstanding opportunities in many undervalued infrastructure companies. This shift proved beneficial to the performance of the water strategy, as infrastructure stocks significantly outperformed in 2012.

Conclusion
Water equities provide exposure to long term sources of growth and unique sources of alpha that are not prevalent in many global equity allocations. While the long term drivers of water largely provide the beta of the theme, specialist active management can exploit inefficiencies through stock selection and position the portfolio to deliver consistent returns across the investment cycle. Opportunities for strong, consistent returns are hard to find. Have a closer look - we think you will want to find a place in your global equity allocation for water.

Steven A. Falci is head of strategy development sustainable investment, Kleinwort Benson Investors

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