Legg Mason Investment Counsel - "On the Water Front(ier)"

On The Water Front (ier)

September 2012

Amanda E. Agati, CFA Equity Research Analyst

Alison Bevilacqua, Social Research Analyst

3.5 million…the number of gallons of water a person consumes in a lifetime.
1 out of 7…the number of people who still do not have access to safe, clean drinking water.
46%...the percentage of people who do not have water piped into their homes.
2.6 billion…the number of people who do not have adequate sanitation services.
90%...the percentage of raw sewage dumped into the water supply in developing countries.
70%...the percentage of untreated industrial waste dumped into the water supply in developing countries.
42,000…the number of people who die each week from diseases related to low-quality drinking water and lack of sanitation.

Sources: World Health Organization and UNICEF.

We are all intimately familiar with water on a day-to-day basis, but perhaps less so when it comes to our investment portfolios. It is important to understand the significant global supply and demand challenges related to water, as well as to consider the far-reaching implications and widespread consequences we face, not only as individuals, but also for our global economies and ecosystems.

The figures above highlight just how acute our global water issues have become. Yet, we believe that solutions to these challenges have the potential to create attractive long-term investment opportunities. The global supply of and demand for water must be rebalanced in order to provide for the many needs of today’s growing societies. In turn, these efforts should spawn unique investment opportunities in creative companies that are advancing technologies and approaches to help the world better manage and sustain its most precious natural resource, water.

The Water Crisis: A Complex Issue

 The supply of water may seem limitless but we are facing a global freshwater crisis. While 70% of the Earth’s surface is covered by water, more than 97% is brackish ocean water unfit for consumption by most living things and unusable in most commercial and industrial applications. Of the remaining 3%, about 70% is locked away in polar ice caps and glaciers. That leaves less than 1% of the world’s total supply of water easily accessible for human use in the form of lakes, rivers, and shallow groundwater sources that are renewed annually. Today, we supplement this tiny supply by tapping into deep, underground aquifers. Buried deep within the Earth, these rock-encased pockets of water were formed millions of years ago and are not naturally replenished within a reasonable time frame.

Further, the idea of a naturally renewing water cycle is a common misperception, because water is not a perfectly renewable resource. Each year, nearly ten times the volume of Lake Superior falls from the sky as precipitation onto the Earth’s surface. More than 60% of annual precipitation cannot be captured or stored because it is absorbed by soil and plants or evaporates directly into the air. Another 36% falls directly into the oceans, leaving only 4% of all annual precipitation available to capture, store or use for various needs, assuming we have the technology, the systems, and the will to do so.¹

While the global supply of water has remained relatively constant over time, the global demand for water has been rapidly increasing. In the last century, global water demand increased more than six-fold and is currently doubling every 20 years, more than two times population growth.² Compounding the issue, the distribution of the world’s water is highly disparate. In short, the water is not where we need it to be. By 2025, it is expected that approximately two-thirds of the world’s population will live in areas facing moderate to severe water stress.³ Dramatic new approaches to water resource management must be developed to help alleviate this alarming supply/demand imbalance.

The Power of Water: Far-Reaching Implications

It is important to realize the integral role that water plays not only to sustain life, but also as a critical production input for industry. The daily drinking water needs of the average adult often pale in comparison to the quantity of water used in the production of goods. For example, it takes an average of 40,000 gallons of water just to manufacture a new car and its four tires.⁴ Often, goods are purchased with little understanding or disclosure regarding the amount of water utilized during production. It is also critically important to realize that many technologies supporting improved water efficiency are already available, just not widely adopted or mandated yet.  Water efficiency has not yet received the same level of attention that energy efficiency has commanded from consumers, regulators, and businesses, but  “water footprints” could become the next generation of carbon footprints.  Going forward, water may become a major constraint or risk for many industries; companies will learn to do more with less.  For others, water may become a competitive advantage or catalyst for future growth.

Source: Scientific American

Bridging the Gap: The Practical Challenges

Today, there is no simple or easy solution to the vast water challenges we face.  They require a multi-faceted approach to effectively bridge the gap between what we have today and what we will need tomorrow.  All options remain on the table, but, in our view, the most  immediate, near-term solutions involve investing in new and better infrastructure and creating a more rational pricing model.

Globally, water and sewer infrastructure investment needs are staggering. Booz Allen Hamilton estimates that “$22.6 trillion of investment will be needed worldwide by 2030 to modernize obsolescent systems and meet expanding demand.”  Here in the US, the Environmental Protection Agency estimates we need annual capital investments of $21 billion for clean water systems and $45 billion for drinking water systems through 2020.  This spending need has more than doubled in the last seven years, as a result of decades of chronic underinvestment and escalating input costs.  Failing to maintain our system’s infrastructure is costing us dearly, not only in hard dollars, but also in the wasted resource itself. 

Roughly, 700,000 miles of pipe make up the nation’s water distribution grid, stretching more than four times the length of the national highway system.  Much of it was installed near the turn of the twentieth century and was made to last only 50-75 years; it is now well beyond the end of its useful life.⁵ Since 1998, the American Society of Civil Engineers has issued periodic “report cards” assessing America’s infrastructure.  Over this period, the country’s water and wastewater infrastructure has deteriorated from a weak C+ to a current low of D–, necessitating a more urgent call to action.  Modernizing just the pipes alone would save more than 2.5 trillion gallons of water annually, going a long way toward alleviating our near-term water challenges.⁶

In spite of this grim assessment, the health of our water infrastructure still seems to take a backseat to hot-button issues such as universal healthcare, quality of public education, immigration reform, energy independence, and so on. Why is this so? It is an unfortunate case of “out of sight, out of mind.”  It is easy to lose a sense of urgency when the problems are buried deep underground and the system still functions, notwithstanding widespread inefficiencies and deteriorating water quality.  As evidence of this disregard, only 2.5% of the 2009 American Recovery and Reinvestment Act was allocated to water.  It was certainly a step in the right direction, but a “baby step” at best.  How long can we afford to forgo the investments needed?

Today, there is a striking disconnect between the intrinsic value of water and the price consumers pay for it.  The average US household allocates about 41% of its annual utility bill to electricity usage and roughly 31% to phone services. Water services represent only 6% of the utility bill, equating to less than 1% of household income on average.⁷   A US household pays roughly four times less for municipal water than those in European countries such as Denmark, Switzerland and Germany.⁸ Among major industrialized countries, only Canadian households pay less for municipal water than do US households, with Canada benefiting from being number one in the world in freshwater supply per capita.⁹   What else may cause the fairly wide disparities in water rates across countries?  Historically, water rates have in general been set artificially low without direct linkage to costs of production and distribution.  Today, water remains acutely underpriced throughout much of the world, with notable differences in pricing across nations owing to wide diversity in regulatory schemes.  Price increases have not kept up with inflation either.  When a resource is priced so low that its use is almost free, the consumer has no incentive to conserve.  Economists consider water demand “inelastic” at current price points, meaning that most people will not vary their usage with marginal changes in prices. Inefficient water pricing globally remains a consistent impediment to investments in infrastructure upgrades and new technologies.

Investing in Water: What Is the Opportunity?

Today, “water” is a $450 billion global industry, including the market in North America, valued at about $100 billion.¹⁰  Our water industry definition incorporates a wide array of products and services:  analytics, automation, desalination, engineering and consulting, filtration, hydraulics, irrigation, meters, pipes, potable water, pumps, treatment, wastewater and valves. Water ranks as the third-largest industry worldwide, trailing only natural gas production and electricity generation in market size.¹¹ Currently, the water industry is growing revenues at an attractive 4-6% annual rate.  However, different parts of the industry exhibit very different growth rates.  In developed markets, infrastructure maintenance and repair demands support 3%-4% annual growth.  Alternatively, developing markets are still aggressively building out basic water distribution and treatment systems, driving higher growth rates in the range of 8-10% or more.¹²

The industry structure is characterized by significant barriers to entry, creating natural competitive advantage and market share defensibility for existing water companies.  There is also considerable fragmentation, yielding only a small number of high quality, investable companies focused solely on water.  However, consumers will continue to demand high standards for quality, reliability and accessibility. Increasing environmental regulations, as well as greater focus on security for our water supplies, create positive catalysts for the industry.  The highly capital-intensive nature of the water business suggests there is potential for consolidation among participants.  Together, the attractive dynamics of the water industry present intriguing long-term investment opportunities. 

At Legg Mason Investment Counsel, we focus on identifying high- quality companies with competitive advantages.  We seek opportunities featuring:  attractive reward-versus-risk profiles in terms of equity valuations; favorable expectations potential for corporate fundamentals; and excellent stewardship by management teams that are particularly competent in their capital deployment activities.  We believe that equities with these characteristics offer a greater likelihood of providing attractive total returns over time relative to those without these distinctions.  In our view, there are certain companies developing and implementing innovative solutions for our water resource challenges that rank well in both our proprietary fundamental research process and social research analysis.

Conclusion
There is much freshwater in the world, but it is not always where the population needs it to be, and we are certainly using and polluting it faster than nature can replenish it.  Water tends to be relatively inexpensive, but the infrastructure needed to deliver it is expensive, and people take it for granted.  Rising affluence and increasing industrialization around the world will put even greater strains on our water resources.  Awareness is increasing, but turning awareness into action takes time. 

1. Rogers, Peter.  “Running Out of WATER,” Scientific American, August 2008.  Pp. 46-53.

2. Hoffmann, Stephen J. Planet Water:  Investing in the World’s Most Valuable Resource.  (New Jersey: John Wiley & Sons, Inc.) 2009.  P. 14.

3. Alexander, Laurence. Clean Technology Primer.  “Water: Secular Themes, Tactical Opportunities,” Jefferies & Company, Inc., March 2010.  Pp. 212-213..

4. US Geological Survey http://water.usgs.gov/watuse/.

5. American Water Works Association http://www.awwa.org/.

6. “2009 Report Card for America’s Infrastructure,” American Society of Civil Engineers, March 25, 2009 http://www.asce.org/reportcard. 

7. US Environmental Protection Agency, Office of Water http://water.epa.gov.

8. “Water Our Thirsty World,” National Geographic Special Issue, Washington, DC. April 2010.  Pp. 114-115.

90. Pernick, Ron, and Wilder, Clint.  The Clean Tech Revolution.  (New York: Harper Collins Publishers, 2007) P. 229.

10. Dray, Deane M. “Water Sector Handbook 2011,” Citigroup Global Markets.  May 24, 2011. P. 64.

11. Blue Planet Network http://blueplanetnetwork.org/water/facts/.

12. Dray, Deane M. “Water Sector Handbook 2011,” Citigroup Global Markets.  May 24, 2011. P. 64. 

Amanda E. Agati
Equity Research Analyst 

Amanda is a Vice President at Legg Mason Investment Counsel.  Her primary responsibility is as an Equity Research Analyst covering a wide variety of industries across the Materials, Industrials, Consumer and Utilities sectors.  Amanda is part of a working group including members of equity research and our Socially Responsive Investing (SRI) group focusing on environment, social, and governance (ESG) issues.  Amanda entered the Financial Services Industry in 2001, beginning her career with Legg Mason as an Investment Banking Analyst in 2001, which involved analyzing and valuing securities for public offerings, and researching targeted acquisitions for corporate clients.

Amanda is a CFA charterholder and belongs to the CFA Society of Philadelphia and the Philadelphia Securities Association.  Amanda earned a B.S. in Finance with a minor in Economics from Penn State University's Schreyer Honors College.

Alison Bevilacqua
Social Research Analyst 

Alison is a Vice President at Legg Mason Investment Counsel.  Her primary responsibility is as the Social Research Analyst where she specializes in Corporate Responsibility research.  In addition, she is a member of the Proxy Committee and participates in the Sustainability Council of Legg Mason, Inc.  Alison joined the Socially Responsive Investing team at Scudder, Stevens and Clark (a predecessor firm) in 1996. Prior to joining Legg Mason Investment Counsel she was on the staff of a multi-disciplinary university-based group pursuing development of an undergraduate business school curriculum that embraced sustainability.

Alison is a member of the International Working Group of US SIF- the Forum for Sustainable and Responsible Investment, and the FTSE4Good US Advisory Committee.  Alison regularly represents the firm at meetings of socially responsible investing-related organizations.  Alison is a graduate of the University of Arizona and the graduate studies program in Economics at Miami University of Ohio.