The Ultimate Monopoly Industry -- And There Are No Substitutes

BA is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Let's toast to an average 40% total annual return on three stocks with an average price volatility less than one-third the overall stock market's. Our toasting beverage is water -- the product of our winning stocks, American States Water (NYSE: AWR), Aqua America (NYSE: WTR), and American Water Works (NYSE: AWK).  

First, a look at the returns the water utilities have been pouring out  -- and then why water stocks look good going forward.   

Little risk, big returns

The three stocks I highlighted as the best water stocks in "Current & Long-term Trends Favor Water Stocks" have an average 1-year return of 40% -- three times the return of the market with less than one-third the risk! (I'm not implying I chose them a year ago, as I wrote the article about nine months ago.)  

<img alt="" src="http://media.ycharts.com/charts/8d41f269dd106773d559da84ce60e503.png" />

YCharts

The past year must have been a fluke, as we all know utilities are slow-growers, right? Wrong! The three stocks have a 5-year average return of 99% -- greater than three times the market's return with roughly one-third the risk.  American States returned 134%, Aqua America 86.9%, and American Water Works 77.4%. 

The three water stocks outperformed many "exciting" techs, such as Google, which returned 72% over five years. Big Water also trumped most of the Big Pharmas, including Merck (49%) and JNJ (49%). 

The past is water under the bridge, so let's look forward. 

5 Reasons Water Stocks Will Continue to Outperform

1. Monopolies: the best moats

What could be better for investors than the government keeping competition out, or at least limiting it? Utility stocks are usually either monopolies or near-monopolies. This has changed a bit in recent years in some regions for electric companies. However, it largely remains true for water companies. For the most part, consumers and businesses don’t have a choice of water companies. 

2. No substitutes

Thirsty and no water? You could drink juice or another beverage, but the substitution would only be on your end. All beverages contain water and/or are processed using water.

Shower time? You could take a dip in a lake. But good luck during the cold weather; and remember to steer clear of sludge and keep out of sight of peeping toms! 

3. Limited supply...and likely to shrink

The U.S. and the world have been in a long-term warming trend. Higher temperatures mean more water loss to evaporation. Additionally, rising temperatures cause glaciers to melt and sea levels to rise -- and rising seas could push saltwater into underground sources of freshwater. 

Supply will only significantly increase when a desalination process (taking salt out of sea water) is perfected and widely available at a competitive price. 

4. Growing demand

Our U.S. population is slowly growing due mostly to immigration, but also because people are living longer. More people = more water needed. 

The long-term warming trend also increases demand. The agriculture industry uses more water when temperatures rise and droughts occur. This is a considerable factor as crop irrigation accounts for about 37% of freshwater use in the U.S.

5. Low interest rate environment

Due to their borrowing needs, utilities and other capital-intensive businesses benefit when interest rates are low. The Federal Reserve has been increasing the money supply to help stimulate the economy since the Great Recession. So some believe inflation and high rates are around the corner. However, things are still far from rosy for our economy (and even worst for much of the world's -- and we're in a global economy), so it seems it will be awhile before rates rise significantly. 

Even if rates rise, there are enough positives for water stocks. 

Water Utility Stocks with Market Caps More Than $300 Million

<table> <tbody> <tr> <td><strong>Company</strong></td> <td><strong>1-Yr Return</strong></td> <td><strong>Div.</strong></td> <td><strong>Fwd. P/E</strong></td> <td><strong>3-Yr Avg Rev Growth</strong></td> <td><strong>3-Yr Avg EPS Growth</strong></td> <td><strong>Profit Margin</strong></td> <td><strong>ROE</strong></td> </tr> <tr> <td>American States  Water                        </td> <td>56.1</td> <td>2.4</td> <td>16.0</td> <td>9.7</td> <td>20.3</td> <td>11.6</td> <td>12.6</td> </tr> <tr> <td>American Water Works</td> <td>23.5</td> <td>2.4</td> <td>14.6</td> <td>5.6</td> <td>0</td> <td>12.4</td> <td>8.2</td> </tr> <tr> <td>Aqua America</td> <td>43.9</td> <td>2.2</td> <td>17.8</td> <td>4.2</td> <td>22.0</td> <td>25.9</td> <td>14.9</td> </tr> <tr> <td><strong>California Water Srv.</strong> </td> <td>11.1</td> <td>3.2</td> <td>12.1</td> <td>7.6</td> <td>6.3</td> <td>8.7</td> <td>10.6</td> </tr> <tr> <td><strong>Connecticut Water Srv</strong>.</td> <td>3.0</td> <td>3.4</td> <td>13.2</td> <td>12.2</td> <td>8.7</td> <td>16.2</td> <td>9.0</td> </tr> <tr> <td><strong>Middlesex Water</strong></td> <td>6.1</td> <td>3.9</td> <td>11.0</td> <td>6.6</td> <td>7.7</td> <td>2.9</td> <td>7.9</td> </tr> <tr> <td><strong>SJW Corp</strong>.</td> <td>11.1</td> <td>2.7</td> <td>11.9</td> <td>6.6</td> <td>13.4</td> <td>8.5</td> <td>8.3</td> </tr> </tbody> </table>

Morningstar; data to Apr. 2; Div = Dividend Yield; all figures are percentages except P/E

My opinion remains the same since the July article:  

"Overall, American States Water and Aqua America look the most attractive."

American States owns several public utilities. More than 90% of its assets are in Golden State Water, which operates in three regions in CA.

Aqua America provides water and wastewater services to customers in PA, VA, NC, OH, IL, NJ, FL, IN, and TX. However, it just sold off the bulk of its Florida businesses, and plans to sell the remaining ones this year. The company also supplies water to energy producers for hydraulic fracturing in the Marcellus Shale; it's a good money-maker, but controversial.

These two companies have the best ROEs and 3-year EPS growth rates. Additionally, Aqua America has stand-out margins. Both also do well on other metrics not shown. Notably, American States ties for lowest debt/equity ratio (0.7). Aqua America has the second best beta (a measure of price volatility relative to the overall market) at 0.35.

Both have 48% dividend payout ratios (dividends paid/net income), which are OK. However, Foolish investors know "earnings" is not the same as cash. A better indicator of how well profits support dividend payouts is dividends paid/free cash flow. Using this measure, things are tight for American States (99%). Aqua America had a slightly negative FCF because it spent heavily on investments and capital expenditures. I'd not be too concerned as this is a conservative measure, and it's only a measure of the past year. Aqua America's investments were considerably higher than usual in 2012, likely related to the fracking water. And its Florida sales just raised nearly $53 million. However, investors should keep an eye on these ratios.

American Water Works is the largest investor-owned water utility in the U.S., so it's very stable (it has the lowest beta, 0.22). However, its size ($7.4 billion market cap vs. $4.4B and $1.4B for Aqua America and American States Water, respectively) limits its growth potential. 

Foolish bottom line

Water utility stocks continue to look attractive: they're monopolies or near-monopolies; supply is limited and likely will shrink; and demand should increase. Additionally, the low interest rate environment is favorable for capital-intensive businesses. 

American States Water and Aqua America continue to look the most attractive.


BA McKenna has no position in any stocks mentioned. The Motley Fool recommends Aqua America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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