Freshwater Favorites: Investing in Water

03/16/2015 10:00 am EST

Focus: UTILITIES

In his Logos LP Journal, value investor and money manager Matthew Castel looks at the water sector, an area he feels presents both long-term global challenges and investment opportunities. Here, he discusses the industry and highlights some top ideas on his long-term investment watch list.

Steven Halpern: Our guest today is Matthew Castel, a value oriented money manager with Logos LP and editor of the Logos LP Journal.  How are you doing today, Matthew?

Matthew Castel:  Hi, Steve.  I’m doing well and weathering this recent volatility we’re seeing in the markets.

Steven Halpern:  And the cold weather, I assume.  You’re up in Canada, correct?

Matthew Castel:  That’s right, that’s right.  It’s getting warmer, but it has been a long winter.  

Steven Halpern:  Could you tell our listeners a little about Logos LP and your investment strategy.  

Matthew Castel:  Absolutely, so Logos LP is an investment partnership which is focused on value to generate long-term risk adjusted returns, and so, we search for quality businesses globally that are trading at fair prices and then we tend to keep a concentrated portfolio for the long-term.  

Steven Halpern: Now, today we’re going to talk about the water sector, an industry that you’re looking at for long-term opportunities and you point out that among the many problems the world faces, the water sector is one that really doesn't receive enough attention. Could you explain why and expand on why you see opportunity there.

Matthew Castel:  Absolutely, so, basically, we believe that—people are taking the resource for granted—fresh water has actually been mispriced. We think that as population continues to increase, we’re going to see demand outpacing supply and thus price increases are bound to come with water.  

This is really a serious problem, because it’s important to remember that the water we drink today has probably been around—in one form or another—for hundreds of millions of years and this is due to the fact that the amount of fresh water on earth has always remained constant, and in fact, there is only 70% of the world that is covered in water, but only 2.5% of it is fresh and only 1% is easily accessible.  

With the population expected to grow around 1.8 billion by 2025, it is estimated that around two thirds of the world’s population are going to live in regions where fresh water is scarce. We’re seeing this actually, even if we look at the United States in particular, many states are facing fresh water shortage issues, if we look at California for example.  

Another interesting catalyst we actually see for an increasing demand for fresh water is actually the growth of hydraulic fracturing in the oil and gas exploration field, because each well that gets used uses somewhere around 3 million gallons of fresh water and only 20% of that water can actually be reused, so we just think that’s another sort of catalyst that’s going to make investing in fresh water for the long-term something to consider.  

Steven Halpern:  An interesting aspect of your latest research report was that you highlight how little has really been done from a technology standpoint in many years and you point out that desalinization has really been a mature industry for almost four decades, with very little change, but you note that there may be some new methods for reusing wastewater that should come to the forefront. Can you explain that?

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Matthew Castel:  Absolutely, so I mentioned in my report that desalinization and reverse osmosis are very mature technologies and that the infrastructure in place for those technologies is quite capital intensive and therefore changing this type of technology is very difficult.  

Given the shortages I just discussed, reusing wastewater is becoming a major priority and this is because most of the water in the United States is actually just sent down the drain or flushed down the toilet and only 1% is actually reused.  

The opportunities here are great, when we’re looking at that 1% figure.  Because as drought, overuse, and increasing demand are pushing communities to focus on wastewater reuse, people are waking up to it.  

We think that current processes for reuse are quite expensive and thus new technologies will need to be developed and that’s why we’re looking at these types of companies that are developing those types of technologies.  

Steven Halpern:  So, let’s look at a couple of companies that have made it onto your long-term watch list within the sector and let’s begin with Danaher.  What’s the attraction here?

Matthew Castel: Danaher (DHR) is quite an interesting play.  It is not exactly a pure play on water, given its identity as a diversified industrial manufacturer, but, you know, it’s an extremely well-run company that consistently generates above average returns for its shareholders.  

What has really allowed it to do so well is its unique acquisition strategy.

Because Danaher grows essentially through acquisitions, what’s interesting is their proprietary business integration system—called the Danaher Business System—and this system which permeates their corporate culture actually allows them to quickly squeeze returns out of their acquisitions and basically allows them to integrate all of their business units in a very streamlined fashion.  

Going back to water, Danaher’s environmental segment provides water-related services, including ultraviolet disinfection systems and industrial water treatment solutions, which have performed really well over the past while.  

Basically, the bull case here is Danaher’s management approach and our belief that the company is fairly valued.  Based on our estimation, with an implied estimate for earnings growth around 8.2% over the seven to ten years, so basically, here what we have is a long-term hold.  

Steven Halpern:  You also point to Aqua America (WTR).  Could you share your thoughts on that company?

Matthew Castel:  Absolutely.  Aqua America is definitely a pure play water company, because it is actually a holding company for water utilities and it provides water and wastewater treatment services to about $3,000,000 commercial and residential customers in about 14 states.  

Operating in the water industry in the United States, the vast majority of its revenue is actually derived from its regulated business and thus cash flows are actually really consistent.  

The bull case here is that Aqua America is a stable company with a stable future. You can't really go wrong with future demand for clean water increasing and this company is one in the utility sector that is going to pay a solid dividend of around 2.5% for income investors over the long-term.  

But, I have to say that there are certain risks with Aqua America because if you actually at the price for Aqua America and the desire over the last few years for investors looking for yield in a low rate environment, well, shares have actually been pushed to highs that we don't believe are justified given its current lack of top line growth.

So, we’re looking at entering a position in this company—or at least considering one—at a more attractive price of around $24 a share and its currently trading around just under $26, so that’s the sort of target that we think the company would become interesting in.

Steven Halpern:  You also cite Pall Corp. (PLL). Could you tell us about this company?

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Matthew Castel:  Pall Corp. is probably our top pick.  This is a company that specializes in making water and air more pure through its patented filtration techniques and technologies.  Its, sort of, mainstay is selling replaceable filters at a high profit.  We think that the company has a lot more potential to grow as the world’s quest for pure water intensifies.  

In the long run, we think that Pall stands to benefit from a steady revenue stream for its filters, which tend to be high margin products and this actually strengthens their competitive position by increasing the switching cost for customers, since it is costly and difficult to switch between filtration platforms.  

This is another company that has great management.  They’re constantly pursuing profitability improvements and they’ve actually got their gross margin to exceed around 50%, which is great.  

The bull case here is that Pall is a steady performer. We think its revenue derived from both equipment and consumables, give the firm flexibility in both good times and bad times, making this kind of a recession-proof company.  

We think that Pall also enjoys outstanding growth opportunities in biopharmaceuticals, because this is a market that is growing at twice the rate of traditional pharma products and this industry uses eight to ten times as many filtration applications as traditional products.  

We think that this actually is a company that has run up in price quite a bit, so we’re looking at a price target of around a $92, $93, and its current price is around $97, so we are hoping there will be a bit of a pullback given worries about the Fed raising rates and so we look to initiate a position around $92 or $93.

Steven Halpern:  Now, finally, you point to an exchange traded fund that provides investors with broader exposure to the overall industry.  Could you tell us briefly about PowerShares Water Resources ETF (PHO)?

Matthew Castel: Absolutely. In our newsletter we are stock pickers, but we like to provide options for our readers if they want, sort of, a broad exposure to a particular industry or sector and so the pick that we have here is the PowerShares Water Resources ETF, which mirrors the Palisades Water Index.  

This ETF seeks to identify a group of companies that focus on portable water, water treatment, and water-related technology and services.  Of the water ETFs out there, this is the most pure play water one.  

Those that are seeking exposure to the investment team of long-term scarcity of fresh water should definitely consider this ETF as a small tactical position within their diversified portfolio.  

I just want to point out that the one sort of issue here to be aware of is that there are, sort of, too few companies that are purely water related and treatment related companies, so in this ETF about 70% of total assets are actually allocated to industrial firms like a Danaher, or a Roper Industries, or Pentair, for example, which are not exactly focused on water, but are rather doing, sort of, diversified manufacturing operations.  

That’s one thing to know and one of the things to consider is the fact that over the past five years the performance of the water ETF here has actually been 93% correlated to the broader industrial sector and also quite closely correlated to the S&P 500.  That’s something to keep in mind.

But as I mentioned earlier, we think that certain catalysts are going to create a real scarcity in water over the long-term, and therefore, we believe that getting exposure to this sector through this ETF is going to be a nice way to benefit from that water scarcity moving forward over the long-term.

Steven Halpern:  Again, our guest today is Matthew Castel of Logos LP Journal.  Matthew, thank you very much for taking the time to join us.

Matthew Castel: Thanks a lot, really appreciate it.  

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