In recent letters, we’ve commented on the new prominence of real assets of all kinds in the new, inflationary, deglobalizing post-pandemic world, where “just in time” logistics have reverted to “just in case” — and where for many investors and speculators “return of capital” is remembered to be worth just as much consideration as “return on capital.” (Speculators in some decentralized finance platforms have been dealt a particularly harsh lesson in this regard, learning that problems of leverage and proper risk management are highly relevant in the crypto space in spite of its vaunted “unstoppable code.” We still believe in fintech innovation, the efficiencies of blockchains, and the utility of some digital assets — and we repeat what we have said from the beginning: if you speculate in this area, understand the platform and the protocol and look for projects willing to subject themselves to U.S. financial authorities.)
In recent weeks, we have talked about semiconductors, rare earths, natural gas, and agricultural commodities — all of them “necessities” for life as it is currently lived on most of Planet Earth. Today we will briefly discuss a necessity even more basic than these, and one which has been a perennial topic for thematically minded investors: water. Here in the southwest United States, water (and its continued availability) is an increasingly important topic. Heatwaves around the globe get people thinking about water as well. Water may have come suddenly to prominence in some minds as a result of the recent explosion at the Hoover Dam. The Hoover Dam’s significance is that for generations it has both held Colorado River water supplies, and provided hydroelectric power for tens of millions of people. Each month it becomes less significant at doing either.
The short and skinny is that while water is a powerful theme, it is that rare outlier in powerful themes — it is virtually uninvestable. We have watched this theme come and go in popular awareness for decades, and have seen many highly touted companies and funds either be delisted or significantly underperform the broad market. Our observation is that water as a theme provides much more fodder for analysts and managers selling their analysis and management services than it provides returns for investors.
Why is this? After all, the reasoning behind water as an investment is compelling.
- Water is scarce in many geographic regions, and getting scarcer — especially where aridity is increasing and population is rising (such as the aforementioned southwestern United States).
- Water infrastructure is aging after nearly 100 years of the rapid growth of urbanization and suburbanization, and investment is a constant need (though some professional engineering societies betray a little self-interest in their predictably abysmal ratings of infrastructure quality).
- Consumers have gotten ever more concerned about the purity and quality of the water they drink, even as populations have grown and stresses on wastewater effluent processing have increased.
- And finally, the internet of things, smart metering, and digitized analytical, control, and management technologies are promising new efficiencies in the water sector as everywhere else.
However, for most of these themes, the reality on the ground turns out to be considerably different than what is offered by many who claim to be pundits — or at least, the issue is sufficiently nuanced and differentiated that it turns out to be not so much a mega theme as a collection of possibly interesting pointers to areas where there may be specific tactical opportunities.
Water scarcity, for example, is not a mega theme. It is confined to very specific regions and geographies. As we noted above, the “aging infrastructure” theme is one that is touted largely on the basis of studies and press releases from professional engineering associations, who have an interest in convincing politicians and the public that their professional analytical services ought to be in very high demand. The integration of the water system into the internet of things, in a global era of cyberwarfare, presents hard-to-evaluate strategic risks which may overshadow the alleged efficiency gains.
But more fundamentally, virtually all of the public companies in the water sector fall into one of two groups. Either they are highly cyclical, slow-growing industrial, agricultural, or construction concerns… or they are stolid dividend-yielding utilities that respond more to policy and politics than to economics. These can be companies that occupy a solid, steady place in a low-volatility dividend-oriented portfolio, but in our view, under most conditions, would not merit any overweighting. Largely, these will be companies that grow at or slightly above the rate of nominal GDP expansion. The theme may be exciting — the stocks are not.
In 2020, the Chicago Mercantile Exchange (CME) launched water futures contracts. In our view, these have thus far showcased the limited utility of financial instruments in the face of real-world scarcity — an aspect of the theme we’ve referred to as “the revenge of the real.” The CME’s water contract tracks an index of water rights in California — but it settles in dollars, not in physical water, and the few California farmers who have used it might be able to get a financial offset from drought, but they get nothing to save their crops. Further, it remains an illiquid market (no pun intended). It’s also a market for which progressives are gunning — believing that speculation on water scarcity is an evil with no potentially good issue.
Investment implications: While water itself is not a broad investable theme, water availability will grow in relevance for particular industries and for real estate in particular geographic regions — in short, not a positive theme, but a necessary screening factor.
In our view, the most interesting water-related ideas will have to do with novel technological approaches to water treatment, particularly with rising regulatory burdens on industry to pretreat industrial wastewater effluent before discharging it into municipal water systems. Here, if anywhere, investors may be able to locate innovators who can grow rapidly — though of course, their stocks will typically sport high multiples. And given the track record in the space, potential investors should ask all the usual probing questions about the technologies, their viability, competition, company management, and valuation before deciding to invest. Perhaps the most significant global water breakthrough would be more efficient desalination technologies; currently, the mass implementation of desalination would imply further upside for nuclear energy — particularly for small modular nuclear reactors.
