There may be investment opportunities in the water sector despite its less-than-stellar 2023 performance

By Myra P. Saefong

Water is essential to human life, but trading in the market for the commodity has failed to show it, with a key global water index of companies operating in the sector barely higher for the year.

Water futures on the Chicago Mercantile Exchange have also struggled to garner much interest three years after their launch.

The S&P Global Water Index , which is designed to measure the performance of companies in water-related activities, has seen a price return of 4% year to date as of Nov. 21, after losing more than 22% in 2022 and gaining almost 30% in 2021, data from S&P DowJones Indices show.

The index saw a "meteoric" rise in 2021 -- more than doubling from the lows of March 2020 to November 2021, said Jonathan Sakraida, equity analyst at CFRA Research.

That coincided with passage of the U.S.'s historic $1.2 trillion bipartisan infrastructure bill that outlined about $55 billion to improve U.S. drinking water, wastewater, and storm water infrastructure, he said. Optimism around the resulting fiscal stimulus likely led to a decoupling of fundamental and sentiment, with stocks moving well beyond their "respective historical valuation averages," setting the stage for a correction.

After the infrastructure bill's passage, it became apparent that funding distribution and project activity would "progress slowly out of the gate, with tailwinds being stretched out over several years for firms tied to water infrastructure investment," said Sakraida. That "threw cold water on momentum" and contributed to a 20%-plus 2022 decline in the water index.

Meanwhile, in the past year, the broader financial market has shifted in the past year.

The focus was more on cyclical and risk-on technology investments, with the broader market largely "ignoring the steady water sector names," leading the underperformance in the water sector, said Deane Dray, managing director and multi-industry analyst at RBC Capital Markets.

Water investing still offers a "steady, predicable earnings stream but right now. Investors have a decided preference for higher risk/higher reward investments," he said. At some point, the cycle will slow and will be accompanied by a "flight to quality and safety, which will include the water sector broadly."

Water index

The S&P Global Water Index includes two separate "clusters" -- companies that manage water utilities and infrastructure, and companies that develop water equipment and materials -- in order to capture the entire value chain of the water industry, according to S&P Dow Jones Indices.

However, Damian Georgino, partner at Womble Bond Dickinson and head of the law firm's water subsector, said the two distinct clusters of companies within the index do not represent the entire universe of investible water assets. He's "not entirely certain that the performance of this index is necessarily reflective of investor appetite for water-themed investments and the success of such investments."

Still, performance for the index has been mostly flat over the year.

That's the result of a similar allocation to the utilities and industrial sectors, with the two sectors experiencing opposite fortunes in terms of performance so far this year, said a spokesperson for S&P Dow Jones Indices. As of Nov. 17, data show the utilities sector this year is the laggard in the S&P Global 1200, while the industrial sector has strengthened.

Water futures

It's been almost three years since the CME Group's launch of Nasdaq Veles California Water Index futures.

The futures contracts can help investors manage price risk associated with the scarcity of water in the California, the largest water market in the U.S., according to the CME.

From the launch in December 2020 to Nov. 10 of this year, Matt Southerlan, a CME spokesman, said 1,840 contracts have traded -- the equivalent to 18,400 acre-feet, or 5.995 billion gallons, with 159 of those contracts traded this year.

With little to no volume, the most-active June 2024 water futures contract settled at $298 per acre-feet on Tuesday, down 69.6% year to date, according to Dow Jones Market Data.

The primary goal of water futures was to enhance price transparency in the water sector, said RBC Capital's Dray. Unfortunately, trading volumes have been notably low, and challenges in generating market interest continue to be a "limiting factor."

The "uniqueness and relatively new nature of these water contracts," have contributed to the low trading volume, he said. Water, meanwhile, is always such a local issue and what California is paying for water has little relevance for other parts of the country, or the world, he said.

CME water futures are based on the Nasdaq Veles California Water Index, which sets a weekly benchmark spot price of water in California.

The state entered a drought in 2020, but recently managed to emerge from drought conditions, according to U.S. Drought Monitor.

Still, Womble Bond Dickinson's Georgino said California is "water short" regardless of classification. "As population, economic activity and usage grow, the demands on an already water-stressed situation will only become worse," he said.

Opportunities

There are a number of attractive investible attributes to the water sector, said Georgino, and the number keeps growing at an "accelerating rate."

It all depends largely on "risk profiles and patience," he said, with climate tech investing being called a "generational opportunity."

"Since water is necessary for life itself, water tech investing could be an everlasting opportunity." Damian Georgino, Womble Bond Dickinson

"Since water is necessary for life itself, water tech investing could be an everlasting opportunity," said Georgino.

Looking ahead, CFRA Research's Sakraida believes that the water sector's underperformance in 2023 presents investment opportunity given that he and his company still have a "constructive view" of the firms tied to U.S. federal stimulus for water infrastructure.

Three companies within his sector coverage, Xylem Inc. (XYL), Pentair PLC (PNR), and Watts Water Technologies Inc. (WTS), fall within the S&P Global Water Index, he said, and all three are industrial-oriented firms. CFRA has a "strong buy" rating on Xylem, an equipment manufacturer and service provider for water and wastewater applications.

Overall, CFRA maintains a neutral outlook on the water sector -- utilities in particular benefitting primarily from rate increases, said Sakraida.

We are positive on manufacturers who are helping to "directly address the rising global demand for efficient water solutions and technologies," he said. Rising infrastructure investments at the federal level should sustain a "healthy rate of demand over the coming years," with greater regulatory support for capital spending projects such as pipe replacement and modernization, and enhancements to storm and flood resiliency.

Emerging markets, meanwhile, are likely to provide a "long growth runway as developing countries increasingly face water scarcity issues," Sakraida said.

-Myra P. Saefong

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11-22-23 1519ET

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