The deranged lunatic

Christopher Gasson argues that change is required before long-term growth in the water sector can be achieved.

Water hasn’t had a great year on the stock exchanges (see story p8). To some extent, it was inevitable that after five straight years of outperforming the main stock exchange benchmarks as a group, water stocks failed to bounce back as strongly as other sectors during 2009. Water is good, but not that good.

Looking forward to 2010, there are strong prospects for outperformance. I base this optimism on the observation that the market is likely to switch its focus from capital gains to yields during 2010. At the moment, there seems to be a widespread feeling that the big share price gains we saw during last year’s recovery are unlikely to continue much into 2010. At the same time, interest rates remain very low. In these circumstances, investors tend to look for safety stocks which offer a reasonable yield. Big water stocks like American Water, United Utilities, Severn Trent, and to a lesser extent Suez Environnement and Veolia Environnement offer a high degree of earnings visibility, coupled with reasonable dividend yields. All of these stocks (with the possible exception of Suez) underperformed the market during 2009, because last year investors were primarily interested in picking stocks which had fallen the furthest on the threat of global financial meltdown. Of course there are other factors at work, such as the share overhang at American Water, the regulatory decisions in the UK, and the French companies’ involvement in the solid waste sector, but overall these issues are fully factored into the share prices.

What worries me is that the safety plus yield argument is not a strong argument for the long-term outperformance of the sector. It worked well between 2003 and 2008. The upturn started in the wake of the dot.com bust. Interest rates were low, and investors had very little appetite for taking risks on companies without real earnings. Water fitted the picture. Add to this the arrival of GE and Siemens to underpin values in the equipment supply sector, and the growth of the infrastructure fund sector which boosted the value of regulated water assets, and it is easy to understand why water stocks motored ahead of the overall stock market.

What would guarantee the strength of water stocks beyond 2010 is an improvement in the underlying performance of the water industry. When we are talking up the water market, we always say a lot about how everyone needs water, and how in 15 years’ time a third of the world’s population will be facing water stress. The thing everyone tends to keep quiet about is the fact that the municipal water sector is highly dysfunctional. It is like someone talking up the attractions of their marriageable daughter to a suitor, without mentioning that as well as being beautiful, she is a deranged lunatic.

The long-term growth prospects of the water sector are blighted by the fact that water, in general, is sold for less than it costs to treat and deliver. Utility investment decisions are driven by the chance availability of capital rather than the returns an investment might offer. In many countries, water utilities are expected to supply social employment, political patronage and kickbacks before they think about supplying water. This is the real opportunity in the water market. If we can change the way people think about water provision, so that the focus is on performance rather than politics, the water sector will not just provide better long-term returns for shareholders, it will also bring an enormous social benefit. The deranged lunatic is a danger to shareholders and water customers alike.

It is something all of us need to work to change. My contribution to making the change is to try to build our annual conference (to be held in Paris on 26 and 27 April this year) into more of a forum for policy-making. We have a big roster of invited guests from the government side, and some high-powered support from the International Finance Corporation. There is already a great buzz surrounding it, and I think it is going to be a step up from last year’s event in Zurich with Al Gore. My goal is, over the next few years, to turn the conference into the effective alternative to the World Water Forum – i.e. a place where change really begins. Come and support it.