5 Stocks to Profit from Water's Scarcity

In coming decades, the words of the ancient Mariner are increasingly likely to seep into the world’s consciousness: “Water, water everywhere, [but not a] drop to drink.” Though lakes, seas and oceans blanket 71% of the planet, only a small fraction of the world’s water is clean enough to drink or use in industry. And even regular sources of drinking water have become tenuous, as illustrated by the toxic algae that fouled Lake Erie this summer, jeopardizing the drinking water for 11 million people. That combination caused the World Economic Forum to conclude that water shortage is one of the top global risks.

The growing scarcity of water also makes it an enduring investment theme, says Matthew Sheldon, co-manager of the Calvert Global Water fund (symbol CFWAX). And this is one theme that, unlike most sector plays, provides a fair amount of diversity. “Water is such a huge part of everything that we eat and manufacture that what drives the stocks represents almost every segment of the economy,” Sheldon says.

The fund manager adds that he’s not particularly concerned that some of the stocks in this group appear expensive. The trend is powerful, and that bodes well for companies that will benefit. “Each additional drop of water is comparatively more expensive because there is so little of it, and demand is growing at two times the rate of population growth,” Sheldon says. “This theme only gets better over time.”

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Here are five water stocks that may quench your thirst for potential money-makers. Share prices and related data are as of August 13.

Shares of Calgon Carbon (CCC) tumbled when second-quarter results came out on August 8, largely because analysts had been expecting the company to post stronger gains in both sales and earnings. Income from operations rose a modest 5.4% from the same period a year earlier, while revenues were up just 3.4%. But what makes Sheldon excited about this Pittsburgh company has little to do with this year’s results. He says that Calgon Carbon is a great long-term play because of clean-water regulations that go into full effect in 2016. Those rules will require boaters to purify their wastewater before discharging it. As a result, ballast treatment, which generates $200 million to $300 million in revenues annually, could quickly become a multi-billion-dollar-a-year industry. Sheldon expects Calgon Carbon, which got into ballast treatment with its 2010 acquisition of Hyde Marine, to be one of the main beneficiaries of the new rules because its UV disinfection systems are a key part of the purification process. At $21.23, the stock trades at 20 times estimated year-ahead earnings per share.

Mueller Water Products (MWA) is a bit more expensive, but it may be a more-compelling stock. At $8.77, Mueller sells for 21 times estimated earnings for the next four quarters. But analysts expect the Atlanta water-infrastructure firm, which specializes in leak detection and smart meters, to boost earnings by 72% in 2014 and 48% in 2015. The growth stems from aging municipal water pipes, which have been disintegrating and causing money to dribble away from city water districts. As water becomes scarcer and more expensive, an increasing number of water districts are expected to shoulder the cost of detecting and fixing leaks. Mueller also benefits from housing growth and regular increases in municipal water rates, says David Rose, an analyst with Wedbush Securities in Los Angeles.

And what Mueller does in the domestic market, Rexnord (RXN) does on a global scale, Rose says. All the factors that drive Mueller’s earnings — municipal rate hikes, housing starts and repair of aging water systems — are boosting profits at Rexnord. Better yet, the Milwaukee-based company has a commercial business that’s picking up thanks to a revival in industrial construction, Rose says. At $26.93, the stock sells for 16 times projected year-ahead earnings. Analysts forecast that earnings will rise 19% in the fiscal year that ends next March and 16% the following year.

Xylem (XYL) is also poised to benefit from a boost in both commercial and residential building. The Rye Brook, N.Y., company makes pumps, valves and analytic equipment used to move, test and treat water in more than 150 countries. Revenues and profits were nothing to brag about in 2013, but Xylem brought in a new CEO, Patrick Decker, in March. Decker is an efficiency expert, and analysts expect him to streamline the company’s operations and squeeze more profit out of each drop of revenue. At $36.74, Xylem shares sell for 17 times projected year-ahead earnings.

Pentair (PNR), a maker of valves, fittings, pumps and filters, is a great company with a compelling story, says Morningstar analyst Daniel Holland. Pentair operates in every segment of the water business, virtually assuring that it will deliver a “meaningful growth story” as the global economy expands and the need for building and upgrading water systems soars, Holland says. Although the company trades in the U.S. and has executive offices in Minneapolis, Pentair has been domiciled overseas since it bought Tyco International’s Flow Control division in 2012. At that point, Pentair reincorporated in Switzerland. But in May, the company’s shareholders approved another international move to Ireland, where the tax rules are more favorable.

The stock stumbled recently when Pentair announced that 2014 earnings would be lower than projected because it recently sold its water-transport unit. Analysts at S&P Capital IQ think the sale is sage, allowing Pentair to focus on faster-growing segments of its business. But the stock’s decline brought it into a more-favorable buying range. At $68.53, Pentair sells for 17 times estimated year-ahead profits. With a market capitalization of $13.2 billion, Pentair is the biggest company on our list.

If you prefer a packaged approach to dipping your toes into water stocks, you can choose from two mutual funds and four exchange-traded funds. All have been around for more than five years. The mutual funds, AllianzGI Global Water A (AWTAX) and the above-mentioned Calvert Global Water, typically levy sales charges, so skip them unless you can invest without commissions. The top-performing ETF over the past five years was First Trust ISE Water Index (FIW), with an annualized return through August 13 of 14.3% (compared with 16.4% annualized for Standard & Poor’s 500-stock index). The ETF charges 0.60% per year in fees. Three of its five biggest holdings — California Water Service Group (CWT), American Water Works (AWK) and Aqua America (WTR) — are utilities based in the U.S.