The world's real liquidity crisis

PORTFOLIO POINT: Growing water needs of emerging economies point to the challenges of the future.

Now that US policy-makers have arrived – after weeks of bickering – at a predictable compromise to cut about $US2.4 trillion from the federal deficit over the next 10 years, it’s about time they turned their attention to something more prosaic yet infinitely more important: the weather.

Buried deep below reports of the latest feigned attempt at reaching a deal have been reports of a deadly heatwave across the US that is estimated to have caused about 20 deaths.

Temperatures peaked above 50 degrees in Iowa, while in Washington, where nerves were already frayed, the thermometer was sent past 40 in the shade as part of a prolonged drought.

But isn’t a phenomenon particular to the US.

East Africa has once again become a tragic famine zone, leading not only to a humanitarian crisis, but adding to security pressures in the restive region. China and India, meanwhile, are experiencing massive droughts of their own.

Tropical storms in China have drenched some provinces but failed to relieve the places that need rain the most. A patchy start to India's monsoon has left millions of farmers in the country’s east with another season of uncertainty.

In a supermarket-mediated world of packaged foods and running tap water, it’s easy to put such things out of your mind but when you consider that the possibility of an interest rate rise tomorrow is almost directly linked to water and weather it becomes worth exploring.

After all, we wouldn’t have higher than normal inflation if it weren’t for the high price of fresh food (caused by the floods) and the high price of petrol (caused by Middle Eastern unrest, in turn caused by food-related protests in late 2010).

So while in the short term economic events are likely to revolve around credit liquidity – whether in the form of America’s fiscal debt, Europe’s debt imbalances or general rich world debt deleveraging (see When worlds collide) – in the long-term, I expect they’ll revolve around water.

This isn’t exactly a new idea and it’s something I’ve covered previously (see Pincer closes on China, A world of worry and Food for thought) but at a time when the rest of the market is focused on short-term issues like the debt ceiling, which is likely to be lifted, and the start of earnings season, which is likely to be boring (click here), it’s worth exploring in some detail.

It’s also a theme that some of the smartest minds in the market are looking at.

As the US debt drama unfolded the highly regarded fund manager Jeremy Grantham ignored those issues to focus his quarterly letter on the issue of soil erosion and moisture content (click here).

And while Citigroup chief economist and former Bank of England director Willem Buiter has been central to the US and European debt debates, he recently turned off the news ticker to pen a 4000-word note on how the world’s water market will eventually eclipse that of oil (click here).

Of course it helped that Citi hosted a global water conference early in June, and it should be noted that the world is years if not decades away from developing a fungible water market but the supply/demand projections of water are nevertheless startling.

Citi’s Buiter suggests that emerging market urbanisation, water-intensive protein based diets, increased pollution and over-use of groundwater and aquifers are leading to a five-fold increase in water requirements.

To make matters worse this increase in demand is largely coming from very places that are already struggling with their existing water requirements.

China, for instance, may be leading the world in terms of population, urbanisation and growth, but it has only one-quarter the world's average share of water per capita: 400 of 600 cities face shortages, including 30 of the 32 largest urban centres. In the country's food belt in the north, the situation is even more dire, with irrigation now relying almost entirely on ancient and largely depleted aquifers.

Further, with 90% of China's urban groundwater and 75% of its rivers and lakes polluted, the country is forced to embark upon increasingly audacious schemes to solve the problem, including the controversial South-North Water Transfer Project, which plans to divert water from the Yangtze in the south to the Yellow and Hai Rivers in the north.

The plan also calls for the diversion of Tibetan headwaters that feed India's Brahmaputra River and the Mekong, which drains into Indo-China. Such a move is unlikely to go unnoticed. China is already facing renewed hostility from neighbours like Vietnam over territorial disputes and its problematic relationship with ethnic minorities such as the Uyghur and Tibetans have already hit a new crisis with another episode of violence in western Xinjiang province yesterday.

This is all very important on a macro-economic and geopolitical level, it is nevertheless difficult for investors to position themselves for this long-term trend. One way that Buiter identified was through companies that deliver water services – whether through desalinisation, storage, purification, transport or recycling. And with a number of these companies being highly liquid and listed on major world exchanges, buying shares in these is relatively easy for investors, as James Frost pointed out on Friday.

One obvious drawback is that each of these companies is subject to highly localised and idiosyncratic risks and most of them have non-water exposures as well. Chief of these is ASX-listed GUD Holdings Limited (GUD), which, based on its 2011 financial year, had only 18% of sales exposed to water via its Davey Pumps division, and only 12% of EBIT. What’s more, Davey Pumps did poorly for the year, with earnings virtually falling in half. One of the first companies to report in this month’s earnings season, GUD as a whole saw earnings per share fall 6% to a disappointing 71.7¢, against a consensus forecast of 76.9¢.

The upside of this, however, is that Davey Pumps was abnormally affected by the extremely wet and cool summer Australia has experienced. GUD notes that the division’s sales correlate strongly with changes in the Southern Oscillation Index, which measures the force of La Niña and El Niño weather cycles, and that this measure was now stabilising, based on Bureau of Meteorology data. GUD is also cheap, with an estimated 2012 earnings multiple of just 10 times and a forecast 2012 dividend yield of 8%. The company's $8.48 trading price at the close of Friday is also about $2 below the broker average.

Yet to take out some level of insurance against such a macro-level risk as global water shortages, investors are better served by investing in a diversified basket of water stocks.

Credit Suisse took that approach in 2007 when it established the ASX-listed PL100 World Water Trust (CSW), which invests predominantly in utilities in the US, Europe and Japan. Due to the defensive nature of these utility assets, dividends have been meagre and the (capital-protected) fund’s unit price hasn’t exactly appreciated in value (a situation not helped by the management fee of more than 1%). What’s more, the nature of its underlying holdings means the fund is hardly exposed to the type of technology-related businesses that could help solve the looming challenge in emerging markets.

But even in Australia’s mining-focused market, such companies exist, albeit with a higher than normal degree of risk. I’ve attempted to compile a list of twelve of them – hardly exhaustive but nonetheless positioned for what Citi’s Willem Buiter says "Will eventually become the single most important physical commodity asset class."

-Water stocks: the damp dozen
Company	ASX		Market cap (m)	Price	Broker target	Change (1 year)	Price / NTA	F'cast P/E
ADG Global Supply	ADQ	Engineering supplier, including pumps	$19	$0.09	N/A	30.77%	2.46	N/A
Aeris Environmental	AEI	Refigeration and water treatment remediation	$20	$0.19	N/A	245.46%	-11.52	N/A
Dolomatrix International	DMX	Hazardous waste management	$30	$0.22	N/A	-12.00%	1.63	6.87
GUD Holdings	GUD	Consumer and industrial products	$586	$8.48	$10.56	-9.31%	6.79	11.03
PrimeAg Australia	PAG	Buyer of farmland and water allocations	$170	$1.13	$1.32	12.25%	0.89	26.28
Phoslock Water Solutions	PHK	Reservoir and water quality management	$22	$0.11	N/A	10.53%	8.62	N/A
Reece Australia	REH	Plumbing and irrigation supplies	$2,060	$20.68	N/A	-13.58%	3.34	16.53
Ruralco Holdings	RHL	Resale of rural and irrigation supplies	$182	$3.30	$3.77	15.79%	1.73	10.71
Saunders International	SND	Designs and supplies bulk liquid storage tanks	$39	$0.50	N/A	14.94%	2.31	N/A
Tox Free Solutions	TOX	Waste management and environmental services	$203	$2.10	$2.65	-9.48%	3.02	16.15
Transpacific Industries	TPI	Industrial cleaning, recycling, waste management	$879	$0.92	$0.94	-15.67%	-1.95	19.06
Waterco	WAT	PVC pipes, pool systems, treatment equipment	$37	$1.12	N/A	9.31%	0.87	N/A
		Source: Stock Doctor, Datastream, Morningstar

Beyond stocks, perhaps the best way to play the long-range water thematic is to increase your currency and geographic exposure to places that are water-rich and reduce it from places that are water-poor.

Buying NZ dollars with Australian dollars is one way for investors to do this, although it should again be stressed that we’re talking about extremely long-term developments. Another way, of course, is with land and reliable agricultural supply. Unfortunately, for all their recent success, Australia’s listed agricultural companies – with possibly the exception of PrimeAg, which is specifically focused on land with secure water supply – probably do not fit this bill, considering our country’s own dry conditions (despite the past year’s rain). This is again why places like New Zealand are more attractive on such a thematic.

Finally, the other way is to invest in other agricultural inputs that, unlike water, are fungible, notably energy and fertiliser. In March I investigated fertiliser, particularly phosphate – a commodity GMO’s Jeremy Grantham likes in particular – (see Phosphate’s promise) and I have repeatedly advocated staying exposed to oil, even if the price of crude is likely to fall temporarily on the resolution to the US debt ceiling (see Bittersweet crude). Exposure to non-hydroelectric renewable energy companies such as Infigen Energy (IFN) or Carnegie Wave Energy (CWE) is another possible solution (for more clean energy stocks see Everybody wins).

Ultimately though, there is no perfect way to completely hedge against a thirstier world as this will cause far more threats than opportunities over the long term. However long it takes to eventuate, the looming global water crisis will make the debt “illiquidity” of 2007–09 look like a drop in the ocean.

Editorial comments

Investing in water is a compelling – if elusive – prospect for retail investors. In the near future local fund managers will launch “water funds” similar to the global fund from Credit Suisse. Meanwhile, the idea that more crops must be grown with less water means energy and fertiliser opportunities hold genuine attractions. – James Kirby, managing editor