LEST WE FORGET, IT'S THE 
GLOBAL WATER INDUSTRY
by John Dickerson, President & CEO
Summit Global Management, Inc.
March 20, 2006

A Compelling Investment Theme

The water industry is comprised of a vast array of companies providing products and services toward the collection, conveyance, treatment and monitoring/analysis of water and wastewater for multiple purposes and end users. As you will see in the table below, investing in the U.S.-based utility component of this industry has historically worked very well, but the time has come for much broader global exposure in water stocks, as this group in the U.S. has generally become overvalued.

Water is the single most important economic input to the global economy, and more specifically, to individual enterprises. The disparity between supply and demand for clean water is an inexorable problem; yet the relentless demographic demand for its uninterrupted supply makes water by far the most stable of all commodities – unaffected by cyclical influences which constantly badger other more typical input commodities.

This global theme of water insufficiency relative to unrelenting demand, along with all the related trends and opportunities it has spawned, continues to benefit the prospects of a broad range of publicly traded companies which help to provide solutions to this supply/demand dilemma. A diverse global universe of investment opportunities exists within the theme of water investing; all the while eliminating the typical resistance to sector fund investments, which are far more limited in scope and susceptible to cyclical influences: Water investing is a broad and deep global theme, (the global factor being a subject that U.S. investors are presently not giving sufficient weight), and is far too diverse to be considered sector investing.

Water Utilities: The Industry Stalwart

U.S. water utilities have generally been the largest core investment group for most water investment portfolios, for the simple reason that U.S. water utilities have been a leading stock market performer for many years. Moreover, dividends have played a large part in these total return figures, which tends to dampen market volatility for these shares.

*An equally-weighted list of all publicly traded U.S. water utility stocks that existed as of 12/31/05. Importantly, this is a negatively-selected list, in that some public water utility stocks were acquired during the years depicted above, and the returns on those acquired companies, normally purchased at large premiums to market prices, are not included herein. Thus, if this compilation included the returns of all water utility stocks that were trading at the beginning of these periods, the returns would have been substantially higher.

A striking and very illustrative fact is that we have found that in any randomly selected five-year period over the last 25 years (1982-87, 1993-98, 1979-84, etc.) water utilities dominated the list of the best performing industry groups in the U.S. stock market on a total return basis. Why? The simple answer is that water utilities have always done very well in good times and bad. When compared to any other industry, water utilities have a more obvious and compelling business model with most persistent demand and probably the most predictable future.

In addition, regular dividend increases tend to keep the stock prices moving ahead on a very consistent and predictable basis. Such regular dividend increases are a hallmark of the water utility group, and are perhaps the best indicator of the quality and stability of any enterprise.  It also says a lot about the cash generated by these businesses.

Aqua America (WTR), formerly known as Philadelphia Suburban Corporation, is presently the largest investor-owned American water utility in the US. Its dividend history is not only impressive, but also quite instructive. In November of 2005, the company announced a 10% dividend increase and a 4 for 3 stock split, which represents the 15^th increase in 14 years. The company has paid dividends since 1945. The March 1, 2005, payment began the 60th consecutive year of shareholder dividend payments. This stellar record led the company to the number one spot in the performance list below.

Similarly, late in 2005, Southwest Water Company (SWWC), another American water utility, announced a 10% increase in its quarterly dividend and a 5% stock dividend payable in January of 2006. This is the kind of news that Southwest Water investors have regularly enjoyed, and helps to explain why Southwest is second in the 10-year performance list below.

The long-term total return of water utilities continued to be a leader in the U.S. stock market through 2005. Below is a list comparing the ten remaining investor-owned water utilities in the U.S. as compared to a list of popular investment icons. With a record like this, it is not hard to understand why U.S. water utilities now carry such remarkably high market valuations. The question investors now need to ask themselves is: “How high is too high?” 

Keep in mind that this utility list used to be much longer, but many companies beyond the ten now remaining were bought by water-savvy foreign investors over the last ten years, and the list is now much reduced. Thus, the current list is somewhat negatively selected, in that many of the better-performing companies are no longer part of the group and some of the laggards remain.

The following table illustrates a list of widely held American stocks for the most recent 10-year period (12/31/1995 through 12/31/2005).

The Water Industry - An Extensive and Diverse Global Universe of Companies

We have discussed water utilities up to this point, but it must be strongly emphasized that water utilities are actually only a small part of our investment universe of global water industry stocks. Indeed, the Summit-defined water stock universe stood at 359 companies on 12/31/05, and only a small percentage of the list was water utilities. Our emphasis in discussing water utilities was intended to illustrate the remarkable stability at the basic delivery point of the industry, and how all companies participating in the industry’s supply and service chain are very positively influenced by this persistency and stability.

Summary by Region – December 31, 2005

The non-utility majority of companies on our list are basic water industrial stocks:  Companies involved with pumps, pipes, valves, filters, testing, instrumentation, engineering, and construction of water systems.  Water utilities are the highly visible point of the spear in the water industry, but the water industrials are the shaft of that spear, and one cannot be effective without the other.

Notice that only 103 of the 359 companies in the chart above are U.S. companies:  This is truly a global industry, although it still does not seem to be perceived as such by most investors.  The over-emphasis on U.S. companies is pointed out by the statistics within the above summary:  Note that the valuation numbers for U.S. water equities are generally above, while the dividends are well below, those of the rest of the world.  We believe that these wide disparities will be removed in due course by a ‘reversion to the mean’ adjustment process that we expect to take place in international markets.

A Comparison of International Water Utility Valuations

In comparing typical water utility valuations around the world, one can see quite clearly that investors have taken U.S. water utilities to what seems to us to be an unsustainable level.  Utilities have always tended to be the bell-weather stocks for regional and country-specific water stocks and for this reason, much can be gleaned from these comparisons.

The table below compares the 1/30/06 valuation of Aqua America, Inc., the largest investor-owned water utility in the U.S., versus three water utilities based in Brazil, Spain and Britain. Many more could have been selected from around the world with similar results, but this short list gets the point across.

Aqua-America is a very well managed company with a superlative record. This is a company that has historically justified a premium market valuation. Nevertheless, we now wonder if the quality of Aqua America justifies the wide valuation disparities that are outlined below. 

If nothing else, this data should serve to remind investors that any incremental assets being deployed in the water sector would probably be better served by investing in selections chosen from international markets.