Make money from the global water shortage

"Blue Marble." That's the title of Nasa's latest series of Earth images, taken from 435 miles above the planet's surface. The same name was used in 1972 for images taken by the Apollo 17 astronauts. You can see why: the Earth's surface is 70% water. So an alien looking down on us from space might be surprised to learn that we face a crisis of "truly biblical proportions", according to Richard Karn in the latest Emerging Trends Report. But that in turn creates lots of opportunity for companies who can help avert this crisis and for those who invest in them.

The wrong type of water

The problem isn't that the planet is short of water. It's that only around 2% is fresh and most of this is locked away in the polar ice caps and glaciers. Yet the world's population is growing fast. And more and more of our clean water is being contaminated by industrialisation especially in developing markets or being lost due to leaky infrastructure. And fixing our water woes will "require time, concerted effort and an inconceivable amount of money", says Karn. Not only is clean water scarce, but it's also awkward and expensive to efficiently relocate to where it's needed most. It evaporates and freezes over a small temperature range (in chemical terms) and is relatively heavy. Being a liquid, it is also tricky to move or store.That hasn't stopped the odd small country, such as Cyprus, ordering from abroad. And the Syrians have tried to move water on water in sea-borne giant balloons. But once larger countries get thirsty, you have a much bigger problem that can't be solved so fast. Some are taking the direct approach buying other people's water (see below). This is fraught with political and investing risk and could even one day trigger water wars. Elsewhere, government stimulus packages have helped accelerate efforts either to save more water or create more via desalination. This is where you can find some of the best investing opportunities.

Desalination

"Look, it's us or the organisms" is how Carlsbad mayor Claude Lewis answers critics of desalination. As he notes, "water is going to be very short until you have a new source". As things stand, "the only new source is desalination". That's an important distinction that separates desalination from every other proposed answer to water shortages. It is the only one not focused on cutting water use, or improving the efficiency with which it is moved, but rather on producing more of the stuff. As such, critics who cite valid environmental concerns such as that it currently uses more energy than it saves, and that the process releases toxic brine into the world's oceans know they are fighting a losing battle.

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Desalination isn't about to get legislated away, not even in the eco-friendliest parts of America. This year California will open the largest desalination plant in the Western hemisphere, capable of turning some 50 million gallons of seawater a day into something thirsty sunshine-coasters can drink.

America is far from alone in wanting to get the desalination process going. According to Global Water Intelligence, capacity has grown by 17% a year since 1990, with an average of 800 new plants being completed a year somewhere in the world between 2004 and 2009. The technology most of which involves filtering salt water through osmosis is pretty expensive. So it's no surprise that some of the biggest projects are to be found in wealthy US states, such as California, or Middle Eastern countries such as Saudi Arabia. The Saudis even plan to have a solar-powered plant up and running by 2013.

In Australia which has been battling unpredictable weather patterns and harvests for years a tender to build the country's biggest desalination plant was awarded to Aquasure, a venture comprising French firm Suez, Australian utility company Thiess, and Macquarie Capital. Once operational, the plant will supply 150 billion litres of water to Melbourne each year. At a cost of $3.5bn, it will be the biggest public-private partnership deal in Australian history, says the BBC's James Melik.

Despite the expense the consortium's Chris Herbert acknowledges that desalination costs two to three times more than an alternative, such as a dam and reticulation system the aim is to try and alleviate the drastic water shortages created by ten years of drought in Victoria State. And not before time. According to Tony Kelly at Yarra Valley Water, due to recent water shortages, "there was a stage when a farmer was committing suicide every day".

Now, the developing world increasingly wants the technology too. Take India. As a recent World Bank report notes, the country is "the largest user of groundwater in the world". This means that its underground aquifers "are being depleted at an alarming rate". So fast, in fact, that by 2025 demand is expected to equal all available supply. So Spanish group Abengoa SA expects to start work on what will be India's largest desalination plant in the second quarter of this year. The $124m project should create the capacity to remove salt from 100,000 cubic metres of water a day, according to BusinessWeek's Natalie Obiko Pearson. Dollars invested on that scale go a long way in India the plant could supply the water needs of up to half a million people.

Firms are constantly trying to improve the conversion rate. The Pacific Institute has calculated that an average of 100 billion gallons of salty water is needed to create just 50 billion gallons of desalinated water. They're also striving to cut the environmental impact of the brine by-product.

Desalination plays

One indirect play on this area is MoneyWeek favourite Amiad Filtration (LSE: AFS), an acquisitive industrial engineer and global supplier of low-maintenance, self-cleaning filtration and irrigation systems. After a decent recent run the share price has ticked up around 18% in the last six months the forward p/e ratio is still a modest 9.4 and the price/earnings growth (PEG) ratio just 0.8. The firm's forecast dividend yield is 2%, with expected cover of just under five times. Hold it if you've got it, buy it if you don't.

But it's time to take profits on another of our past picks, Hyflux (Singapore: HYF). There's nothing wrong with the company, indeed quite the reverse CEO Olivia Lum is one of the region's most respected business people. She runs what Chew Xiang in The Business Times calls a "high-tech, highly productive" desalination and water-treatment company. Among other accolades, it has a $636m contract to build the world's largest desalination plant. As Xiang asks, "are there no boxes it doesn't tick"?

Well, yes China. Having just reported yet more record profits based substantially on building plants there, its new orders book is down. "China, the former cash cow, seems to be suckled dry," notes Xiang. In 2009, revenue from China halved. Construction projects are getting harder to agree. With headline-grabbing big wins slowing, aggressive growth targets will be missed unless the company starts taking big risks on price to win deals.

In short, Hyflux may be moving from rising star status to that of a utility with low margins and, "given its emerging-markets customer base, subject to all sorts of risks". After a great ride, it's time to take profits for now. But keep an eye on it Lum has big plans for African and Middle Eastern expansion.

For a brighter, albeit far riskier play, there's Modern Water (LSE: MWG). Since my colleague David Stevenson tipped it in August, the share price of this £44m market-cap firm has risen steadily. The company owns a range of water technologies, including a cutting-edge desalination filter that cuts the energy cost of the process and results in fewer hazardous chemical byproducts. Not for the faint-hearted, but a potentially rewarding long-term bet it could even be a Hyflux of the future, given time.

Finally, for income-seekers, there's another indirect play. Australian Aquasure consortium member and French utility giant Suez Environnement (Euronext: SEV) offers a respectable forecast yield of 3.9%. The shares trade on a forecast p/e of 18 for 2010. Dividend cover is low at 1.2 times, but this is offset by relatively strong cash flow.

Fixing the pipes

A typical Briton flushes eight litres of water down the sink cleaning their teeth. Flush the loo and you have just sent more water down the pan than many Africans have access to during an entire day. But water used domestically and even industrially can be easily recycled as long as it isn't lost first. And that means it needs to be carried in pipes that do what pipes are supposed to do: hold water. It's a pity, then, that many in America and other Western countries don't.

"Many industrialised countries' infrastructure appears to be living on borrowed time," says Karn. European cities lose "up to 30% of the water in antiquated systems" to leaks and bursts. In America, home to "the fastest-growing population of any industrialised country", there are around 237,000 water main breaks each year. This is not an easy or cheap problem to fix, given that the US is home to more than 700,000 miles of water pipes, many of which are "more than 100 years old" and may be "amalgamations of various pipes from various systems cobbled together to 'make do'". The American Water Works Association estimates the cost of fixing such a bodged system may be as high as $6,900 per head in some rural areas.

One company at the heart of helping firms sort out these issues is Northwest Pipes (Nasdaq: NWPX). It makes large diameter, high-pressure steel pipes and smaller diameter welded pipes for a variety of applications. The trouble is that, on a forward p/e of 58, it's pretty pricey.

A cheaper, albeit less directly water-related bet, is Halma (LSE: HLMA). The firm develops a range of safety devices and monitors, including infrastructure sensors that detect leaks in failing water and sanitation pipes. It offers a dividend yield of 3.2%, covered twice, and trades on a 2010 p/e of around 16. The order flow is currently strong and cost cutting is now boosting margins.

Buy a fund

For investors nervous about individual water plays, funds can be a good way to spread your risk. Investing in water is still relatively specialist, however, so the choice of funds with sensible management fees is still fairly limited.

There are two exchange-traded funds (ETFs) worth a look. The first is the Powershares Water Resources Portfolio (NYSE: PHO). It aims to invest in around 30 US-listed water stocks with no single one allowed to comprise more than about 5% of the overall portfolio.

A slightly more diversified fund is the Claymore S&P Global Water Index ETF (NYSE: CGW). This aims to track the performance of a range of international water stocks, with a bias towards the American market. It is up by just over 30% so far this year. Both funds have an expense ratio of 0.6% a year.

Fancy a riskier, but potentially more lucrative, water play? Try the Ecofin Power & Water Opportunities Investment Trust (LSE: ECWO). This trust invests in a relatively small number of firms, ranging from a Belgian windpower turbine manufacturer to an American utility company.

But buyers should note, says the Financial Times's David Stevenson, that it is an "unorthodox, highly geared, actively managed fund". It's certainly pretty volatile, as the chart shows (above). And we would steer clear of its zero-coupon preference shares in favour of its ordinary shares. Despite an 8% pick-up in its net asset value over the last 12 months, these still trade at a 22% discount. If that gap between its market capitalisation and its investments closes, investors happy to accept a bumpy ride will get an extra kicker.

The great water grab

"Everyone Saudis, Turks, Chinese, Egyptians is looking." So Tegenu Morku, an Ethiopian land agent, tells The Guardian. He's describing what has become known as the African land rush, or what UN Secretary-General Ban Ki-moon calls "the new 21st-century colonisation". What's behind this land grab? Water. Buy land that is fertile and you acquire its associated water rights too plus a healthy return. "Farmland in sub-Saharan Africa is giving 25% returns a year and new technology can treble yields in short time frames," says Susan Payne, chief executive of Emergent Asset Management.

It's no surprise, then, that "nowhere is out of bounds", as The Guardian's John Vidal puts it. And it's also no surprise that few countries are passing up the chance to work a farm in Africa. At Awassa in Ethiopia, millions of tomatoes, peppers and other vegetables are grown in computer-controlled rows in "Ethiopia's largest greenhouse", built by Spanish engineers and Dutch technologists. As for the food itself that ends up 1,000 miles away in the restaurants of Dubai and Jeddah. The Awassa greenhouse is built on land leased to Saudi businessman Sheikh Mohammed al-Amoudi, one of the world's 50 richest businessmen, for 99 years. He plans to develop 500,000 hectares and argues that he will one day employ 10,000 local people.

Ethiopia, notes Vidal, is just one of at least 20 African countries that have seen similar land grabs. Indeed, The Observer estimates that an area more than twice the size of Britain has already been snaffled up, leading to "evictions and civil unrest".

In countries such as Ethiopia, if land can't be bought outright, it is simply leased instead at around $1 per year per hectare. The Saudi government alone is said to have ear-marked $5bn to provide loans at cheap rates to firms that want to invest in countries with "strong agricultural potential". Meanwhile, China has signed a contract with DR Congo to grow 2.8 million hectares of palm oil for biofuels. Only the eruption of riots recently stopped South Korean firm Daewoo buying half of Madagascar's arable land. India wants hundreds of thousands of acres too, searching everywhere from war-torn Sudan to Mozambique. In short, "nowhere is out of bounds".

The ethics of this quasi-colonisation are debatable, but one thing's for sure the process won't stop anytime soon. Growing populations in cash-rich nations, supply crises in many countries, and even the threat of food shortages and riots when domestic demand isn't satisfied will see to that.

For investors, all of this points to a strong long-term future for soft commodities (agriculture is a big water user). However, we'd be wary of piling in to the cheapest and closest thing to a direct play on soft commodity prices agricultural exchange-traded funds.

That's because, as Bedlam Asset Management notes, two worrying trends may be about to collide. The first threat is that Chinese commodity demand may falter as government stimulus programmes are ended. The second and more important, though, is the vast number of "exotic" leveraged (or similar) commodity ETFs that now exist. Together, this means the scene is set for "an avalanche" that could lead to short-term sharp corrections in everything from live hogs to cocoa, as investors pull their money out of these markets.

Our preference when it comes to agriculture is to invest in the companies involved in making farming more productive and efficient over the long-term (see Grow your profits on a farm for specific stocks). The same goes for water usage, which is why we think desalination and infrastructure improvements are the best way to invest in this theme, as we discuss above.

This article was originally published in MoneyWeek magazine issue number 477 on 12 March 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.