Profit from the global water shortage

Remote, cold, entirely uninhabitable in places: the Tibetan Plateau wasn't seen as a particularly important place in geopolitics at least not until the Chinese seized control in 1950. More than 60 years on, people still disagree about the reasons behind China's actions, but one thing has become clear: why Tibet is so strategically important.

The country's glaciers are the largest store of freshwater on the planet outside of the polar regions. They are the source of water for rivers that serve almost half of the global population, according to the United Nations. So with population growth, urbanisation and pollution placing huge pressure on water supplies across the region, China's possession of Asia's Water Tower' now seems a shrewd strategic move.

It also puts Tibet firmly back on the geopolitical agenda. For example, when China recently announced plans to build another dam on its side of the Tibetan border, Indian prime minister Manmohan Singh issued a terse complaint to Chinese officials. Half of India's river water flows down from China, and more dams will give the Chinese more control over that vital supply.

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These high-level spats show just how serious concerns over future water supplies are becoming in the area. And the race to find a solution will bring great opportunities for investors.

Soaring demand for water

Parts of India and China have among the worst water supplies on earth. The most obvious reason for this is population growth. In the last 20 years alone, India's population has grown by 350 million people, while China has added 210 million. More people means more demand for drinking water, of course. But the real drain on supplies is growing demand for food.

This varies from country to country. One of the few silver linings around Britain's soggy climate is that farmers don't need to add much water to what pours out of the skies agriculture takes up just 3% of all water withdrawals in Britain.

But elsewhere the figure is much higher, with agriculture accounting for 70% of the world's total water withdrawals, and even more in hot countries such as India, where agriculture accounts for almost 90% of all water withdrawals.

The movement of more and more people to the cities has also increased pressure on water supplies. Both India and China have seen a massive shift of country dwellers to newly expanding mega cities', a move that has been repeated in other parts of the developing world.

In 2008, for the first time, more of the earth's people lived in cities and towns than in the countryside. The trend is set to continue, according to consultants McKinsey between 2005 and 2050, the urban population of China is set to have grown by 400 million, while India's will expand by 215 million.

The relatively sophisticated lifestyles of city dwellers mean they use up much more water than their country cousins. As cities continue to grow and become more wealthy, says McKinsey, changing diets and greater usage of water for sanitation will cause demand for water to rocket, from around 190 billion cubic metres (bcm) per year to 270bcm. More than half of this extra demand will come from south and east Asia.

Terrible mismanagement of existing water resources has only made the situation worse. In India and China (and in America too), farmers have grown water-intensive cash crops in arid lands that could never normally support them. They do this by digging boreholes to tap the water stored deep down in underground aquifers.

This seems painless at first. But once everyone starts doing it, you run the risk of depleting the aquifers, which take millions of years to fill. In India, the government has no idea how many boreholes there are, although some put the figure at 20 million. Existing boreholes in the areas surrounding Beijing no longer reach the shrinking water table, showing just how depleted the aquifers are becoming.

Of course, all water is part of the water cycle. As any secondary school geography pupil will tell you, this water isn't lost in the absolute sense it just moves onto the next stage of the cycle. Most of the water that farmers use for irrigation in hot countries will escape through evapotranspiration'.

But the trouble for farmers using boreholes in arid parts of India and China is that the water, which took so long to accumulate underground, won't be replenished anytime soon.

Mismanagement and poor infrastructure is also affecting the water that's left. Poorly conceived dams have slowed river flows and allowed silt to build up, which further restricts flow. Indeed, for much of the 1990s, silt stopped China's Yellow River from reaching the sea. The Indus River in Pakistan and the Ganges in India have had similar problems.

Another mistake has been the unrestricted dumping of pollutants in many Chinese and Indian rivers. In many places the water is too toxic to touch, never mind drink or use for farming. Other pollutants, such as human waste, also add to the problems.

All of this is too much for poor, or nonexistent, treatment facilities to cope with. In effect, this further cuts the supply of useful water, creating even more pressure on the clean water that's left.

The threat to water is global

While south and east Asia has some of the worst problems partly as a result of its rapid growth and poor-quality existing infrastructure the water crisis is a global one.

In America, a drought in the southwest has led to a sharp rise in the number of court cases as land users try to assert their legal rights to dwindling supplies. Meanwhile, in South America the melting of Andean glaciers is disrupting water supplies. In the short-term the melting increases flood risk but in the longer term, experts at the World Bank expect it to lead to drought.

Another sign of global water problems is the number of once-great rivers that now struggle to reach the sea. America's Rio Grande and Colorado rivers, Australia's Murray Darling, Central Asia's Amu Darya and Syr Darya rivers and the Nile in Egypt, have all fallen short of the sea in recent years. Even temperate countries such as Britain have stressed water zones. For example, during last year's drought, the southeast of England received less rainfall per person than Libya and Sudan.

So the situation is serious. The good news (in as much as there is good news) is that this falling level of freshwater per person is a problem governments and companies simply can't ignore. Flooding or drought are the prime causes of most food emergencies, notes the United Nation's Food and Agriculture Organization. That makes water a political issue hungry citizens tend to be angry citizens.

From the French Revolution to the Arab Spring, history shows that governments who can't safeguard the food supply have a short shelf life.

Water is also essential for continued growth. Water is a crucial part of most industrial processes. For now, industry accounts for less than 10% of India's water usage, but that demand is growing HSBC estimates it could rise by 57% by 2025. And it's bringing the demands of industry into conflict with the agricultural lobby.

"Disputes with farmers demanding rights to their irrigated land have stalled about $80bn of investment by companies" in recent years, notes Bloomberg's Archana Chaudhary.

Energy is another issue. Other than wind power, most forms of energy need serious amounts of water: for cooling towers in nuclear reactors, for cleaning solar panels, and for refining oil. It's the same for everyone's favourite fuel of the future shale gas. This is extracted from the rocks by forcing vast quantities of water and chemicals down into the earth. With global energy use set to rise by about a third between now and 2035, this will only heap further pressure on water supplies.

What is to be done?

One way to get around these problems is to move water from wet to dry areas. Thanks to its ownership of Tibet, China is officially a water-rich country. But that is very misleading, because most of its water is in the wrong' place. Broadly speaking, the west and south of China have abundant water supplies, but the more densely populated north and east face severe shortages.

In an audacious bid to solve the problem, the country is halfway through a $65bn project to divert the south's water to the north. The first stage of the project is almost complete. When all four channels are finished, it is estimated that the project will send 45 cubic kilometres of water a year. That's 0.01% of the world's entire freshwater supply.

However, in many countries, the real challenge is to move the water through time, not space. "Too many people focus on transferring water from one area to another," says Michael Norton, head of the Institution of Civil Engineers' water panels.

Taking England as an example, he notes that: "Really, there is enough winter rainfall in dry' areas. We just need to get better at transferring water from winter to summer." That means building more reservoirs to store the water, but also remodelling urban environments so that they channel water to underground aquifers.

The other option is to get more out of the existing water supplies in any one place. This can range from fixing leaky pipes (so less is lost in transit) to improving water treatment so that dirty water can be more easily reused. Obviously, the need for this is greatest in the world's bulging cities, where the water supply is undermost pressure. But this will take a lot of money.

McKinsey estimates that "building or expanding the municipal water-supply infrastructure will require cumulative investment of about $480bn by 2025, including investment to increase supply and to expand the distribution and treatment of wastewater".

The last resort is to make' more fresh water. The most common way to do this is to convert seawater using desalination. It's an expensive, energy-intensive process that either involves boiling and distilling water, or removing the salt by forcing it through membrane filters.

Traditionally, the process was so expensive that only rich people in hot places typically cruise liners or Arabian Gulf states would use it. However, as water shortages spread, so does the technology.

Thames Water now has a desalination plant. As more plants are being built, more money is being invested in improving the technology. We look at the best ways to invest in these, and other water-related areas, below.

The stocks to buy into now

Perhaps the most obvious way to invest in water would be to go for a utility. However, we're not so keen on water utilities at the moment. In the developed world, unemployment is unusually high in many areas, while wages are also lagging inflation, so governments are under pressure to ease the pain on their suffering populations by tightly regulating utilities' profits.

And if water really was to jump to a price that perhaps more realistically reflected its value, it would come as a massive and almost certainly politically unacceptable shock to consumers.

So we prefer to invest in the companies that make the gadgets or infrastructure that keeps the clean water coming. The good news is that the annual global market for water infrastructure is worth $500bn already and is growing at 7% per year. That means there are a lot of opportunities in the sector.

One of our favourites is US-based pumps and filters maker Pentair (NYSE: PNR). Since we first tipped it in August 2011, the stock is up almost 70%, while its sales and global reach have been boosted by a merger with an American pipes and valves producer, Tyco Flow.

But despite the massive rise in the price, which leaves it on a forward price-to-earnings (p/e) ratio of 15.9, we still like the stock. It gives great exposure to the international water story: thanks to the merger, 20% of its group sales now come from Asia Pacific, up from 10% last year.

Moreover, as the merger is digested, it should continue to add to profits. Simon Gottelier of Impax Asset Management believes the merger should deliver around $250m in cost savings. Given this, the stock still looks good value.

One Chinese firm that's done very well out of the country's water problems in recent years is China Everbright International (NYSE: CHFFF). The firm builds and operates wastewater treatment plants on the Chinese mainland and runs waste-to-energy plants.

Everbright was spun out of a state-owned enterprise and, perhaps unsurprisingly, has a good track record in picking up government contracts. In a sum of the parts valuation, which looks at what each division is worth to the business, analysts at JP Morgan estimate that wastewater operations account for 32% of the firm's value, with the rest coming from associated businesses, such as waste-to-energy. So it's not a pure play' on the water theme.

However, management has highlighted wastewater as a key area to focus on, and sales in the area have grown by almost 60% in the last year alone.

The firm operates treatment plants in Lake Tai, a massive freshwater lake near China's industrial east coast, where a high-profile pollution scandal has increased pressure and funding for treatment operations. Everbright also has treatment plants in Bohai Bay, which is also on the east coast.

At present the company's 18 plants process 1.8 million cubic metres per day, ranking it in the country's top 20 wastewater treatment providers, while it is building four more plants to boost capacity. On a p/e of 18.7, it's not cheap, but JP Morgan is optimistic, noting that "additional projects are likely to be awarded".

In the long run, especially as water becomes more scarce, consumers are going to have to start paying the true price for water and using it more efficiently. And the first, essential, step in this process is knowing how much water has been used.

Itron (NYSE: ITRI) makes automated meters for water, gas and electricity utilities. Its devices can help water firms find leaks, fix inefficiencies in the system, know how much each customer is using and manage water distribution more efficiently. With 21% of the global market of utility-level water meters, Itron is the leading global player in the field.

More than half of its sales come from outside America. With its water business growing at 14% each year, many believe that the company could eventually be snapped up by a larger industrial group, such as General Electric. On a forward p/e of 12, it looks cheaper than many of its peers.

If you want to gain exposure to all these different types of water companies, the cheapest way to do so is through an exchange-traded fund (ETF). Our favourite is the Claymore S&P Global Water Index Fund (NYSE: CGW). It tracks the S&P Global Water Index and has a total expense ratio of 0.65%.