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Liquid assets

Water stocks have outpaced the broad commodity index, despite spotty research coverage and limited investment products.

Never mind oil and gold. Water is the hot commodity. . \ As the demand for infrastructure facilities to supply and purify H2O expands across developed and emerging markets, more and more investors are filling their glasses with water stocks. The category consists of utilities and contractors that deliver water; manufacturers of pipes, filters and valves; and firms that provide such services as desalinization and wastewater treatment. Goldman, Sachs & Co. estimates global water industry sales at $380 billion in 2005, up from $250 billion in 2000.

A basket of all 12 publicly traded U.S. water utilities, including Aqua America, in Bryn Mawr, Pennsylvania, and Los Angeles­based Southwest Water Co., has generated annualized returns of more than 18 percent over the five years through 2005. That basket, tracked by San Diego's Summit Global Management, which has $125 million invested in the industry, far outpaces the Commodity Research Bureau commodity index, which appreciated 7.8 percent a year, on average, in that period.

To understand water stocks' allure, begin with the basics: Water is a finite resource, and demand is exploding. Even in the U.S., $500 billion will have to be spent in the next 20 years to repair an aging water infrastructure, estimates the Environmental Protection Agency. In China, Goldman Sachs reports, $22 billion of water-related projects are slated for the next seven years.

How to use the finite resource is a subject of political debate. Last month in Mexico City protesters clashed with police at a global conference on water management. The protesters argued that the forum served corporate, not popular, interests.

Hans-Peter Portner, co-manager of Geneva-based, $1.2 billion Pictet Global Water Fund, says that many manufacturers are turning to private sources to accommodate their growing need for water. In 2004, to meet demand for pure and so-called ultrapure water, General Electric Co. acquired Watertown, Massachusetts­

based Ionics, the largest desalinization company in the U.S., for $1.1 billion plus the assumption of debt.

"This is a market that's growing at double-digit rates," Portner remarks. There aren't many of those.

Still, there are only a handful of water-focused investment products, and sell-side coverage of the industry is spotty. But that may be changing.

PowerShares Capital Management, a Wheaton, Illinois­based asset manager owned by Amvescap, recently came out with the Water Resources Portfolio, an exchange-traded fund that tracks an index of 35 water-related stocks worldwide with a combined market capitalization of $549 million and trades on the American Stock Exchange. They include North Andover, Massachusetts­based Watts Water Technologies, which makes water safety and flow control products, and Golden Valley, Minnesota­based Pentair, which manufacturers pumps and other products for water and wastewater use.

In 2001, Zurich-based Sustainable Asset Management started a global water fund that invests in a diverse group of water stocks; as of year-end 2005 it reported $320 million in assets. Over three years ended February 28, it generated annualized returns of 23.4 percent. In 2005, Lisle, Illinois­based Claymore Securities issued $223 million in three unit trusts that buy water-related stocks, providing exposure to utilities and related industrial companies.

The global water industry is also tracked by the Praetor Global Water Equities Fund, an ETF that trades on the International Securities Exchange. Designed by suburban Philadelphia­based broker-dealer Boenning & Scattergood, it launched last year. William Brennan, the firm's director of equities, runs the Luxembourg-based $40 million value fund. (He also picks stocks for two of Claymore's unit trusts.)

Brennan seeks out investments focused on water infrastructure projects because of strong underlying demand in both developed and emerging markets. One of his best picks to date has been Bio-Treat Technologies, a company based in Guangdong province, China, with a market cap of $600 million and listed on the Singapore Stock Exchange. It boasts a proprietary waste-water treatment process that has been used in many Chinese municipal projects. For the six months ended last December, Bio-Treat's revenues rose an annualized 31.4 percent, and its profits, 29.2 percent. Between May 2005, when Brennan staked his position, and early March, Bio-Treat's shares appreciated more than 90 percent. The holding represents roughly 1.6 percent of Praetor Global's portfolio.

Pictet's Global Water Fund, the largest by far, has half its holdings in water utilities, nearly one third in infrastructure and related materials, 10 percent in consulting services and another 10 percent in bottled-water suppliers.

The fund was up 33.4 percent, in euros, in the 12 months through the end of February, versus 26.1 percent for the MSCI world index. Three-year annualized returns top 24 percent, versus 18.3 percent for the benchmark. However, the fund's five-year annualized results were brought down to earth by the 2002 bear market. With utility shares especially hard hit, it lost 31.69 percent that year. Still, its five-year annualized gain of 3.07 percent beats the MSCI world index's 1.25 percent.

The fund's top holding, representing 7.7 percent of its assets, is French global water company Veolia Environnement, based in Paris. Portner regards the $20 billion conglomerate as a good proxy for the water industry, even though only two thirds of its revenues come from water-related activities. He particularly likes the company's niche: Governments hire Veolia to operate water systems.

"It keeps the company asset-light, allowing it to rapidly expand," says Portner. A core holding since the fund's January 2000 inception and purchased at an average cost of E28 ($34) per share, on average, the stock closed at E44.71 on March 14.

Portner was an early believer in Aqua America, the biggest U.S. water utility. He liked the $3.8 billion-market-cap company's aggressive acquisition strategy. With a price-to-book-value ratio of 4.5, Aqua can increase its own market value by buying utilities at or below book, he says.

Portner established his $13 million position between 2000 and 2002 at an average cost of $18 a share. In mid-March of this year, the shares traded at $27.43, at a steep trailing price-earnings ratio of 40. Although Portner isn't selling his shares, he isn't adding to his holding, either. The stock has slipped from 4.5 percent of his portfolio in 2002 to 1.2 percent.

Neil Berlant, a portfolio manager at Los Angeles­based Seidler Cos., which manages $40 million in water securities, emphasizes infrastructure plays. He's especially bullish on Pasadena, California­based pipe maker Ameron International Corp. Berlant moved into the small cap in June 2004 at $32.38, after it had been hit by disappointing earnings. Seeing a well-managed company with a healthy balance sheet, low debt and an expanding global business (fast approaching one third of revenues), he invested 5 percent of Seidler's assets in the stock.

Ameron's earnings more than doubled in 2005 from their depressed 2004 levels, helping to propel Berlant's investment up by more than 68 percent. In mid-March, Ameron was trading at $58.49.

Another company Berlant likes is Milwaukee-based Badger Meter. The portfolio manager is convinced that as the price of water rises, so too will demand for precise metering, driving stocks like Badger. The company's earnings have grown at an annualized 21 percent over the past three years. After February 2005, when Berlant established a position of 5 percent of Seidler's assets at $29.95, Seidler's stake appreciated 70 percent on expectations that 2005 earnings would come in 37 percent higher than 2004's, as they did. The shares closed in mid-March at $55.20.

Berlant's top four holdings, though, took a drubbing in 2005; his portfolio of 20 water stocks was up only 4.64 percent for the year. His biggest loser was Pittsburgh­based Calgon Carbon Corp., the world's biggest manufacturer of activated carbon for water purification. Its shares dropped 37 percent in 2005 on weak sales, disappointing earnings and the failure of a widely anticipated takeover bid to materialize. But investors took a second look, and through mid-March this year Calgon Carbon shares were up nearly 25 percent.

When Ben Walker took over management of the Gartmore Global Utilities Fund in 2003, it had no exposure to water stocks. Today they account for 7 percent of the $50 million portfolio.

Walker is keen on U.K. water stocks. "They are generally well managed, have strong cash flows and were selling at trailing P/Es of 10" when he began buying them in spring 2004, he says. He had seen an unmistakable buy signal: British water regulators had raised the water utilities' approved rate of return on capital to 8 percent. Walker notes that this is 1 to 2 percentage points higher than the rates permitted for other regulated U.K. industries, including electricity.

In April 2004, Walker invested 5 percent of his fund's assets in three British water utilities: Pennon Group, AWG and Northumbrian Water Group. As of mid-March the shares had more than doubled in value. Water utilities, Walker points out, "offer an essential service whose profitability is ensured, and they pay out dividends that average 5 percent."