California may be thirsting for water, but water utilities in the state—and elsewhere—are an overlooked niche that investors should be eyeing for steady earnings growth and dividends that can keep pace with rising bond rates.
Water utilities have traditionally been regarded as a sleepy stock backwater, churning out dividends for widows and orphans and no more. But that's changing. Analysts say the utilities—though still regulated monopolies—are in growth mode, snapping up acquisitions, forging agreements with friendly regulators and, in some cases, moving into unregulated markets.
Drought headlines have only added to the typical misunderstanding about water utilities, making the the sector an under-bought market opportunity.
Most of the water utility stocks are down this year, but according to David Parker, a Robert W. Baird senior utility analyst, "these utilities are going into faster growth mode."
Take California Water Service Group, which serves 83 California communities. Though mandatory-use restrictions have slowed water demand, the utility is expected to pump out increased earnings for the next few years. "This company has been forgotten in the shuffle," said Michael Gaugler, a Janney Montgomery Scott senior analyst. "And the stock is cheap."
Its current price-to-earnings ratio (P/E) of roughly 18 times is among the lowest in its peer group.
Read MoreNo more nukes? Try 80 more years
"You flip on the nightly news and you see a town has run out of water, but investor-owned utilities don't have the same issues private companies do," Gaugler said, adding, "There is negative sentiment around it, but there shouldn't be."
The investor-owned utilities have been making sure to have adequate supply and water rights—in contrast to many municipal entities. "I met with the Cal Water CEO last Wednesday, and he said that a neighboring system had run out of water and they were supplying them now," Gaugler said.
When a region is in conservation mode, less water is used but regulatory mechanisms ensure that utilities still get paid—as volumes go down, the authorized rate of return is maintained. So despite dipping demand, "regulation is your friend in this circumstance," he said. "Cash flow isn't compromised."
The California utility is also favored by Matt Sheldon, co-portfolio manager of the highly rated Calvert Global Water Fund. "Decreased water consumption has created undue pressure on the stock," he said. "But there are several mechanisms in place to keep profits stable."
If there's any stock in the water utilities space that should have attracted the notice of investors, it's the Calvert fund's biggest water utility holding, American Water Works.
It's the largest water utility in the U.S. and serves customers in 30 states, though most of its business is in New Jersey and Pennsylvania, which both have attractive regulatory regimes, Sheldon said.
It's been the most impressive stock in the space, up more than 140 percent since its 2008 IPO, as well as every stock in its peer group—by 100 percent or more over five years. The stock has pulled back with the peer group this year as Federal Reserve interest-rate-hike fears have handicapped the utilities sector, but analysts believe that's provided another reason to give the stock a look.
"American and the other East Coast players are not trading where they could be on a valuation basis," Gaugler said. He said the interest-rate concerns that have hit the stocks miss one important sector dynamic: The water utilities can raise dividends to keep pace with rates, so even if the spread between their dividends and the 10-year Treasury narrows, yields can still be made attractive.
"Everyone thinks you need to get out when you really don't," Gaugler said.
California Water Service's current yield is 2.9 percent, versus 2.4 percent on the 10-year Treasury.
Baird's Parker also likes American Water Works. The utility's 6 percent to 9 percent annual earnings growth is fueled by a number of strategies, including moving into non-regulated businesses, such as military base water services. The homeowner services business is another untapped market, Parker said. "The utility is on the cutting edge of expanding supply and growing its base," he said, including getting approval for a desalination plant in California.
Ladenburg Thalmann analyst Richard Verdi said, "In 2015 the best water utility bet is American Water Works."
As beleaguered municipalities struggle to maintain their water systems—not only due to drought out West but hamstrung municipal budgets all across the country—American Water Works stands to benefit the most, analysts contend. According to Baird estimates, investor-owned utilities still only compose 16 percent of the U.S. water market, leaving lots of room for mergers.
In June, American Water Works made three acquisitions in one week alone. "Municipal water systems are poorly managed and fall apart," Verdi said.
Verdi's also favors Aqua America, which mostly operates in Pennsylvania. The company has been bagging lots of acquisitions, snapping up 16 in 2014 alone. And it also sells water used for fracking at higher, unregulated rates. "These shale plays need a ton of water," he said. Verdi expects Aqua America, which has been expanding into other states, like Texas and Illinois, to grow its earnings 11 percent annually from 2016 through 2019 after rate increases kick in.
Smaller, less liquid and less diversified utilities come with greater risk, but it's hard to ignore Consolidated Water. The stock is up 25 percent this year on investor bullishness about a contract to construct a desalination plant in Mexico, which will eventually ship 100 million gallons of water per day to San Diego.
"Earnings growth will be flat this year and next," Gaugler said, but he added, that's "because money is being plowed into plant development." And even if California's dire water woes abate, San Diego will still need more water to sate the thirst of growing populations, he said.
"The Mexico project will continue to have everyone's attention going forward. De-sal is a growth opportunity, and they are the only pure-play," Gaugler said. But he also noted that the stock's size—a $200 million market cap versus more than $9 billion for American Water Works—is a significant factor in such a strong stock move-up during a period of weak performance for the sector.
Even with P/E ratios in the space below historical norms, don't expect these stocks to have a major catch-up trade in the short term. Most can't move on one major project like the Consolidated Water de-sal plant, and Fed rate fears remain a headwind.
But these aren't quick-hit stocks, Gaugler said. "It's always been slow, steady earnings, up a little each year and dividends going up in each year."
—By Constance Gustke, special to CNBC.com