The world is running out of fresh water. How to invest in the companies trying to prevent this crisis

Published Mon, Nov 7 202212:17 PM EST

Christina Cheddar Berk @in/christina-cheddar-berk-b864404/

"If you see me, weep," are the words inscribed on a boulder that was exposed as water levels receded on the Elbe River in the Czech Republic this summer. It was one of many so-called hunger stones that were carved over the years to commemorate historic drought levels. Lately these markers — and other landmarks like them — have been appearing much more regularly. As Lake Mead dried up this summer, there were grisly discoveries like human remains. Then, in the fall, barges were stranded along the Mississippi River when it hit a 30-year low. Headlines about drought have been persistent reminders of how limited this resource can be. The other side of the coin is equally as troubling. Climate change is resulting in more severe storms that can be accompanied by flooding, which can contaminate water supplies. Residents of Jackson, Mississippi found this out. It took more than two months for the Environmental Protection Agency to deem the city's water safe to drink after its local utilities were inundated by back-to-back storms. Even more dramatic was the flooding that submerged nearly a third of Pakistan in August, killing more than 1,700 people and displacing 33 million . Water is essential to life, and as these events show, there is a need to keep supplies safe and available. A growing number of companies are working on solutions. The trend can provide opportunities for investors as stresses on water systems around the world grow more acute in the coming years and boost demand for these services. Still, investing in the space requires some care, according to Deane Dray, an analyst at RBC Capital Markets, who emphasized that not all water stocks are equal. "There's this element of frustration," Dray said. "There are not that many ways to invest in the water sector. The reality is there is a scarcity of investable assets. And they tend to be very expensive because there is such demand for them." Investors who want to support this megatrend are providing some of the demand, according to Dray. This includes dedicated water funds or broader ESG funds that back companies that fit environmental, social and governance criteria, he said. Dray's preference is to pick stocks in the sector that provide specialized technology, which can mean faster growth and higher margins. Many operate in areas like filtration and desalination, testing and analytics or smart water networks that can help use water more efficiently. A huge need for fresh water The United Nations Framework Convention on Climate Change estimates that some 2.3 billion people live in water-stressed conditions . At least once a month, it said, about 4 billion people experience inadequate water supplies, and this number is expected to rise to 5 billion by 2050. While more than 70% of the planet is covered by water, the vast majority is in the ocean, which means only about 1% is fit for human use. The critical need for water in arid regions like the Middle East or countries like Bahamas, Maldives and Malta, has prompted a reliance on the extremely energy intensive desalination process . Saudi Arabia gets about half of its drinking water this way. On top of the expense, the process can be harmful to the environment. "For every litre of potable water produced through desalination, around 1.5 litres of liquid polluted with chlorine and copper is generated, which is twice as saline as ocean water and is very harmful to marine life," said HSBC Global Research analysts in a report published in September. While governments and companies will weigh the alternatives, desalination will likely continue to be an option as large populations are concentrated on coastlines, with access to abundant saltwater. A number of companies leading the push to make desalination work are private, Dray said. However, he cited Energy Recovery as one example of a public company in the space. It makes pumping systems and turbochargers that are used in seawater reverse osmosis. As its name suggests, Energy Recovery tries to recapture the hydraulic energy from the high-pressure pumps used in desalination in order to drive down its cost. Better membranes also will be key. These semi-permeable barriers are used to separate the molecules in the water. The idea is to sort out the salts, minerals and other impurities. DuPont is among the companies working on this. Beyond desalination is reusing wastewater. The United Nations estimates that 380 billion cubic meters of water can be recovered annually from wastewater and it predicts that figure could rise to 574 billion cubic meters by 2050. Treated wastewater can be used for drinking water or funneled for industrial or agricultural uses. "In the U.S. people immediately say, 'Oh, from the toilet to tap? That's disgusting. Don't ever even think of that.' But the folks in Singapore, by necessity have started to," Dray said. A pure-play advantage In order to make the shift, people will need "extra faith and confidence" in water treatment and testing, he said. He cited Danaher as an example of a company that is well-positioned in this area. However, it is expecting to spin off this division, known as EAS , by the fourth quarter of 2023. The environmental and applied solutions segment generated about $4.7 billion in revenue last year, and about 55% of that is recurring. Sales are expected to grow at a mid-single digit pace over the long-term "As a stand-alone, EAS should have the scale and ability to make more meaningful organic and inorganic investments, supported by their strong M & A pipeline," wrote Stifel analyst Daniel Arias, in a research note, published after the spinoff was announced in mid-September. Once the unit is spun off, it will be nearly a pure-play water stock, which may make it more attractive for water-focused funds. Still, some of these water-centric funds have already found ways to diversify their holdings. Take the Calvert Global Water fund. It concentrates its holdings among companies that operate in the water industry or supply water-related services and technologies. However, it is able to diversify by investing in big users of water, such as semiconductor or apparel companies, as long as these firms are driving efforts to be more efficient users of water. It also invests in water solutions companies like Danaher even if the share of their revenue from water-related businesses is below the 30% threshold the fund typically requires. "If you're going to address global water challenges, you can't really ignore these really water-intensive areas," said Jade Huang, managing director of applied responsible investment solutions at Calvert Research and Management. "Let's invest in the ones that are really driving the industry to improve them." Calvert's class A fund has fallen about 23% this year, according to FactSet. Water metering also is important for conservation efforts, and companies in this space include Xylem , Badger Meter and Roper . Xylem shares are trading higher than the stock's average price target on Wall Street, according to FactSet. Dray considers it one of his top picks. As a pure-play water company, he expects it to take advantage of several industry trends. One advantage for Xylem is that it half of its business is tied to the steady demand from municipal utilities. This can be a real benefit in periods of economic uncertainty. In recent quarters, semiconductor shortages have weighed on the company's ability to deliver products, but it has not suffered from cancellations. Stifel analyst Nathan Jones said, "In our view the setup for Xylem over the next few quarters is very strong with a large, low risk backlog, relatively defensive markets, and normalizing price/cost, which has flipped from a headwind to a tailwind for margins." Last week, he reiterated his buy rating on the stock. Jones expects these conditions to continue for at least a few quarters. Then, improving chip supply could add fuel to its outlook for 2023 to 2024, he said. Stifel has a $113 price target for Xylem, which closed Friday at $107.21. In the water quality space, Evoqua Water Technologies is a name RBC likes. The company has been shifting away from capital equipment sales to providing outsourced water services. In this arrangement, Evoqua provides water treatment services for its customers for a set fee. This business has been highly profitable for Evoqua, Dray said, in research note. The company also has attracted attention for its ability to clean up PFAS, a so-called forever chemical. Although this service is a small piece of its overall business, Dray expects the PFAS remediation to become a long-term driver of its earnings over the next five-plus years, and it's not currently factored into the company's long-term 3% to 5% sales growth target. Huang said water quality will continue to be a driving force in the sector because the ability to use technology to clean water will help ease the scarcity issue. "That's very much connected to water scarcity," she said. " ... You can have a ton of water, if the quality is not good enough to use, it's not helpful." —CNBC's Michael Bloom contributed to this report.