Week 153 - Water Utilities

Situation: You know that water is the major component of food, and essential to life. But it is also a main ingredient for a lengthening list of modern-day wonders such as hydraulic fracturing (“fracking”), server farms, and extracting oil from tar sands. The price for a liter of water is rising faster than the price for a gallon of gasoline. Cities in the southwest US, where a drought is entering its 5th decade, struggle to provide enough drinking water to growing numbers of residents. Wichita Falls, Texas, has resorted to recycling toilet water; San Diego, CA, has resorted to recycling sea water. Water utilities produce an essential good that inflates faster than the Consumer Price Index. Other sub-industries sharing that distinction are food processing (see Week 152) and healthcare (see next week’s blog).

Farmers in the US have managed to sidestep the crisis by digging ever deeper wells and more of them to supply water to center-pivot irrigation systems. Those meter out groundwater to rotating sprinklers, which cuts water usage 40% compared to “flood irrigation” based on canals. But aquifers are being depleted, especially in Texas and California where farm production is in long-term decline.

For this week’s Table, we examine water utilities among the Dividend Achievers. Those utilities have increased dividends annually for the past 10 or more years but there are only 4 that make our list. So, we have had to cast a wider net--looking for future Dividend Achievers--and found a winner. American Water Works (AWK) has increased its dividend annually since the stock was listed in August of 2008. Along with Aqua America (WTR), AWK supplies water for “fracking” the Marcellus Shale, which extends from West Virginia up through Pennsylvania and eastern Ohio to southern New York State. For both companies, that is the fastest-growing part of their business.

Bottom Line: You’ll want to think hard about investing in a water utility. Why? Because the stock will hold its value during a recession but also reflect earnings outperformance during an expansion.

Risk Rating: 3.

Full Disclosure: I have stock in AWK.


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Week 152 - Food Processors in the S&P 500 Index

Situation: How many people think that they know a way to beat the S&P 500 Index? We keep saying that it can’t be done, not even over as few as two market cycles. If you are one of the ones who have made it a goal to beat the S&P, why not aim for the consolation prize? Namely, take Warren Buffett’s advice and invest in the lowest-cost S&P 500 Index fund from Vanguard (VFINX). The next best choice after this would be to invest in food processors. Yes, I know. We’ve said that before, too.

The S&P 500 Index has 19 such companies (see Table). Those companies typically outperform the S&P 500 Index but are also valued 10% higher than the Index (see Column J in the Table). That is acceptable because food prices have been growing more than 10% faster than inflation for a long time, and the gap is growing: Over the next two years, the US Department of Agriculture expects food prices to increase 3-4%/yr while overall inflation is increasing ~2%/yr.

Bottom Line: “Concentrated” stock portfolios are never a good idea, but food processing companies are the exception that proves the rule, right now and forever. How can that be? Well, food and water are the most essential goods (we'll talk about water next week). So, its no surprise that food processing companies continue to grow earnings even during a recession (see Column D in the Table). Go ahead and overweight those companies in your portfolio. What does “overweight” mean? Food processing companies are in the Consumer Staples industry, which has a 12% weighting in the S&P 500 Index. Be aware that "Consumer Staples" include companies that produce housewares, diapers, and personal care items (Procter & Gamble, Colgate-Palmolive, Clorox, and Kimberly-Clark) as well as superstores (Wal-Mart, Costco, and Target). So, we’re suggesting that you invest up to 10% of your stock portfolio in food processing companies. Start by researching those that are Dividend Achievers (see Week 122) with S&P credit ratings of “A-” or higher, then favor those with low volatility (Column I in the Table) and high Finance Value (Column E in the Table). As of this writing (5/6/14), Hormel Foods (HRL), McCormick (MKC), Coca-Cola (KO), and PepsiCo (PEP) meet those 4 criteria. 

Risk Rating: 3.

Full Disclosure: I dollar-average into KO, and also own shares of HRL, GIS, MKC, and PEP.

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Week 129 - Crop irrigation equipment

Situation: The “Green Revolution” of the 1970s grew out of innovations in farm equipment, augmented by improvements in tillage techniques, fertilizers, insecticides, herbicides, and seeds (see Week 124). Possibly the most important innovation came soon afterward, when groundwater irrigation (from wells) began to replace surface water irrigation (from canals). That transition grew from the innovation of “center-pivot” sprinklers in the 1950s and 60s. Those sprinklers can water 136 acres (of the 160 acres in a quarter section of land) in a single rotation around the center pivot. That cuts the water requirement for growing corn by over 40%. Now another innovation is gaining acceptance, and that is buried drip irrigation systems which selectively irrigate the root zone and cut water requirements by another 40%.

At present, there are a billion acres of irrigated land worldwide. Nine million of those acres are in Nebraska, which is arguably the most productive region for agriculture on the planet. Nearly 8.5 million of those 9 million acres are irrigated by groundwater pumped to center pivots. This doubles productivity in a state that gets only 22 inches of rain a year. Dryland farming depends on rainfall and rainfall of less than 20 inches produces only 110 to 140 bushels of corn per acre, whereas, the yield with center-pivot irrigation is roughly doubled. 

Historically, dams have been the most important piece of irrigation equipment. The technology of storing water during the rainy season, for use during the dry season when crops are maturing, has until recently been the only way farmers could “ride out” a multi-year drought. Dams also protect fields and towns from flooding, recharge the aquifer, and provide recreation opportunities that bring in tourist dollars. The unfortunate aspect of the Green Revolution is that farmland has increased 10-fold in value, making it too expensive to buy up and flood with a new dam. (Eminent Domain cannot be used to seize land for the apparent purpose of enriching farmers.) Here in the US, the Army Corps of Engineers worked in the 1970s and 80s to map out all the best locations for placing dams but few have been built. That forces greater use of groundwater wells but also removes the best way to recharge the aquifers that support those wells, which is the reservoir behind a dam--combined with drainage canals that divert excess water (produced by floods) into holding basins. For further information on crop irrigation strategies visit the University of Nebraska at Lincoln website (http://water.unl.edu/web/cropswater/).

As an investor, we think you’ll want to know which listed companies provide irrigation equipment. There are two companies that make center-pivot sprinkler systems, Valmont Industries (VMI), which holds the original patent, and Lindsay Corporation (LNN). You’ll also want to know which listed companies make and install subsurface drip irrigation (SDI) systems. Again, there are two: John Deere (DE) and Toro (TTC). For groundwater irrigation systems, you’ll want to know which companies make the pumps and plumbing that bring well water to the surface and distribute it. Here there are 3 leaders: Xylem (XYL), a company that only recently started issuing stock, Flowserve (FLS), and Marmon Water, a subsidiary of Berkshire Hathaway (BRK-A). Diesel and propane powered generators supply power to groundwater pumps; Cummins (CMI) and Caterpillar (CAT) are the most prominent suppliers. 

The future of irrigation will be driven by data collected on crop moisture levels when tractors make a pass through a field. Trimble Navigation (TRMB) has software that uses satellite weather information to produce virtual data on rainfall at any GPS location specified by the farmer. Modern tractors have global positioning systems (GPS) that link to an onboard computer containing data from previous passes through the field. Software packages take over the chores of seeding the field, deciding how much and what kind of fertilizer to place where, and doing the same for insecticides, herbicides, and fungicides. In a new program called Field360, the data collected on John Deere (DE) tractors will be wirelessly downloaded to a local DuPont Pioneer (DD) field office for analysis. Information on crop moisture levels in different parts of the field will be made available to the farmer to use in programming sprinkler (or drip) irrigation systems. A similar system is being rolled out by Monsanto (MON) and another is available through Raven Industries (RAVN) that links to AGCO tractors. 

For this week’s Table, we have populated our basic spreadsheet with data for the companies cited above; total returns are impressive. There is, however, a problem for investors: the spreadsheet looks like it has the measles because red highlights are everywhere. Those indicate substandard performance vs. our benchmark (the bond-hedged S&P 500 Index - VBINX). This means that while the potential rewards from investing in irrigation equipment are high the risk is even higher. 

Bottom Line: Modern farming is increasingly about automation, and programmed with the help of GPS. This system is gradually reducing the overuse or underuse of inputs like fertilizer, insecticides, herbicides, fungicides, and now water. That automation is based in tractors and combines, standard pieces of farm equipment for generations, that now cost several hundred thousand dollars apiece. For example, at a cost of less than a thousand dollars a year that information can be transferred wirelessly in real time from Deere (DE) tractors to a DuPont Pioneer (DD) field office for analysis. In many parts of the world, water scarcity is the key factor limiting production farming. The new era of micromanagement via GPS promises to optimize water use by responding to known crop moisture levels and rainfall in different parts of a field. Further progress in optimizing water use will depend on large-scale financing for projects that collect and store rain and flood waters by using dams, diversion canals and holding basins. In agricultural areas afflicted with creeping desertification, such projects are the only known way to recharge the depleted aquifers that support groundwater irrigation.

The only stocks mentioned here that currently have good long- and short-term Finance Value, along with high S&P bond ratings, are Berkshire Hathaway (BRK-A) and Monsanto (MON).

Risk Rating: 7

Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com

Full disclosure: I have stock in Deere, Flowserve, DuPont, Cummins, Caterpillar, and Berkshire Hathaway.

Week 121 - Water Utilities Among the Dividend Achievers

Situation: Globally, water use is growing twice as fast as the population. This represents more intensive water use than in the past. For example, a recent study out of Columbia University notes that withdrawals from US municipal water systems increased 130% since 1950 while the population was increasing by 99%. Is exponential growth in water use sustainable? Not as long as water remains so cheap. If you use withdrawals under a regime of improved conservation measures to estimate sustainable water use, how many people can be supported going forward and still allow rainfall and snowpack to halt the depletion of our aquifers? About 5 Billion, which is 2 Billion fewer people than we have now and half the population the planet will have by 2060. Can desalination of ocean water make up the difference? Yes, but it is energy-intensive, expensive, and polluting. The new desalination plant at San Diego County has cost more than a billion dollars to build. The water it produces will have to be priced at twice the current rate, i.e., at $1,000 for a family of four for one year instead of $500. And, the pace of building desalination plants in the Western Hemisphere is much too slow to address the problem. In the Eastern Hemisphere, a wider acknowledgement of the problem has led to appropriate investment in desalination plants but the pace needs to pick up.

Most experts expect the pricing of water to increase rapidly, given the rate of population growth and the fact that 70-80% of water has historically been used for agriculture. The water distribution problem is compounded by global warming, and the fact that a billion people already live in regions undergoing desertification where water must be imported. A global water crisis can be expected in the next 10-15 yrs, unless the construction of desalination plants (and the expansion of water allocation regimes) “scale-up” much faster than is currently envisaged. For example, farmers in California have long prevented the legislature from imposing an allocation regime for groundwater use (wells), and resist metering.

Water utilities often take the form of municipal or regional cooperatives, using a clean water source combined with rate-based financing of the distribution system. However, the use of fertilizer by farmers can introduce excess nitrates into these water systems, necessitating the construction of water treatment plants. That requires financing, which may include issuance of common stock. Water rights can be expensive, which also requires upfront financing. This week’s blog looks at 7 water utilities that have increased their dividends annually for at least the past 10 yrs (see Table). Note: all values in the Table are current as of October 26, 2013. Red highlights denote values that are inferior to benchmark (VBINX) values. The main “takeaway” from the Table is in Column J, where you see that 5 of the 7 companies already have unsustainably high valuations. In other words, investors are well aware that water is undervalued and are betting that the dividends paid by these companies will grow faster.

Bottom Line: There aren’t many solid growth industries but water utilities certainly represent one. Clean water is destined to become more valuable than oil in our lifetimes. All 7 of the water utilities in this week’s blog represent worthwhile investments in terms of long-term Finance Value (Column E of the Table). In terms of dividend growth plus dividend yield, Aqua America (WTR) stands out. It is also a large enough company to have a Standard & Poors stock rating (A/L).

Risk Rating: 3

Full Disclosure: I don’t own any shares issued by these companies.

Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com