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Now That's A Liquid Investment


Oil and copper stocks are benefiting handily from booming commodity prices. But another substance even more precious is boosting a previously overlooked group of stocks. Savvy investors, including small-cap maven Chuck Royce, Fidelity (FCNTX) Contrafund manager William Danoff, and hedge-fund manager Stanley Druckenmiller, have been accumulating water stocks for months. Water? That's right, good old H2O, a gallon of which sells for more than an equal amount of gasoline, as some analysts who follow the sector are fond of noting.

A confluence of trends has led to increased interest in companies that make water treatment and filtration equipment, build water infrastructure such as pipelines and sewage treatment plants, or run water utilities. The several dozen stocks in the sector had a terrific run last year but have sold off in the first quarter, offering a more attractive entry point for long-term investors.

Spending on various water projects will be huge. The Environmental Protection Agency estimates it will cost $500 billion over the next 20 years to maintain the country's water networks. The agency is also cracking down on cities with water pollution problems, such as Atlanta, Cincinnati, and San Diego, and forcing them to upgrade their facilities. Clean water is an even bigger problem in China, where the government is building treatment plants. The damage caused by December's tsunami will require the rebuilding of water infrastructure across other parts of Asia as well.

DIVERSIFICATION

The best investment strategy is to diversify among several kinds of water companies. Both Danoff and Drunkenmiller own CUNO (CUNO), which makes filters out of everything from glass and ceramics to cellulose. Such filters are used under kitchen sinks and in wineries and pharmaceutical companies. Record new orders came in during its Jan. 31 quarter, and the company is forecasting a 15% rise in earnings this year.

Danoff and Drunkenmiller have also bought Pentair, which gets two-thirds of its revenue from pump and filter sales and is projecting 45% growth in earnings per share for 2005. And they both added Nalco Holding, a leading provider of water-treatment chemicals that went public in November. The company is paying down debt, and expects to increase cash flow at double-digit rates. Analysts who follow the sector note that defense contractor ITT Industries (ITT) gets about 38% of its revenues and 45% of its operating income from its water-related businesses.

For value investors looking for less pristine companies, one of Royce's holdings, Insituform Technologies (INSU), is out of favor because of an ill-fated foray into tunnel construction. Now the company is benefiting from a growing number of sewer-repair projects, says Debra Coy of Washington Research Group. Similarly, Tetra Tech (TTEK) is refocusing on water projects after getting into trouble building cellular-telephone towers. Last month the company announced a $50 million loss, but Coy thinks that's the end of those woes. "They're coming back to the core things they do well," says Coy. "Earnings will recover this year." Calgon Carbon (CCC), a Royce holding which makes ultraviolet purification systems, is reorganizing, taking a write-off, and expects to achieve a 29% gain in operating income this year.

Some investors are looking at water utilities, too, since they don't face the same deregulatory pressures that affect power companies. "You can't deregulate water unless you figure out how to beam it from place to place," notes David Schanzer at Janney Montgomery Scott.

The biggest publicly traded water utility is Aqua America (WTR), formerly known as Philadelphia Suburban but now operating in 13 states as far away as Texas and Missouri. Utilities typically don't grow much faster than the overall economy, but Aqua has been an active acquirer, buying 111 companies over the past five years. The company hiked its dividend 8% last year, the 14th increase in 13 years.

Investors buying now may have missed out on some of the runup in water-related equities. But the world's unquenchable thirst suggests that these stocks won't be running dry anytime soon.

By Aaron Pressman


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