Three-quarters of Earth’s surface is covered by water. But approximately a third of the world’s population lives in areas where water supplies are either stressed or scarce. The latter applies most to the Middle East, but the problem is growing rapidly elsewhere as well.

According to the United Nations, sometime in next 15 years, some 64 percent of the Earth’s population will live in areas where water supplies are stressed. In some cases, demand will simply grow to exceed supply. In others, environmental concerns and economic growth will severely stress water quality to the breaking point and beyond.

Unfortunately, the globe’s supply of fresh water is relatively static. A fifth of water use is from ground sources that can’t be replenished quickly. That’s particularly true in the big consumption countries–the US, Australia, India, and China. Total depletion to date in North America’s biggest aquifer, for example, is equivalent to the annual flow of Colorado’s 18 largest rivers.

It all adds up to a colossal opportunity to invest in water. And we’re well tapped into it in the VRI Portfolio. If you haven’t yet picked up our favorites, now is the time.

Asia Focused

China offers by far the most exciting opportunity in water investing. Strong economic growth, extremely deteriorated water quality and well-laid plans to deal with the problem add up to a compelling opportunity.

Two-thirds of China’s cities are facing water shortage problems. According to the country’s Ministry of Water Resources, 64 percent of ground drinking water is severely polluted and 54 percent of the country’s seven major bodies of water are unsuitable for drinking.

Furthermore, per capita water consumption in China was 220 liters per day in 2006. In contrast, economically advanced countries like Japan and the US consume 268 and 305 liters per day, respectively. The greater consumption potential isn’t difficult to see as the Chinese continue to modernize their economy and improve their living conditions.

At a high-profile conference in late spring in Beijing, Chinese authorities reaffirmed that the 11th Five-Year Plan (2006-10) has allocated USD150 billion to address water issues such as supply, wastewater treatment, water re-use, sewage and environmental protection.

Cheng Xiaobing, Deputy Director-General of the Department of Water

Resources Management in the Ministry of Water Resources, outlined the new approach adopted by the government at a high level to handle water problems. The primary focus is on the people’s well-being, followed by an emphasis on ecological soundness, sustainable use of water resources and water conservancy, a balanced development of water resources and, lastly, forming a sound legal framework through continued water reforms and innovations.

Source: Ministry of Construction of the People’s Republic of China

That adds up to a lot more money to be invested in the country’s water sector. To that end, China has also started allowing private companies to invest through acquisitions of water assets. The idea is new technologies and better management practices will improve quality. In order to make the proposition more appealing, tariff increases are being planned. And the government has a lot of room to maneuver, as China has some of the lowest water rates in the world.

Over the next several years, the investing opportunities in water will increase tremendously, and farsighted investors will be rewarded handsomely. Water is gradually becoming as important as oil in this world to sustaining growth. All the companies along the business chain will benefit.

VRI’s Picks

Singapore-based Hyflux (OTC: HYFXF) remains our favorite leveraged play on the sector. The company has four core businesses.

Its water business includes seawater desalination, raw water purification, wastewater cleaning, water recycling, water reclamation and ultra-pure water production for municipal and industrial clients.

The industrial business includes separation, concentration and purification treatments for manufacturing process streams. The structured project division includes privately financed projects either as build-own-operate (BOO) or build-own-transfer (BOT) schemes.

Finally, the consumer division includes air-to-water and home filtration products, including faucet and under-sink filters for the consumer. The company is well known for its membrane technologies. Its membrane and materials research center in Singapore is the largest in Asia, outside of Japan.

A couple of weeks ago, Hyflux announced strong second quarter earnings, with net profit of USD16 million, up 311 percent year over year. The big increase was from the municipal sector, with China and the Middle East contributing 61 percent and 34 percent of total revenue, respectively.

Hyflux’s share price has pulled back in the past couple of months mainly because of worries regarding inflationary pressure due to higher raw material costs. This is a material concern that management has until now addressed successfully, keeping costs in check while gross margins improved to 48 percent.

Nevertheless, reality is that companies as well as their customers will need to live with and adjust prices accordingly. Hence, we do expect margin improvement to continue as the company will have some pricing power, given the importance of its services to the economic growth of the countries it does business in.

Looking into the second half of the year, China remains the focal point of the company’s strategy. Wastewater treatment in the worst polluted regions of coastal China as well as water shortages around Beijing should help Hyflux add to its order book. Desalination projects, especially in Africa and the Middle East, will also be very important.

Its order book now stands at USD1 billion versus USD610 million at the end 2007. We expect that its recent contract wins in North Africa (Algeria) will add to the company’s track record and will prove to be very useful in future contact biddings. Buy Hyflux at current prices.

Suez Environnement (Paris: SEV) is our big-name recommendation in the water and waste business. There haven’t been any new developments since our initial recommendation; our aim here is to acquaint new readers with the company.

The company was spun off from its parent Suez after the latter merged with Gaz de France earlier this summer. Its association with parent GDF Suez also offers a lot of benefits, especially in the energy-intensive desalination business. And Suez Environnement’s waste-to-energy operations can only benefit from its parent’s global electricity presence and associated engineering skills.

Suez Environment also has the strongest balance sheet in the global water treatment sector, with relatively lower debt levels and a strong investment program of EUR4.5 billion for the next three years. Annual earnings growth of 10 percent looks set, with considerable room on the upside as well.

The company has a great reputation in research and development (R&D). Sector R&D is becoming ever-more important as the water/waste sector advances and the global need for highly sophisticated operation becomes paramount.

The international division of the company contributes 22 percent of Suez Environnement’s earnings and is split roughly 50/50 between water and waste. In recent years, the company has been expanding its international water and desalination operations in the US, China and the Middle East, while its waste business has found new growth avenues in Australia, Hong Kong and Morocco.

Its subsidiaries Degremont and Safege specialize in water treatment and operate in more than 70 countries, allowing Suez Environnement to explore new market opportunities.

Degremont is often used as a way to enter new markets, initially in a small, leveraged manner (i.e., the construction of a water treatment or wastewater treatment plant). Once the local relationships have been developed and the viability of bigger projects established, Suez Environnement comes in for the much larger projects.  

Although smaller operators can occasionally be extremely competitive for certain of Suez Environnement’s business, the company’s integrated business model and global presence often allows it to get the whole contract, using the knowledge of the smaller competitor for a specific part of the project.

Suez Environnement is a buy at current prices. We recommend buying on the Paris exchange, the primary market for the stock, in order to get the best price.