Water and Waste – A Compelling Dual Investment Opportunity

Hubbis in October co-hosted an event for selected prominent decision-makers from the wealth management industry in Asia that focused on the dual investment opportunity in water and water waste management. Our co-hosts J O Hambro Capital Management and Regnan, were represented by Andrew Ang, Head of Distribution at J O Hambro Capital Management in Asia, based in Singapore, and the key speaker was Saurabh Sharma, Co-Fund Manager at J O Hambro Capital Management, who offered his presentation and insights to our hand-picked delegates, all private bank gatekeepers, and senior wealth management professionals in Asia. Saurabh is a Fund Manager on the Regnan Sustainable Water and Waste strategy. He joined Fidelity in 2014 as an Investment Director before becoming an Assistant Portfolio Manager in February 2020. He has also held equity research analyst roles at Moody's Analytics and GlobalData. Saurabh has an MBA in Finance from IBS Hyderabad School in India and is a CAIA and ICFAI Charterholder.

Opening words from Andrew Ang, Head of Distribution at J O Hambro Capital Management in Asia, based in Singapore:

I am delighted to welcome you here today. The Regnan Sustainable Water and Waste fund is actually our second Regnan fund. The first one was a Global Equity Impact Fund that was launched the year before. Water and Waste was launched late last year, and is run by both Bertrand Lecourt and Saurabh Sharma, who is presenting for us today.

Both of them joined us in 2021 from Fidelity, where they designed and managed a similar strategy. Most of our peers’ funds are water only, and Saurabh will today argue the case as to why waste management should also be included.

And to clarify the distinction between Regnan and Hambro. I am in Singapore with Hambro and have been there for the past 10 plus years. Saurabh himself works with our Regnan franchise, which is actually our brand for responsible investments.

Regnan as a brand has been around for more than 25 years, starting in 1996 in Monash University as a think-tank academia, and accordingly in the last two plus decades has developed deep expertise, brand strength, advisory and research work with asset owners, asset managers and companies, but predominantly Australia focused.

JO Hambro’s parent company, Pendal Group, first took a smaller stake in Regnan years ago and accumulated its holding to represent 100% a few years back.

We then launched our first product under the Regnan brand two years ago with an impact equity fund, and our water and waste fund is our second Regnan fund. And you can expect more thematic ideas from us under the Regnan brand. Regnan funds are very similar to JO Hambro funds, in the sense that we aim to deliver alpha with high conviction, and all the funds are capacity constrained.

Setting the Scene for the talk

Water is a life force. It is an utterly precious, yet remarkably underappreciated and undervalued resource. It is used in nearly all forms of economic activity including food and energy production, industrial manufacturing, textiles, and materials extraction. Put simply there is no life and no economy without water and no sustainable economy without waste management.

Bertrand Lecourt, Senior Fund Manager and Head of Thematic Investments Strategies and Saurabh have positioned The Regnan Sustainable Water and Waste Strategy to combine what they believe are some of the best opportunities around water and addresses issues and opportunities around the sustainable economy through efficient waste management.

The strategy has been formulated to identify water and waste value chains with the aim of generating long-term capital growth with enhanced active management, combining defensive and growth stocks. It is a high conviction strategy with unique characteristics and extremely low overlap with global equity portfolios.

Selected Key Observations & Insights from Saurabh Sharma:

Thematics are increasingly important in the world of investments, primarily for institutions and increasingly also for private clients

Saurabh explained that thematics around sustainability are rising in prominence and popularity, with major investors in Europe such as from the Nordic region having driven the demand. He pointed to Morningstar data that states AUM under thematics is now around USD700 billion globally. Europe leads the way, and the US is also growing apace, with the rest of the world, including Asia, following with growing enthusiasm.

He stated that the data shows that if you are investing for five years or more, some 60% of your returns are being driven by earnings, while volatility plays a much lower role. And he said they look at things thematically, to participate in the predictable nature of structural drivers. He said while thematics had centred on areas of technology, there is a shift in focus to the physical world, and broader thematics, adding that water and waste fit tidily into this trend, and that they are essentially excellent defensive growth opportunities.

Investing in water and water management can encapsulate many positive attributes aligned to ESG

The managers focus on companies that are responsible and sustainable in terms of development and that are well aligned with ESG investment principles, which are increasingly popular with investors around the world.

It makes good economic sense and also fits the drive to sustainability to focus on an interesting thematic such as water

Saurabh explained that water investments offer robust returns and had delivered “great performance” over the last 10 years.

Together with his colleague Bertrand, they make all investment decisions centred on companies around the globe that provide solutions to the water and waste management challenges the world faces.

These companies span anything from regulated utility type operators to equipment providers, engineering, water, and waste management related technology companies. They focus on the water delivery side across the value chain starting from pump and valve manufacturers, water network operators, water treatment and recycling companies. And similarly on the waste side, they select from companies in collection, treatment, transportation, specialised waste companies, each with their own unique fundamentals.

The combination of water and waste in a single thematic is both logical and compelling

Saurabh explained that the concept is not to invest heavily in regulated utilities, which represent less than 10-15% of investments. The focus is on water, combined with waste management, and the spectrum is global, essentially any companies anywhere providing services and equipment related to water and waste.

He said these opportunities represent a defensive growth story that over the last 20 years have been outperforming the MSCI AC World NR index by around 3% to 4% per year, and even better than that over the past decade.

The beta they curate is typically considerably below 1, and some 80% of the roughly 35-50 stocks they invest in are not covered by the big banks and don’t feature in mainstream indices.

Rotation is modest at around 30% of the typical portfolio. The balance currently is roughly 60% water, and 40% waste, with that latter element increasing in size each year. Their investment approach is determined by bottom-up analysis.

While geopolitics, economies and financial conditions might vacillate, the world of water remains more constant

One way to get through all the noise around us is to look at what never changes, Saurabh observed. For our lives, health, and commerce, we all need water, and we all need to manage our waste efficiently. This has been true throughout history. The only difference is the rapidly increasing urbanisation over the centuries, a process that has accelerated markedly in recent decades.

As that happens, consumption rises all the time. And that creates more waste, which in turn places more pressure on infrastructure, with massive amounts needed to keep older infrastructure simply operating properly and in newer economies and cities vast new infrastructure required.

Wastewater infrastructure is lagging new water infrastructure, regulation is encouraging, and water usage keeps growing apace

Saurabh reported that wastewater infrastructure lags well behind, especially in the immensely populous emerging economies. In India, for example, circa 50-60% of the country’s waste is not even properly collected[1].

Regulation is another very good element of this thematics story. Activity in the sector tends to be licensed both nationally and locally, but with a built-in return on capital to encourage investment.

And water needs span everything from agriculture, horticulture, to taking showers to washing clothes to making coffee to industrial processes, and so on and so forth.

He explained that often we have no clue how much water we use or need. He said a simple cup of coffee takes around 130 litres of water, because to grow the beans requires water and because agriculture is a very water intensive industry.

As water usage expands apace, the price of supply and waste management keep rising

Saurabh explained that this is not only a volume story, but also a price story. The richer any place becomes, the more they can and do pay for water. China and India are still lagging in cost versus some countries like Germany or the US, but typically, it is around USD60 per month for a family of four, which is really not so much, especially compared with rapidly rising energy costs.

Investment targets comprise any companies associated with any element of the capturing, delivery, and then waste management of water

Saurabh reported that they select target companies from the truly vast universe of water, from source to waste treatment, and everything in between. This allows for a highly diversified portfolio. And as cities and economies become wealthier, they invest more in solid waste apart from wastewater, which is adding further momentum to the story.

He said initially, people might think that the water companies are the only network operators but noted that there's an entire value chain relating to water that one can invest in starting from intake companies, like pump and valve manufacturers, then water treatment companies, network operators, metering and billing companies, even wastewater treatment and recycling companies. He said they therefore look at the entire value chain.

To summarise, he said more and more people are moving to cities, they are getting richer, consuming more, there is more pressure on water delivery and water waste management infrastructure, and the same is true in the worlds of agriculture and industry, which are the biggest consumers of the world’s water.

The investible universe of target companies represents a total value pool of over USD2 trillion

The investible universe comprises more than USD2 trillion worth of companies to invest in across more than 370 stocks[2]. And the selected universe of companies has been growing all the time and becoming increasingly global. Capital market IPO activity and M&A activity were both increasing year on year. As the companies increase in size, there is greater liquidity. Moreover, the universe of target companies from which to choose also lends itself to ESG-centricity, with ESG metrics and analysis delivered to them both from external sources and from within, through Regnan’s own ESG experts.

There is great ‘purity’ of investment exposure to water and water waste

Saurabh explained that the constantly expanding universe of opportunities they focus on now features an average market cap that is increasing with time, with an average capitalisation of around USD 5 billion, allowing for plenty more liquidity than in past years.

The companies that they focus on are very ‘pure’ in terms of their own exposure to this sector. Saurabh reported that their selections at portfolio level are roughly 90% ‘pure’ water and waste on a weighted average basis.

Once selected, there are several key parameters, including of course financial performance, quality, stability, and longevity, ESG criteria, the corporate outlook and, naturally, a significant set of valuation metrics.

He said they apply 10 quality factors that are spread across profitability, cash generation and financial strength, and they model all their companies to come up with a valuation upside, to come up with a price target. And then they look at liquidity and sustainability risk and any technical support. The final cut comes down to 35-50 names.

Saurabh also noted that that they take a blended approach. What they saw earlier this year is that a lot of big companies weighted in ETFs in this field were over-bought, and then the January sell-off pulled them down.

However, he said they had outperformed peers, due to this blended and balanced approach, which helps them generate alpha. And because there is a lot of upside potential in terms of earnings, valuations are not too demanding at all. Moreover, coming out of the pandemic gradually, there will be a new infrastructure push globally, and that will be very beneficial to this thematic, he explained.

The water and waste sector offers significant portfolio diversification and de-correlation potential
Saurabh also observed that this sector is not one that most investors own, as they tend to focus mostly on the giants from the worlds of tech, pharma, consumer, industrials, financials, energy, and so forth.

They do not represent what most investors have in their portfolio. And come higher energy costs or lower costs, and across all geographies, he said the macro risks are minimal, as needs for water and waste management keep rising, and governments the world over must ensure supplies and positive outcomes at both ends of the spectrum, delivery, and waste management.

Additionally, their universe of target companies does not include any behemoths. There are no ‘Googles’ or ‘Amazons’ or ‘Apples’ of the water and waste sectors. If everything stopped with supply chain issues, these companies are very local and continue to do their jobs and they're very resilient, he said, which is very important to remember, especially with their blended and balanced approach.

Effectively, he said investors are hedging the fact that this new world ahead will cost everyone more. Water bills will go up; waste bills will go up.

He explained that even with the most conservative estimates, the waste market, for example, is expected to double in the next 10 to 15 years. He said data shows average waste being generated in terms of kgs per head per year is around 450kg of waste on the global average, in other words each human on earth generates more than one kg of water waste every day.

And while the average water bill globally is around USD60 per month for any family, the average waste bill is around USD20 per month; in other words a small amount that if inflation surges will rise but it won’t be a noticeable fact in monthly bills. And he reminded guests again that there's no economy without water and there's no sustainable economy without waste management.

Yet despite all the many positives, stock prices across this universe remain low

Saurabh told guests how despite the sector’s diversity, resilience and potential for growth, valuations tend to be modest, with share prices typically currently around a PE multiple of 15x to 16x. He said the overall universe of stocks they invest in is around 10x EV to EBITDA, and very importantly free cash flow yield for 2023 based on his estimates is around 7% right now. He explained that cash flow and earnings visibility are of course central to their decision-making process. The valuations and earnings potential look attractive right now both in terms of absolute and relative perspective.

Closing and summary comments

To summarise, Saurabh observed that the world has become more complex and much harder to predict. He said investing in water and waste is a long-term investment theme. Water and waste have been there for thousands of years and will endure for millennia to come. There is no life or economy without water and no sustainable economy without waste management.

Both water and waste have outperformed the broader market in the past 20 years. And in our opinion, the high visibility of earnings and cash flows is what makes them interesting investment opportunities.

They like to describe them as defensive growth opportunities and have identified five long term drivers for water and waste.

The first one is population growth and urbanisation, in fact, it is just the concentration of people. Since 2011, for the first time in human history, more than 50% of people live in cities. By 2050 it will be 70%[3].

And when you move to a city, you become wealthier and you consume more, which is the second driver – consumption. Everything you consume is water, to total water footprint close to 10,000 litres per day for a city-dweller.[4] And everything you consume becomes waste within a few years.

The third driver is the infrastructure gap, as you need to develop your infrastructure in water to be sure that you have no leakage, which is a problem in developed countries at the moment, but also to develop new infrastructure for new cities in developing markets.

But waste is also a problem, and the optimal infrastructure is still not in place, by any means. Saurabh noted that some 50% of waste is not collected on a global level; it needs to be at least collected and treated, and that essentially leads to the fourth driver, which is regulation.

He said we all need to make sure that we have a sustainable economy. Regulation provides new pockets of growth in terms of setting standards for quality of water or a way to deal with waste.

He offered some examples of how regulation can create opportunities. He cited ballast water in a ship going from Asia to Europe, and that ballast water (required for balancing the ships in the water) by the time it gets to Europe is full of fish and bacteria of all sorts, most of which is not native to Europe and but is then released in European waters. He said regulation was passed that this ballast water must be treated within the ship before releasing it back into the ocean, opening up a USD50 billion market, a market expected to surge to more than USD500 billion within ten years.

And their approach represents a dual investment opportunity to invest in companies which have these huge challenges and immense opportunities ahead of them.

The fifth driver is scarcity of resources. There is a lot of water in the world, but you need to have access to it, transport it and clean it.

Saurabh concluded that we are at a critical point in world history, where resources and population growth are at a crossroads. With ESG investments, a lot of focus till now has been around CO2 but he said they believe that water and waste are also absolutely at the heart of sustainability. And with their investments, they are not only looking to generate returns, but also want to create awareness around water and waste challenges.

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Regnan is a standalone responsible investment business division of Pendal Group Limited (Pendal). Pendal is an Australian-listed investment manager and owner of the J O Hambro Capital Management Group. Regnan’s focus is on delivering innovative solutions for sustainable and impact investment, leaning on over 20 years of experience at the frontier of responsible investment. “Regnan” is a registered trademark of Pendal.

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[1] https://www.epw.in/engage/article/institutional-framework-implementing-solid-waste-management-india-macro-analysis

[2] Regnan, Bloomberg. Universe as defined by Regnan. As of 30 April 2021.

[3] Regnan, Shikpmanov 1999, US Census bureau 2011; IFPRI; McKinsey analysis, 2009

[4] https://populationeducation.org/how-to-calculate-the-water-footprint-of-different-products/?utm_content=188767097&utm_medium=social&utm_source=twitter&hss_channel=tw-2647865652

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