Water as an investment theme

It's scarce and ABN AMRO Private Banking Asia thinks water is a great investment.
The demand for water
Dwindling resources coupled with rising demand has made water a precious commodity. No other commodity is experiencing such a rise in demand juxtaposed with declining supply. According to the World Water Council, the worldÆs population tripled in the 20th century while water consumption increased six-fold. The United Nations (UN) estimates that the demand for fresh water will triple in the next 30 years. The acceleration in the demand for water can be attributed to the following factors:

ò Agricultural production is waterintensive and accounts for 70% of water consumption. The demand for water on this front is growing with the emergence of developing economies like China and India. The following statistics provides some perspective on the volume of water consumption involved in agricultural and food production:

ò One orange needs 50 litres of water to ripen. A kilogramme of meat requires 5,000 litres of water to produce

ò Rising world population
ò Higher environmental standards, particularly in industrialised countries

ò The use of water for tourism and leisure

The supply of water
Contrary to public perception, fresh water supply is scarce and finite. According to UNESCO, only 3% of the worldÆs water is made up of fresh water and most of this is located in polar ice caps. Experts put the amount of available drinkable water at 1%, of which, some two-thirds of this amount is already polluted.

The only renewable source of freshwater is continental rainfall which generates a constant global supply of 40,000 to 50,000 cubic km per year. With the world population increasing by an estimated 85 million per year, the availability of freshwater per capita is decreasing rapidly.

Managing Water Efficiency to achieve Water Security
Given that water supply is finite and diminishing, the only recourse for countries to achieve ôwater securityô is to enhance water efficiency.

The term ôwater securityö is akin to the widely used terms ôfood securityö and ôenergy securityö and it refers to reliable access to an acceptable quality and quantity of water for production, livelihoods and health coupled with an acceptable level of risk to society of unpredictable water related impacts. In the recent 4th World Water Summit which took place in Mexico in March 2006, achieving ôbasic water securityö was linked to sustaining economic growth.

Governments must undertake a multi-pronged approach to ensure that freshwater supplies are sufficient for their populations in the near term. This will involve governments investing heavily in existing as well as new water infrastructure as well as investing in new technology to harness water from previously unusable sources notably the desalination of seawater.

Water as an Investment Theme
The 4th World Water Summit highlighted two important trends in the water industry. The first is the increasing role of corporate involvement across the entire water supply chain which encompasses water collection and processing, supply and wastewater management, the laying of pipelines and the building of water treatment plants. Historically, investments in water infrastructure were largely financed by governments. Now it is widely accepted that government authorities lack the financial resources and expertise to manage this process on their own.

We see governments across the world increasingly privatising their water infrastructures, which has been a boon to industrial companies the like of Suez and Veolia Environment.

The second is the huge demographic pressures that are being felt as a result of rapid urbanisation and industrialisation of highly populated countries like China and India. The World Health Organisation estimates that 35% of the worldÆs population will live in areas with water problems by the year 2025.

The investment community has embraced this investment theme and this is evidenced by the proliferation of mutual funds dedicated to investing in water related stocks. Since 2005, we saw the launch of at least 12 waterthemed mutual funds.

A key attraction for investing in the water industry is that water stocks have outperformed the broad-based MSCI World Index over the last few years. Chart 1 (above) shows the performance of the water stocks proxy by the Bloomberg World Water Index relative to the MSCI World Index.

The Sweet Spot - Asia
Given that the water investment theme has already garnered considerable attention and investment inflows, we believe that investors who want to participate in the growth in the water industry need to look beyond identifying and investing in stocks with exposure to the water industry. We are of the view that the sweet spot of this industry is in the emerging Asian markets where the water industry is still in its infancy, which presents greater opportunity for the growth of companies operating in this region. Beyond identifying the geographic region to invest in, we believe that it is also important to identify which segments of the water industry to invest in. The water industry can be divided into four key segments, namely: water supply, environmental services, water technology and packaged water.

While there has been a proliferation of mutual funds dedicated to waterthemed investments, we are not aware of any fund that focus purely on the water industry in Asia. This lack of an investment vehicle makes it challenging for investors to gain exposure to the Asian water industry as investors must first identify segment(s) to invest in and then identify stocks within the sector to invest in.

The water industryÆs landscape in Asia differs significantly from the developed world. The developed world has been investing or has invested considerable resources in developing water supply infrastructure and the challenge for these nations is the continued investment to maintain the infrastructure. In contrast, there is an acute shortage of water supply infrastructure in Asia, particularly in countries like China which is experiencing demographic pressures that stem from the rapid urbanisation of its population. Typically companies or water utilities that operate in the water supply segment have limited pricing power because water is generally regarded as a social good, which means that governments will limit the profitability of water utilities. However, the dynamics of water supply companies operating in Asia are substantially different where the acute shortage of water infrastructure projects has led to governments offering lucrative contracts to attract companies to set up water infrastructure projects. For instance, Guangdong Investments Limited (270 HK) has secured a 15 year contract to supply water with provisions to raise water prices at five year intervals.

Another key difference between Asia and the developed world is the state of fresh water supply. As a result of the recent rapid industrialisation of their economies, Asian governments have to contend with higher levels of water pollution. We note that Asian governments are also becoming increasingly more environmental conscious. The Chinese government announced that it plans to invest $5 billion on water treatment and waste disposal plants to treat water pollution that resulted from the recent completion of the Three Gorges Dam on the Yangtze River We believe that the Environmental Services segment is the most important segment in the water industry for investors.

We think that the following stocks will be the front runners to benefit from the increased government spending to preserve their diminishing freshwater supply: Bio Treat Technology Limited (BIOT SP), Hitachi Zosen Corp (7004 JP) and Nitto Denko (6988 JP).

Investors should also consider having an exposure to the Water Technology segment because a key solution to achieving water security hinges on the development of new technology to harness water from previously unavailable sources. The most notable development in this area is the desalination of seawater and one of the leaders in this arena is Kurita Water Industries (6370 JP).

Investors who want to gain exposure to the fledging Asian water industry can obviously invest directly in these five stocks. However, given the recent increase in volatility that we have observed in the market, investors may want to consider using a structured note that offer some downside protection. ABN AMRO Bank has put together a structured note, the ABN AMRO Asian Water Basket Note, linked to these five stocks. The key features of this note are:

ò Three year investment tenure,

ò US dollar denominated and quanto, ie no exposure to the underlying currencies of the stocks at maturity of the note for US dollar referenced investors,

ò Enhanced capital returns if the five stocks, on aggregate, appreciated at the noteÆs maturity. In such an event, investors will receive about 110% of the aggregate appreciation of the basket,

ò Capital protection at maturity as long as the aggregate value of these five stocks does not fall below 75% of its initial aggregate value.

The above article is reproduced from the Summer issue of Asian Private Capital, a supplement to FinanceAsia magazine.
¬ Haymarket Media Limited. All rights reserved.
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