Water Stocks: The Best Water Utility Stocks to Invest in Today

By Markets Fool.com

Image source: Getty Images.

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We're going fishing for the best water stocks to invest in today for the long term.Water stocks make compelling investments because they deal in an essential commodity. The supply of fresh water is limited, and demand should grow as the world's population increases and more people in developing countries move into the middle class.Water utility stocks are particularly attractive because their core businesses are monopolies and they pay modest dividends.

Water utility stocks

Ninewater utility stocks with market caps greater than $300 million trade on major U.S. stock exchanges.

Company Market Cap Dividend Yield P/E (TTM)
American Water Works $12.8 billion 2% 26.2
Companhia de Saneamento or "Sabesp" $6.4 billion 0.7% 15.9
Aqua America $5.3 billion 2.4% 25.6
California Water Service $1.5 billion 2.2% 33.7
American States Water $1.4 billion 2.3% 24.1
SJW Corp. $862 million 1.9% 18.9
Middlesex Water $554 million 2.4% 25.6
Connecticut Water $553 million 2.2% 22.8
York Water $370 million 2.2% 30
S&P 500 2%

Data sources: YCharts and Finviz.com. Data to Oct. 4, 2016. Returns that have beaten the S&P 500 are boldfaced.SJW Corp. has significant real estate operations, so it's excluded from the analysis.

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American Water Works: The best water stock to invest in today

American Water Works (NYSE: AWK) is thelargest water utility from a market cap and revenue standpoint. Its size is a huge reason it's the best water utility stock. The water utility industry is very fragmented and capital-intensive, so the bigger companies are more likely to have the resources needed to take advantage of the many potential acquisitions that exist.

American Water operates in 47 U.S. states and Ontario, Canada, and operates as a regulated water and wastewater utility in 16 of these states. Along with its size, its geographic diversification also provides it with a significant competitive advantage. This feature often allows it to expand by acquisition near its current operations without adding entirely new management teams. It also makes it less vulnerable to droughts and other region-specific conditions that could negatively impact its business.

American Water's market-based segment primarily builds, operates, and maintains water systems for military bases. In 2015, the company began supplying water and related services to natural gas exploration and production companies in the Appalachian Basin via its acquisition of Keystone Clearwater Solutions.The "fracking" water business has been negatively affected by the huge downturn in the energy markets that began in mid-2014. However, Keystone is holding its own -- management expects it to have a neutral effect on 2016 earnings. And management is optimistic about Keystone's prospects once the recovery in the natural gas market makes further strides.

Analysts estimate that American Water will grow earnings per share 10.6% this year, which is the highest growth rate projected for the stocks in the chart, and at an average annual rate of 7.6% over the next five years, which is the second highest projected rate (behind California Water Service) among the pure plays operating in the U.S. Management said on the second-quarter conference call that the company is on track to achieve its goal of increasing EPS at a 7% to 10% average annual rate from 2016 through 2020.

American Water's dividend is historically on the low end of the range for the industry, as the chart shows. This can be viewed as a positive unless you're an investor primarily concerned with current income. The company targets a conservative payout ratio (dividends paid/net income) of 50% to 60%. If it paid out more in dividends, it likely wouldn't be able to pursue as many acquisitions.

Sabesp: A potentially attractive water stock for the risk tolerant

Companhia de Saneamento Basico do Estado de Sao Paulo(NYSE: SBS)-- or "Sabesp" -- is a volatile stock, as its fantastic one-year return coupled with its poor five-year return suggest.Itisnota stock for more typical utility investors who are interested in relatively low-risk stocks that pay dependable modest dividends.

This volatility stems from the fact that Sabesp provides water and wastewater services in Sao Paulo, Brazil. Brazil has frequent water-supply concerns due to droughts, has been mired in political turmoil, and its currency has been experiencing huge swings in value relative to the U.S. dollar. (Sabesp has benefited from exchange rates for the Brazilian real improving significantly relative to the U.S. dollar in 2016 after plunging relative to the dollar in 2015.)

However, Sabesp does have some features that make it a potentially attractive investment for investors comfortable with higher risk levels. Along with more favorable exchange rates, drought conditions in its territory have recently begun to ease. Analysts expect it to grow EPS at an average annual rate of 35.1% over the next five years. Its price-to-earnings (P/E) ratio of 15.9 is by far the lowest of the pure plays. It generated $290.4 million in free cash flow over the trailing 12 months -- by far the best in the industry.

Now we'll discuss why most investors should pass on the other water stocks.

American States Water and California Water Service: Exposure to California's drought

A drained reservoir in the Sierra Nevadas, Calif. Image source: Getty Images.

American States Water(NYSE: AWR)has had a particularly tough year as reflected in its negative 7.3% one-year total return. The primary reason is the epic California drought, now in its fifth year. While the company has a market-based business that provides services at military bases throughout the country, its core regulated water and wastewater business operates solely in the Golden State. The state's mandatory water-use restrictions, enacted in the spring of 2015, resulted in decreased revenue, which flowed down to negatively affect American States' bottom line. Moreover, drought conditions usually increase operating costs.

California lifted its mandatory restrictions on June 1 because conditions had improved somewhat, but much of the state remains in a severe drought. Moreover, American States is still waiting to hear from the California Public Utility Commission about its rate requests for 2016 through 2018. Given the drought challenges and the uncertainties surrounding rates, most investors should pass on American States for now.

Investors should also pass for now on California Water Service (NYSE: CWT) because it's facing the same drought headwinds. However, all its regulated eggs aren't in one dry basket. While its largest regulated operation is in its namesake state, it also has regulated businesses in Washington, New Mexico, and Hawaii.

Aqua America: Takes a backseat to American Water in size and geographic diversification

Aqua America (NYSE: WTR)is the second largest water utility operating in the U.S. and thesecond most geographically diversified in the industry. It operates regulated businesses in eight states vs. American Water's 16. Its projected average annual growth rate of 6% over the next five years is solid, but trails American Water's 7.6%. Like American Water, Aqua America is also pursuing a fairly aggressive acquisition strategy. While Aqua America bears watching, American Water is currently the better water stock to invest in unless you're an investor who wants exposure to water utilities and are most concerned withdividend yield; Aqua America's 2.4% yield is tops in the industry.

Middlesex Water, Connecticut Water, and York Water: Very small

There are some good things that can be said about Middlesex Water, Connecticut Water, and York Water. For instance, Middlesex and York are two of only four companies (along with American Water and Sabesp) in the chart that were free-cash-flow positive over the trailing 12 months. That said, their small sizes combined with their lack of geographic diversification limit their long-term growth potential, in my opinion.

Middlesex Water has regulated and non-regulated operations in very limited parts of New Jersey and Delaware. Connecticut Water's regulated and non-regulated service territory is comprised of 56 towns in Connecticut. York Water's operations cover48 municipalities within York and AdamsCounties, Pennsylvania.

Tread carefully

American Water and the stocks of the other pure play water utilities operating in the U.S. have pulled back since July. American Water's stock, for instance, is down about 15% since hitting an all-time high in early July. These pullbacks were to be expected since valuations ballooned due to the huge price run-ups in this group over the last year. Valuations remain high, so these pullbacks could continue. However, a top water stock like American Water Works should prove an attractive investment for those who hold it for the long term.

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Beth McKenna has no position in any stocks mentioned. The Motley Fool recommends Companhia de Saneamento Basico. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.