Top Water Stocks to Buy in 2017 -- and the Ones to Avoid

By Beth McKenna Markets Fool.com

Water stocks, especially water utility stocks, have had a great run in recent years. Several of them -- including the largest player,American Water Works(NYSE: AWK) -- have crushed the market over the last three years. So, it's not surprising that some of these stocks have pulled back since the middle of 2016. While there could be further pullbacks among the group over the near to mid term, water stocks still make solid investments for the long term.

Continue Reading Below

Water utility stocks are especially attractive within the water stocks category because their primary businesses are regulated and natural monopolies, and most of them pay dependable 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

Forward P/E

Projected Average Annual EPS Growth Next 5 Yrs.

1-Yr. Total Return

10-Yr. Total Return

American Water Works

$12.8B

2.04%

23.6

7.6%

17.3%

349.8%*

Companhia de Saneamento Basico do Estado de Sao Paulo (or "Sabesp")

$6.9B

--

9.8

35.1%

115.7%

152.7%

Aqua America

$5.2B

2.50%

21.6

6%

1.5%

114.5%

American States Water

$1.6B

2.14% 24.7 4.4%

6.3%

192%

California Water Service

$1.6B

2.06%

25.6

7.8%

43.9%

121.4%

SJW Group**

$1.0B

1.64%

N/A

14%

63.9%

68.6%

Middlesex Water

$630.7M

2.09%

N/A***

N/A***

46.3%

203.1%

Connecticut Water

$607.1M

2.06%

24.0

5.7%

36.7%

220%

York Water

$464.9M

1.73%

35.2

4.9%

48.3%

170.4%

S&P 500

2.01%

21.4%

96.7%

Data sources: Yahoo! Finance and YCharts. Data to Jan..23. P/E = Price to earnings. *Return since its April 2008 IPO. **SJW has significant real estate operations, so is excluded from the analysis. ***No analysts follow Middlesex, per Yahoo! Finance. Returns that have beaten the S&P 500 are boldfaced.

Continue Reading Below

American Water Works: The best water stock for most long-term investors

Image Source: Getty Images.

American Water Worksis thelargest publicly traded water and wastewater utility in the U.S. It has regulated and market-based operations in47 U.S. states and one Canadian province. It remains my favorite in the industry for most long-term investors. The two main reasons are its industry-leading size and geographic diversity.

American Water's size provides it with the resources to acquire small utilities in what is an extremely fragmented and capital-intensive industry. Its geographic diversity -- it has regulated operations in 16 states, double the number as second-most-diverse Aqua America (NYSE: WTR) -- provides it with more opportunities for efficient expansion than its competitors. Expanding near where it already has operations results in economies of scale. This geographic diversity also better insulates it from region-specific challenges, such as droughts.

American Water's main market-based businesses include building and operating water systems for military bases and supplying water and related services to natural gas exploration and production companies in the Appalachian Basin. It entered the latter business via its 2015 acquisition of Keystone Clearwater Solutions. While the fracking water business has been hurt by the big downturn in the energy markets that began in mid-2014, it has the potential to bounce back nicely once the recovery in the energy market progresses further.

Analysts estimate that American Water will grow earnings per share at an average annual rate of 7.6% over the next five years. This is the second-highest projected growth rate for pure-play water utilities operating in the U.S. While California Water Service (NYSE: CWT) is projected to grow EPS at an average annual rate of 7.8% over this same period, nearly all of this growth is expected in 2017. American Water's projected growth dynamics are more attractive, as they're relatively steady.

American Water has increased its dividend payout each year since it went public in 2008.

Sabesp: Worth considering by those comfortable with higher risk

Companhia de Saneamento Basico do Estado de Sao Paulo(NYSE: SBS)-- Sabesp, for short -- is worth a look by those comfortable with higher risk. This is a volatile stock -- as the following chart shows -- that is not suited for investors who are interested in relatively low- to moderate-risk utility stocks that pay dependable dividends.

Data by YCharts.

Sabesp provides water and wastewater services in Sao Paulo, Brazil. This is a country that suffered a severe drought in much of the southeastern region (which is where SBS's territory is located) from 2014 to 2016, has been embroiled in politicalturmoil, and has a currency that has made big swings in value relative to the U.S. dollar. All of these factors add up to inherent volatility. In fact, the stock's five-year beta is 1.87 -- which means it's been about 87% more volatile that the broader market, which has a beta of 1.0. Most water utilities have betas considerably lower than the market's; American Water, for instance, has a five-year beta of just 0.21.

Sabesp does sport some features that make it a potentially attractive growth stock for investors with higher risk tolerances. First, exchange rates for the Brazilian real relative to the U.S. dollar improved in 2016 after significantly declining in 2015. (Just less than half of Sabesp's total debt outstanding at the end of the most recent quarter was denominated in either U.S. dollars or Japanese yen, so currency fluctuations can have a huge impact on its interest expenses.) Secondly, drought conditions in its coverage territory began easing in 2016.

Over the next five years, analysts project that Sabesp will grow EPS at an average annual rate of 35.1%. This robust growth rate looks mouthwatering for a stock with a forward P/E of 9.8. However, investors need to remember that projected growth rates are just that -- projected -- there is no guarantee companies will achieve them. The stock is priced attractively because it's considerably riskier than other water stocks, as well as the overall market.

Another metric bolstering the case for Sabesp is that it spouted off $241.6 million in free cash flow over the trailing 12 months -- by far the tops in the industry.

California-based water utilities: Continue to avoid due to drought exposure

California has begun to emerge from its epic drought, now in the fifth year, thanks to a very wet winter. According the the U.S. Drought Monitor report released on Jan. 12, just over 65% of the state is now in a drought, down from 100% three months ago. Moreover, only about 2% of the state remains in the most extreme category, "exceptional drought," down sharply from 43% a year ago. Most areas in Northern California are now drought-free, though much of the south is still in some type of drought.

Darker shades correspond to more intense drought conditions. Data released on Jan. 12. Image source: U.S. Drought Monitor.

While this news is encouraging, it's still too early to declare that the end of the California drought is near, according to many experts.So, I continue to believe that most investors should pass on investing in American States Water (NYSE: AWR) and California Water Service.

American States Wateris the water utility that's most exposed to the California drought. The company's core regulated business operates solely in the Golden State, though it does have a market-based business that provides services at military bases throughout the country. Drought conditionsusually increase operating costs, which water utilities must then try to recoup after the fact through rate increases.

In December, the company finally received the final decision from the California Public Utilities Commission (CPUC) regarding its rate hike request for 2016 through 2018. Positively, much uncertainty -- which the market hates -- has been removed, as this request dates back two years, because some items have been litigated. The overall rate decision was a mixed bag. Among other things, the CPUC authorized only 87% of the company's capital expenditure requests in customer rates. As a result of all the rate case factors, earnings per share at the company's water utility segment for the first nine months of 2016 would have been lower by approximately $0.07 per share from the company's reported results. The company reported earnings of $1.32 per share in the first nine months of the year, which means that earnings for this period were overstated by 5.6% due to factors related to the rate case.Because the new rates are retroactive to January1,2016, American States will record this negative impact to its Q4 earnings. .

American States Water has a reputation for being very well run. However, I think most investors should continue to pass on the stock for now because there is uncertainty involved in how much longer the drought will persist. This add uncertainty as to whether the company will be able to successfully fully recoup its increased operating expenses related to the drought. Moreover, future rate hike cases could drag on forever like the most recent one did. Furthermore, even when the current drought ends, more frequent and severe droughts in certain areas of the country -- such as California -- will likely become the new norm, in my opinion. There is clear scientific evidence that the U.S. -- like much of the world -- is in a warming trending.

California Water Service also has significant exposure to the epic drought, though not to the same degree as American States. It operates its largest regulated business in its namesake state, but it also has regulated operations in Washington, New Mexico, and Hawaii.

Aqua America: Decent size and geographic diversity, but long-term returns are concerning

Aqua America is the second largest water utility operating in the U.S. and thesecond most geographically diverse in the industry. It has regulated operations in eight states.

Like American Water, Aqua America has also been pursuing a fairly aggressive acquisition strategy. While Aqua America is worth watching, American Water is currently the better water stock, in my opinion. American Water is projected to grow EPS at an average annual rate of 7.6% vs. Aqua America's 6% -- and its stock is just a bit pricier from a forward P/E standpoint than Aqua America's. Moreover, Aqua America's 10-year return significantly lags the returns of most of the group. While past performance is not indicative of future performance, past performance over the long term does often reflect a company's sustainable competitive advantages and how well it's run.

Small players: Lack good long-term growth potential

Some positive things can be said aboutMiddlesex Water, Connecticut Water,andYork Water.However, their small sizes combined with their lack of geographic diversity limit their long-term growth potential, in my opinion.

Middlesex has operations in very limited parts of New Jersey and Delaware. Connecticut Water provides services to 56 towns in Connecticut. York Water's operations span 48 municipalities within York and AdamsCounties, Pennsylvania.

10 stocks we like better than American Water Works
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now...and American Water Works wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of January 4, 2017.

Beth McKenna has no position in any stocks mentioned. The Motley Fool recommends Companhia de Saneamento Basico. The Motley Fool has a disclosure policy.