China has many things in abundance. People. Land. Ambition. But when it comes to the world’s most precious commodity, supplies are painfully short.
In the farming heartlands, rivers are drying up. The famous Yellow River shrinks a little further each summer. Near the cities, they’re in full flow – but too often with pollution and waste, not water.
This crisis – the result of China’s huge population and breakneck growth – grows worse with every passing year. Within the next decade, the government will have to take huge steps to solve it or risk setting back everything the country has achieved in the last 20 years. That will mean enormous amounts of investment, far-reaching changes – and a very big investment opportunity…
Why does China have such a serious problems with water?
Why does China have a water problem? For starters, it simply doesn’t have enough of the stuff. Its renewable water reserves are about a quarter of the world average, as you can see below.
And the pressure on those reserves is soaring. Demand as a percentage of supply had been growing steadily for years, but exploded in the late nineties as the country began to transform.
Much of that increase is due to industrialisation and urbanisation, but around two-thirds of demand is still due to farming – and that’s where some of the biggest problems are.
Much of China’s grain farming takes place on the North China Plain. Unfortunately that’s a relatively dry area and needs a lot of irrigation. Making matters worse, Chinese farming is inefficient and much water is wasted. It’s this that’s putting huge strain on the Yellow River and other local sources.
So the government is trying another of the huge engineering projects that are a hallmark of modern China: a $60bn canal to ship water from the headwaters of the Yangtze in the south up to the northern farmlands. But that project, which has already been pushed back from next year to 2014, is running into its own issues – as will many smaller schemes to move water around the country.
That’s because China’s water is increasingly unfit for use. The worst side effect of rapid industrialisation has been a huge increase in pollution – land, air and water. As you can see below, 28% of China’s water falls below Grade V – the national standard for farming use. Even worse, 79% falls below Grade II – the minimum standard for daily use, such as drinking.
China is one of the best markets for playing the global water shortage
Cleaning up the environment is China’s next big challenge. Officially, environmental protection spending has risen by around 20% a year in recent years. In reality, it’s fair to say that it hasn’t been the top priority – growth has led the way and scarce resources and the environment have suffered. But that’s set to change.
First, the water shortage will only get worse, increasingly threatening China’s food security. Second, to sustain its growth China will have to rely more on internal demand in the years ahead and this sector will be a good place to direct investment (the government stimulus package contains RMB210bn ($30bn) for energy conservation and environmental protection).
Finally, popular pressure will demand it. As societies become richer, people begin to care more about their environment. It’s a pattern we’ve seen every time a country has industrialised. That will mean tighter regulations, stronger enviromental laws and much higher spending on treating and preventing emissions.
Of course, China isn’t the only country with water and environmental issues. This is a global problem. But it’s one of the most environmentally stressed countries; tackling this issue will be crucial to its successful development; and it has the resources to do so. All of this makes it one of the best markets for investing on this theme.
The best plays on the water sector
The table below shows a selection of stocks with large water businesses. They fall into several different groups, from biotechnology to infrastructure, and I’ve tried to classify them, although the lines often aren’t clear-cut.
| Name | Market | Ticker | P/E | Yield | Sector* |
|---|---|---|---|---|---|
| Suez Environnement | France | SEV | 10.87 | 5.49 | DWW |
| Veolia Envionnement | France |
VIE |
40.50 | 6.19 | DWW |
| China Everbright International | Hong Kong | 257 |
16.94 |
0.86 | I-China |
| China Water Affairs | Hong Kong | 855 | Neg | 0 | I-China |
| Guangdong Investment | Hong Kong | 270 | 10.81 | 3.05 | I-China |
| Pan Asia Environmental Protection | Hong Kong | 556 | 9.54 | 0 | TSE |
| Tianjin Capital | Hong Kong | 1065 | 11.46 | 2.86 | I-China |
| Xianjiang Tainye Water Saving Irrigation Systems | Hong Kong | 840 | 48.37 | 0 | IS |
| Kurita Water Industries | Japan | 6370 | 15.40 | 1.53 | TSE |
| Brite-Tech | Malaysia | BTEC | 17.86 | 4.60 | AC |
| Jaks Resources | Malaysia | JAK | 74.63 | 0 | P |
| Salcon | Malaysia |
SALC |
22.91 | 0 | TSE |
| Asia Environment | Singapore | AENV | 3.93 | 0 | TSE |
| Asia Water Technology | Singapore | AWT | Neg | 10.53 | TSE |
| Bio-Treat Singapore | Singapore | BIOT | Neg | 0 | B |
| Darco Water Technology | Singapore | DWT | Neg | 9.09 | TSE |
| Dayen Environmental | Singapore | DAYEN | Neg | 0 | TSE |
| Epure International | Singapore | EPUR | 9.14 | 1.83 | TSE |
| Hyflux | Singapore | HYF | 16.18 | 1.90 | TSE |
| Hyflux Water Trust | Singapore | HYFT | 9.45 | 16.17 | I-Global |
| Memstar Technology | Singapore | MSL | 7.54 | 1.14 | MT |
| Pan Asian Water Solutions | Singapore | PAWS | 3.76 | 5.56 | P |
| Sinomem Technology | Singapore | SINO | 6.90 | 0 | MT |
| United Envirotech | Singapore | UENV | 8.66 | 2.73 | TSE |
| Pentair | US | PNR | 1.70 | 2.86 | PF |
| Watts Water Technologies |
US |
WTS | 11.66 | 2.06 | PV |
|
* |
|||||
Pentair and Watts are often picked as good water plays by American investors, but they look expensive given their growth potential. Their sales are dominated by their US and European operations: Asia accounts for just 7% and 3% of revenues respectively.
Veolia and Suez are the two global heavyweights in the water and waste industry. Again, Asia is a relatively small part of their business (around 8% of sales) and rapid growth is hard for firms as large as this. But their high dividend yields make them look very attractive, since dividends are often the biggest part of investment returns in the long term (as I discussed in the second half of this article: The most important driver of stock market returns).
However, they’re cheap for a reason – both carry high levels of debt and investors are suddenly allergic to leverage. Certainly, this is a risk, although being French ‘national champions’ should ensure they get help if they have real trouble refinancing. Of the two, I would favour Suez as a more focused play (50/50 water/waste), while Veolia also has energy and transport operations (water is around 35% of sales).
Most of the Singaporean stocks are pure plays on China and other water-stressed regions such as the Middle East and North Africa. The best known is Hyflux, which builds desalination and purification plants based on its technology. It’s undoubtedly an impressive, innovative company with a good track record; however engineering firm Epure looks better value at these prices.
On the whole, I’m not enthusiastic about the Hong Kong-listed infrastructure plays, which aim to make money out of owning Chinese water treatment and supply facilities. The main point of infrastructure stocks is to pay a steady, high income. Yet yields on these stocks are low or non-existent, making them pretty unattractive.
For income-seeking investors, Hyflux Water Trust – which buys and runs plants that have been built by Hyflux – looks more attractive. However, you should bear in mind that last year’s yield is higher than it will be in future, since Hyflux waived its 31.5% share of the trust’s dividends in 2008.
The most exciting stock in the sector
However, the most interesting risk/reward trade-off that I can see in the sector is Hong Kong-listed Pan Asia Environmental Protection (HK:556). This is a small manufacturing and engineering firm that supplies water treatment systems, pipes and engineering services to municipal and industrial projects in mainland China. It’s also branching out into flue gas treatment systems, set to be another major growth area given China’s appalling air quality.
The firm is controlled by a businessman called Jiang Quanlong, who was the first mainland Chinese entrepreneur to list his firm outside China, back in 1999. That business was China Rare Earth Holdings, which processes and refines a number of rare metals that are a vital component of much of today’s technology (see China’s stranglehold on rare metals for my colleague Eoin Gleeson’s story on this sector). Since floating, CRE has been extremely successful, with profits growing by an average of 32% a year over the past five years.
Pan Asia Environmental Protection is a newer firm that floated in 2007 (although its key arm has been operating since 2000). Up until last year, growth had been very strong, as you can see in the table below.
However, the latest results show a 16% fall in revenues and 72% fall in profits, all due to a very weak second half. This isn’t a firm-specific problem: most water treatment stocks were hit by a combination of fewer new contracts (the result of credit drying up) and higher costs (after the commodity price spike earlier in the year).
Costs have already come down sharply, but the difficulty of funding new projects is likely to hurt the global water sector for a while. But China – which accounts for all of Pan Asia’s Environmental Protection’s sales – is likely to buck the trend.
As I discussed last week (Better news from China), it looks as though growth there fell very sharply in the second half of 2008, but is now picking up again. Increased bank lending and the stimulus package should ensure that infrastructure spending remains strong and China-focused water treatment firms should be big beneficiaries.
Pan Asia Environmental Protection is down by two-thirds from when it floated at the top of the bull market (see chart below). On a price/earnings ratio of 9.5 times its (depressed) 2008 earnings, it now looks pretty good value.
In 2008, it paid a dividend of five Hong Kong cents a share – equivalent to a yield of 4.8% on the current price. However, the dividend was dropped for 2009. While this is often a bad sign, in this case it looks like management are simply being very prudent. In all other respects, the firm’s finances look sound: it has RMB849m in cash, against total bank borrowings of just RMB82m. There’s no guarantee of course, but it seems reasonable to assume dividends will resume once business picks up again.
I have to stress that this is a small, obscure company (only one analyst covers it) and consequently it’s a highly risky stock. And while I think that family-controlled companies are often the best investments, since they’re more likely to take a long-term view, the downside is that investors have no influence on the direction of the business.
However, Pan Asia Environmental Protection seems to have a solid business, good prospects and a founder with a good track record. This is certainly not for widows and orphans, but could be worth a small investment if you have the appetite for it.
In this week’s other news …
| Market | Close | 5-day change |
|---|---|---|
| China (CSI 300) | 2,573 | -2.9% |
| Hong Kong (Hang Seng) | 15,259 | -2.2% |
| India (Sensex) | 11,329 | +2.8% |
| Indonesia (JCI) | 1,591 | -2.7% |
| Japan (Topix) | 830 | -1.8% |
| Malaysia (KLCI) | 993 | +2.9% |
| Philippines (PSEi) | 2,104 | +0.5% |
| Singapore (Straits Times) | 1,853 | -2.3% |
| South Korea (KOSPI) | 1,354 | +1.9% |
| Taiwan (Taiex) | 5,881 | +2.2% |
| Thailand (SET) | 474 | +3.8% |
| Vietnam (VN Index) | 310 | -7.3% |
| MSCI Asia | 81 | 0% |
| MSCI Asia ex-Japan | 326 | +0.4% |
Korea unexpectedly reported that its economy grew by 0.1% quarter-on-quarter in the January-March period. A big increase in government spending was the main driver, although private consumption recovered slightly after plunging the previous quarter. However, high household debt and weak global demand for exports suggest that a strong pick up in the domestic economy is unlikely for now.
Malaysia raised or scrapped limits for foreign investors in a number of industries in an effort to boost overseas investment, strengthen services industries and reduce dependence on manufacturing exports. Foreign investment into the country is expected to fall 50% this year.
Credit growth in India continues to slow, from 24% year-on-year in December to 17% year-on-year in March, according to the Reserve Bank of India. The RBI slightly reduced its forecast that the economy will grow by 6% in the year to March 2010; the IMF forecasts 4.5%.
Hong Kong’s Court of Appeal ruled against a privatisation proposal for telecoms firm PCCW. The local regulator opposed the deal, alleging that the bidder – a consortium headed by chief executive Richard Li, son of Hong Kong’s richest man Li Ka-shing – had distributed shares to third parties in exchange for them agreeing to vote for the takeover, in an effort to get around local rules that a physical majority of shareholders had to vote in favour of the proposal. The decision was seen as a boost for corporate governance, since the regulator and courts have a poor record of intervening in matters like these.
• This article is from MoneyWeek Asia, a FREE weekly email of investment ideas and news every Monday from MoneyWeek magazine, covering the world’s fastest-developing and most exciting region. Sign up to MoneyWeek Asia here