Buying AWK at $116.25
*0.25% position*
A question was posed on Twitter on 5/9/20 asking if you could only make 1 investment from here on out, what would it be?
Many of the answers were various index funds, Amazon, or gold.
After thinking about it for a long time, the answer became clear: U.S. regulated water utilities. And there is really only one of them that is worth considering: American Water (AWK).
Before getting into AWK, this is a different kind of purchase. It's not a "cheap" stock. As such, we aren't buying it in a "normal" 2% position size. It's going to be one we add to each week in small amounts until a real position is reached. Most weeks will be 0.125% - this is is the first week of buying, so 0.25% feels appropriate. This is an extremely rare exception to how we manage our portfolio, but we feel the outcome is worth making an exception. Water utilities are special.
American Water is the only pure-play, mulit-state, regulated U.S. water company that's publicly traded. There used to be a second one, Aqua America, but they recently purchased/merged with a gas utility. There are a few tiny water utilities that operate in California, but having exposure to just one state creates hefty regulatory risk. American Water operates in many states.
What makes regulated water utilities special is really 3 major things:
*0.25% position*
A question was posed on Twitter on 5/9/20 asking if you could only make 1 investment from here on out, what would it be?
Many of the answers were various index funds, Amazon, or gold.
After thinking about it for a long time, the answer became clear: U.S. regulated water utilities. And there is really only one of them that is worth considering: American Water (AWK).
Before getting into AWK, this is a different kind of purchase. It's not a "cheap" stock. As such, we aren't buying it in a "normal" 2% position size. It's going to be one we add to each week in small amounts until a real position is reached. Most weeks will be 0.125% - this is is the first week of buying, so 0.25% feels appropriate. This is an extremely rare exception to how we manage our portfolio, but we feel the outcome is worth making an exception. Water utilities are special.
American Water is the only pure-play, mulit-state, regulated U.S. water company that's publicly traded. There used to be a second one, Aqua America, but they recently purchased/merged with a gas utility. There are a few tiny water utilities that operate in California, but having exposure to just one state creates hefty regulatory risk. American Water operates in many states.
What makes regulated water utilities special is really 3 major things:
- Reasonable, regulated return on assets and equity.
- Reasonable regulatory environment with minimal political impact.
- Nearly unlimited growth from a variety of levers. Even in times of pandemic, recession, and depression.
Starting with #1, regulated utilities enjoy a regulated return on assets and equity. The average ROA is something in the 6-8% range. Most utilities are "allowed" 50% debt and 50% equity. Regulated ROE tends to be somewhere between 9-10%. Realized debt costs, up to the 50% of assets level, are passed through into customer bills without much argument. Using debt up to about 50% means lower bills than a 100% equity company and doesn't increase the risk too much given the long asset lives. The argument with regulators tends to be on the margin between 9-10%, but that's too into the weeds. Just think of utilities as able to earn 10% on their equity and you'll be close enough. A "guaranteed" 10% ROE is pretty darn good, over the long-term!
Moving to #2, regulation of monopolies is important to ensure there is no price gouging. Because of the volatility of electric and gas bills - especially in times when energy prices skyrocket - the bills of those utilities can be a political issue. People care about their electric bill being low - because they feel like the utilities are taking advantage of them. (That's not the case in actuality, but the political pressure remains). Water is different. Bills tend to be fairly stable. Usage doesn't impact bills too much. And they never spike in the way that electric and gas bills can on a hot or cold day when energy prices skyrocket along with usage increasing. People use about the same amount of water and it has no commodity cost to create a double-whammy effect. Thus, water bills aren't really something most people think about. Because of that, water utilities enjoy fairly accommodative regulation that provides a reasonable return in a timely fashion without undue risk. Customers don't complain and all parties are happy.
#3 is the interesting point. Because huge swaths of US water utilities are still municipally owned and operated, there is potential for them to sell out to guys like American Water. If a town has a need for capital, they sell their water utility for a one-time payment. The newly sold utility will be regulated to ensure bills don't get out of control - and almost everybody wins. American Water can run the utility more efficiently than a municipality, bills remain stable, and the town gets money. Also, about 20% of all water is lost via leakage. Fixing leakage means lower treatment costs and therefore lower bills. So as utilities
So, American can grow earnings without impacting customer bills - by adding new customers as municipalities sell out. Further, they can grow earnings by cutting various costs - with leakage being an obvious cost. The average water pipe in America is nearly 100 years old and we're currently replacing it on a 200 year cycle. That's not fast enough - and there is a lot of catching up to do.
For these reasons and more, American Water is a wonderful long-term investment to build into over time. It's not cheap, but the story isn't getting any worse any time soon. If it becomes cheap, we'll make a larger purchase. As a point of reference, we believe AWK is probably worth somewhere between $110-120/share in 2020.
The target is for this position to be ~5% of our portfolio when fully invested.
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