Water Analysis - Part III

On a global basis, there is sufficient water to go around to meet demand. However, the issue is one of demand/supply imbalance across different parts of the world. As it is, you already need to increase supply and decrease demand. The situation is made worse by the fact that demand is still increasing and supply is decreasing.

One need to note an interesting point on pricing – a demand/supply imbalance does not affect prices of water here because prices are government regulated. Generally, the price of water is below the economic cost of providing the water. Hence, there is an implicit government subsidy being provided here. Theoretically, a demand/supply imbalance should make such subsidies unsustainable, especially as the imbalance worsens and the cost of providing such subsidies increase. This is true but one must acknowledge that subsidies tend to be persistent/sticky and any expectations of rapid changes in the pricing of water need to be taken with a pinch of salt.

The demand/supply imbalance is one experienced globally across many countries. Hence, we should think global when making our investment decisions. To that end, we need to decide where to invest in particular. Ideally, the best place to invest should be:

1) facing a demand/supply imbalance – an opportunity

2) have a supportive regulatory environment which recognizes the situation and actually support that with action – increase in tariffs, favourable tax laws, PPP that lead to more investment. An important point, because this industry is largely a regulatory play. Moreover, even if an imbalances imply a need for investment, it does not necessarily translate to actual investment unless the government takes active step to. This is largely because it is a regulated industry and does not react as readily to market forces.

These are the basic criteria because a demand/supply imbalance is already serious enough in many countries and there should be cause for action to address the issue.

But to sweeten the deal, additional favourable factors should be considered

3) growing demand for water – because this will increase the utilization of your plant. So you want places that are experiencing industrialization, urbanization, etc

4) growing imbalance (e.g. supply decrease at a faster rate than reduction in demand) – so that government is compelled to act

These 4 factors should be taken into account when deciding where to invest globally.

After filtering down on the countries, we need to decide the particular segment(s) of the value chain to invest in.

In particular, we want:
1) a particular segment which is facing the most stress and which the government feels the most need for action on – favourable regulations and PPP opportunities

2) a particular segment that does not serve the public so that there will be no/low public opposition when prices are moved – so that tariffs can be raised to reflect the true economic cost with little opposition. This may not be a necessary requirement in countries where the public are generally more okay with price changes but you have the best odds when you avoid the risk altogether. Note that segments which serve the public are generally more stable as public demand is less volatility – so you may be trading higher returns from increase in tariffs for higher volatility stemming from volatility in volumes.

3) Low cost of funding environment

After deciding on the sector, you will need to do the filtering by companies
So firstly, you need to determine whether to invest in the operator or just the EPC or something between those 2 – companies with both EPC segment and a BOT/TOT segment.

Logically, an EPC might be better than an operator in an environment where regulations are unfavourable and you don’t earn enough to adequately cover your costs. But if we work backwards, we may also realize that an EPC will not do well in an environment where their client (the operator) may not make profits because few will venture into the industry if it is not profitable. And if few would want to venture into the industry, then demand for EPC works will correspondingly drop. Hence, even though the EPC will be a better play relative to operators in such environment, it may still not be such a good play overall on an absolute basis. Ideally, you want to be in a sector that works well for both types of company.

Regardless of which type of company, you need to choose one that is able to get debt and at a low cost. This is because this is a capital-intensive industry.

In particular, a company transiting from a pure EPC to a TOT/BOT operator will have greater pressure on their funding because they recover their cost over a much longer period of time than when they were doing EPC work, where they recover the cost + profit once they finished the construction. On this point, companies with the potential to improve their capital structure/ improve their financing cashflows via capital recycling through a water trust will be preferred.

In terms of size, we may want to look at mid-caps (what abt small caps?) This is largely due to the fact that contract size has reduced due to several factors – 1) companies are moving to smaller cities which are growing, need the infrastructure but need it on a smaller scale compared to the larger cities, 2) shorter payback periods for smaller plants, 3) its easier to scale up to meet increased demand than to scale down and risk having a plant running at low utilizations.

We could also switch the sequence of analysis around, look at sectors first than countries before we filter by companies. It might lead to a set of companies that are unique from the initial approach.

Filter…

§ By Countries
But following the initial approach, we see that the countries we want to invest in are likely to be emerging markets like MENA, Brazil, China and India. In particular, the list get reduced to Middle East, Brazil and China. North Africa is removed as it is unclear that clear favourable regulations exist. India may have a supply/balance imbalance but there is a surprisingly lack of coordinated effort to address that (just like their transport system). There might be other countries. Any suggestions welcomed.

I am particularly for a focus on China because I can get access to China-related stocks much more easily than companies which do Middle East or Brazil.

§ Sectors

In terms of these countries, low-priced water is a given. Hence, to expect huge tariffs hikes in these countries without the relevant public backlash might be unrealistic. Nonetheless, I note that China has proven an ability to hike prices in the recent years. More research need to be done here to ascertain the quantum of increase but it might still be better to play in segments with less risk of a public backlash.

Using our criteria list, we see that companies dealing with wastewater treatment plant and water recycling plants are the best placed to ride the trend. As water consumption increase, wastewater naturally increases. In particular, industrialization and urbanization often leads to hikes in wastewater volumes that need to be treated due to construction works. Wastewater plants may deal with the public (municipal) or it may not (industrial). Hence, you may have companies that do both and thus give you a portfolio of assets and exposures to both segments – one offering more stability (municipal), while the other offer the returns (industrial) Moreover, from a regulator’s perspective, a wastewater treatment plant kills two birds with one stone. Firstly, it helps increase supply of water as it reduces the pollution that brings water supply down. Secondly, it helps improve the pollution issue that governments are concerned with and help improve the overall standard of living.

Water recycling plants are equally attractive to a regulator because by recycling the water, you help to immediately increase the supply of water available (think x2) And recycled water is generally cheaper than other forms of new water supply (e.g. desalination) and suitable for use in industrial applications where water of high quality standards is not needed, which inevitably free up potable water for use by the general population. By the same vein, water recycling plants tend to concern themselves with the non-public sectors.

§ Companies
In these 2 sectors, I am personally for operators because I like the associated cashflow stability and the asset-heavy nature of the business. Makes it easier to value. Plus, volumes and in turn utilization should go up as demand growth is pretty rapid in emerging markets like China, especially with the rate of urbanization and industrialization which lead to increase in wastewater volumes.

However, I recognize that the true potential might lie in EPCs who are transiting to an operator model. Such companies are preferred because their earnings stream will increase in stability, and this will lead to improved valuations as investors preferred that. Hence, therin lies an opportunity but as mentioned, there is a risk here because of the financing stress which the companies might face. it is important to have a sound funding model due to increased stress on funding that comes with the change in the business model. Hence, the companies best positioned for this will be companies who already have a portfolio of assets which they can create a trust with. They could list the trust and use the trust as a capital recycling vehicle. Being able to do a trust will see a marked improvement in the financing structure and will represent a growth inflection point.

Lastly, choose mid-size (small size?) companies, with low cost of funding.

So in a nutshell, mid-cap (small cap?) Chinese water companies in wastewater and water recycling sectors, transiting from EPC to BOT/TOT model and has a portfolio of assets to create a water trust with. Need also to have a successful track record of growth/winning contracts, so that the capital raised from the water trust is able to fund growth.

Now, you just have to find that company!

"Mama say waterrrr is goooddd" - From the movie Water Boy

Water Analysis - Part II

Here are graphical representations of the gist of the analysis:

Water Analysis - Part I

Had an interest in water. Did some research. Here's some excerpt of my research:

1. Current Status

1.1. Global Distribution of Water


There is roughly 1.4bn km3 of water on Earth, of which 35m km3 (2.5%) is freshwater.

Of the total amount of water used globally, 65% is from surface water (rivers, streams and lakes). Just over 20% of water used globally is from groundwater.

1.2. Global Water Demand-Supply Balance

In aggregate, there is sufficient fresh water to meet global demand.

We only need10.5m km3 of freshwater to adequately supply the current 6.5 billion global population.

According to United Nations World Water Development Report, 2007 – providing universal access to the basic minimum of 50 litres a day per person would mean re-distributing just 1% of the amount of water used currently.

§ Key Issues
Hence, the key issue is not insufficient water globally but insufficient water locally. If we could export water to places where it is needed, then the problem will be solved.

But the water demand-supply balance is a very location-centric issue. Essentially, there is insufficient water supply in areas where we demand water. Particularly, the concentration of water demand in a smaller geographical area has increased stress on water supply.

In these areas particularly, the supply of water is falling even as demand for water is rising.
Moreover, the volatility/variance in water supply has also increased

At the core of it, it is a question of distribution of freshwater resource given spatial and time variations in its natural delivery – i.e. matching demand to supply.
Where we can’t effectively match demand to supply, the solution is to decrease demand and increase supply.

§ Measures of Water Deficiency
There are two measures of water deficiency as defined by the UN:

a) The absolute standard
Water stressed: <1700m3/person
Water scare: <1000m3/person

b) The relative standard – ratio of water demand relative to supply
High relative water stress: Demand/Supply >40%
Medium-high water stress: 20%> Demand/Supply > 40%


1.3. Global Water Supply

§ Overuse
Sharp falls in groundwater levels (in India, Australia, China and parts of the US, in particular) and natural reservoirs (for example, the Aral Sea) illustrate the unsustainable nature of water consumption patterns.



§ Pollution
Pollution has further reduced the available resource.
As one measure of river pollution, we can look at the Biological Oxygen Demand (BOD) of water. This is a chemical procedure for determining the rate of uptake of dissolved oxygen by the biological organisms in water. The higher the BOD reading, the worse the level of pollution.


§ Climate Change
Climate change will affect the volatility of water supply – where, when, how much and how water falls,

One of the main impacts of global warming is on glacial river flow. If the glacier disappears then so does the river (at least in the dry season).


In Australia, shifts in rainfall patterns (attributed to climate change) saw inflows into dams decreased by between 30% and 70%, according to the Australian Water Services Association. Brisbane came close to running out of water before rain late last year, according to the Australian Water Association.

It might also affect the overall level of water available in the system
1.4. Global Water Demand

3 main sources of water demand
1) agricultural demand – 70%
2) industrial demand – 22%
3) domestic demand – 8%

§ Increase in Population
Increase in population will naturally increase the overall water use.

§ Increased Water Usage per Capita
Not only has population been increasing but water usage per capita has increased too. This is natural given that water is a normal good and as GDP per capita increase, its consumption per capita will rise.

Growth in water usage has significantly outstripped population growth for three broad reasons:
(i) Rising real incomes have increased the demand for food and more water intensive food groups
(ii) Growth in industrial processes has added to greater demand for water
(iii) Tech advances & urbanization make it more convenient for people to use in greater quantity


§ Intensity of Demand
Rural/urban migration is increasing the stress on the supply/demand balance for two reasons:
(i) Increased water usage due to increased accessibility to water
(ii) a greater concentration of consumers in a smaller geographical area typically places increased pressure on neighbouring water resources (i.e., local water tables)

ARA Update

I still do not have time to write up a summary of the lengthy ARA analysis. My apologies.

I have time, however, for a quick update. On 13 Jan 2010, the Business Times reported that ARA is going to set up a REIT with CWT. This was mentioned in passing in a short paragraph in an article that is almost totally irrelevant (it was about the future of SGX as a listing ground). Makes you wonder if it was a deliberate leak. I take that back, lest I get sued.

On 14 Jan 2010, ARA and CWT came out and clarified that they are planning to put together a logistic REIT but nothing is firmed up. SGX has yet to provide the approval. But given that SGX is desperate to get more listing fees (especially since few Chinese co. are listing here, many are planning to go HK and the newest sign of desparation - proposing to allow SPAC (essential a backdoor vehicle for an SGX listin) on the exchange), this is unlikely to get in the way. The deal is more likely to fall through if ARA and CWT can't agree on the terms between themselves.

The potential listing of this REIT was first highlighted in the previous posting(s). And you know that favourite pet phrase they use on TV? I am going to say it - And You Heard It First on wIy.blogspot.com!

Stock has gone up in tandem since the announcement. Makes you wonder why it didn't move when they annouced the cooperation with Regency Group. Was it already all priced in before the annoucement? (someone knew someone who know someone who knew and had all bought the stock?) Or did the lack of price movement merely reflect an inefficient market and the price should move up further to price that in?

Something to mull on - investment food for thought.

The Fallacy of Debt/GDP

If you read the news, you will often read about economists, politicians and god knows who opining on countries having excessive debt/GDP ratio and it is all unsustainable because a debt/GDP ratio is bad. Now before you accept that and go down the street with a placard saying that the world is going to end, hang on and think - does it make sense?

What does debt/GDP ratio measure? GDP is akin to the income that a country makes annually - not unlike what my annual income is to me, which by the way is pathetic. So debt/GDP = debt/annual income.

To see why the debt/GDP ratio does not make sense, let us draw a parallel to a common situation that many of us have found or will find ourselves in. Let's say you want to borrow some moola from the bank. What does the bank look at when assessing whether to lend you some money? The bank will look at your debt/asset ratio. The bank will also look at your interest coverage ratio - income/interest payment. But does it look at your debt/income level? No! Because it doesnt make sense. The comparison is flawed because there is no basis of comparison between the numerator and denominator.

The correct way to see it is to look at the debt of a country versus its assets. But admittedly, it will be hard to identify and place a value of the asset. An alternative is to look at the debt payments versus the tax revenue of the country - a much easier analysis. And undoubtedly a more correct one. Moroever, this measure makes more sense, because when we talk about sustainability, we also bring into the concept of solvency - the ability to meet payments. A interest coverage ratio for the country shows that. A debt/GDP ratio does not.

I have yet to done the requisite work to prove this but I am pretty convinced that if we measure sustainability by a debt/asset or a debt payment/tax revenue method, we will see that many countries that are deemed to have a non-sustainable debt level is actually pretty much sustainable.

To include an additional dimension to the analysis, let us expand on the concept of sustainability. Sustainability does not just include the concept of interest coverage and leverage but also the ability to roll over debt. And also equally important - at what terms does the debt get rolled over at? Unlike an individual or a corporation, the government/country is in a unique position to influence the cost of debt. This is because the cost of debt is partially determined by the market (investors) and by the existence of alternative investments which price or return is partly determined by the country's monetary policy. And many a times, the reason why a country's debt gets to roll over may not be based solely on sustainability of the country's fiscal position but could very much be contingent on other factors not dissimilar to factors that influences a bank decision to lend more to existing high risk clients - e.g. a country is too big too fail.

In conclusion, I put forth the hypothesis that many countries have a sustainable debt level if measured by the correct measure. And if that is true, all these concerns by renowned economists are over-hyped. And if the markets move in fear of such concerns, that will represent a golden opportunity to profit at the misinformation of the masses.

Summary of "The General Theory of REIT Investment"

· Best REIT to buy is the one that can make yield accretive investments (raise DPU across time)
1. Discount to P/B
2. Sufficient cash on book so that they do not need to raise eqty to make acquisitions
3. Gearing is low so that don’t have to raise eqty to bring gearing down in order to make acquisitions
4. Able to secure low cost of debt and high leverage

· In circumstances where it is the best time to buy REITs, it is generally good for any real estate stock. So you are better off buying higher beta real estate stock in this environment.

· If you are buying REITs for yield, a REIT may be inferior to a fixed income product.

· Bond + developer stock may give a better risk/reward proposition than REIT+ developer stocks

· Angle 1: LT Hold – Buy when DPU is at a level below the average LR average level and is going up.

· Angle 2: ST Hold – Buy REITs when they are super depressed P/B wise and you buy to get an income stream while waiting for a recovery in the real estate/eqty mkt so that the share price moves up

The General Theory of REIT Investment

What is the Best REIT to Buy – The REIT That Can Make Yield Accretive Investments
Ceteris paribus, a REIT that can only make yield accretive investment is the one where div yield < leveraged asset yield. And that’s only possible when P/B >1

But it doesn't make any sense to buy something at P/B>1. Might as well go buy actual asset (if you can afford).

When P/B <1,> leveraged asset yield. Unless they make investment without raising new eqty.

Buying asset at discount is good (i.e. P/B <1).

But if REIT wants to make acquisitions and they do it via eqty raising (because they don't have enough cash), then it will bring yield down

We assume that book is asset – debt = eqty. There might be some random stuff within assets which is not the property.

So the best REIT to buy is the one that can make yield accretive investments (raise DPU across time)
1. Discount to P/B
2. Sufficient cash on book so that they do not need to raise eqty to make acquisitions
3. Gearing is low so that don’t have to raise eqty to bring gearing down in order to make acquisitions
4. Able to secure low cost of debt and high leverage

When is the Best Time to Buy REIT – When DPU will increase for the overall market
So far, we have been assuming ceteris paribus. So what is it that we have been holding constant?
1. Cost of debt
2. Amount of debt (Leverage)
3. Yield on assets
4. Capital values

Asset acquisitions may give a leveraged asset yield > dividend yield if
1. cost of debt continues to go down,
2. amount of leverage possible go up,
3. yield on new assets higher than existing assets
4. capital values going up

Capital values affect debt capacity. So when capital value go up, leverage possible can go up. Or when the credit market is looser – when banks are ready to lend more as % of asset.

Yield on assets increases when rents are expected to go up or when capital values are falling but rents are falling proportionately less because of mitigating factors such as long-term leases in place/rent escalation clauses, etc. (the latter don't hold because the capital value that matters is the price u paid for)

The best time to buy REIT is when
1. Cost of debt is expected to stay low or go lower
2. Credit environment improves – leverage % increases
3. Yield on assets are expected to go up - rents are going up
4. Capital values going up

But in circumstances where all these applies, it is generally good for any real estate stock. So you are better off buying higher beta real estate stock in this environment.

Why You Want to Buy REIT
Hence, the only reasons you want to buy REITs are
1. You want something with supposedly less volatility (REITs may not be less volatile?);
2. You have a yield objective that higher beta real estate stocks like developers can’t provide.
In the long run, you should only be able to achieve the average asset yield enhanced by the average level of leverage at the average cost of debt (aka the average leveraged asset yield)

· Because you buy REIT mainly for the income, you have to MIN[capital risk].

· Because this is a stock, not a fixed income product, you may not get back your capital at the end of the day, depending on the stock price.

· So in fact, REITs may be a less attractive proposition relative to some high-grade corporate bonds, where you face lower risk of default, better chance of getting something back if they default because you are a debtor not an equity holder, you are assured of your capital after X year and you may enjoy a higher return. Plus, your yield (DPU/your entry price) is not secured because of potential capital raising (your yield is volatile)

· The downside of bonds is that you may have no, if limited, capital upside. Movements in REIT’s share price arguably give you a capital gain component. But remember, the time when it is positive for REIT is when it is good for the general real estate sector. So buy higher beta stocks if you want to benefit from the upside. REITs are only good for income? --> I guess the other angle is to buy REITs when they are super depressed P/B wise and you buy to get an income stream while waiting for a recovery in the real estate/eqty mkt so that the share price moves up (i.e. get dividend stream when waiting) --> REIT are good in a depressed eqty mkt.

· The downside of bonds is that it is not inflation-adjusted. Rental stream of real estate arguably is. But may not be true because if you look at the rental levels of real estate, it has not been going up across time (e.g. SG office rent). However, one may say inflation is take into account using the rental escalation clauses. But this only works if you have such clauses. Such clauses do not exist for office market

Hence, a REIT may be inferior to a fixed income product. So you may want to consider corporate bonds instead.

REITs may be combined with real estate developer stock to give you a better risk/reward proposition. But in view of the above analysis, bond + developer stock may give a better risk/reward proposition. Diversification works better across asset classes (eqty + fixed income) May not work well in the same asset class and especially same industry class.

But if you still really really want to buy REITs……

When Is REALLY The Best Time to Buy REITs
Angle 1:
Given that you want to min capital risk, you need to buy in at a level where you are most unlikely to face capital dilutive issues.

Hence, you need to buy in at a level where
1. yield is sustainable,
2. leverage is sustainable,
3. cost of debt is sustainable
4. rental rates are least volatile – govt regulations involved

AND THIS WILL ONLY WORK IF YOU HOLD FOR THE LONG-TERM (10,20years?)

· So idea is not max yield but max sustainable yield.
· Buy in at a level where DPU is sustainable in the long run and expected to keep going up – Imagine a curve where DPU oscillates across time like.
· So best to buy when DPU is at a level below the average LR level and is going up. The ideal is bottom of DPU curve.

Angle 2:
Buy REITs when they are super depressed P/B wise and you buy to get an income stream while waiting for a recovery in the real estate/eqty mkt so that the share price moves up (i.e. get dividend stream when waiting)

Therefore, REITs are good in a depressed eqty mkt where you wait for the upturn.