Look to Water Utilities for Steady Growth

The utilities sector has been the No. 2 performer so far this year. And with estimates of up to $1 trillion needed for water infrastructure replacement, it looks poised to grow.

In this episode of Industry Focus: Energy, Nick Sciple and contributor Matt DiLallo answer listeners' top energy and industrial questions. Find out how the water utility industry is a perfect fit for yield-seeking investors; they also have some recommendations for water outside of utilities. Next they figure out how to play the natural gas/LNG oversupply. See how can you avoid stock capital gains. Finally, they  take a look at the lithium market.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Feb. 5, 2020.

Nick Sciple: Today is Thursday, February 13^th, and I'm Nick Sciple. Today we have a fun show planned for you. We've got a mailbag show hitting some of your top energy, industrials questions that you've sent over the past few months. Joining me today is Industry Focus contributor Matt DiLallo. Matt, how's it going?

Matt DiLallo: Doing good. How are you?

Sciple: I'm doing great, Matt. It's been kind of dreary around here in D.C. lately, but I'm trying to be upbeat and we're answering some fun questions here from our listeners today. Before we dive into that first question, though, just a question on the broader market. You look at how sectors are performing in the S&P 500 so far this year, the tech sector leading the way doesn't surprise anybody; energy has been struggling. But the surprising one for me here is, you look at utilities has been the No. 2 performer so far this year.

Matt, I know you invest in a lot of dividend stocks. NextEra Energy (NYSE:NEE) is a utility we've talked about on this show. What's been kind of your reaction to how utilities have performed so far this year?

DiLallo: Yeah, I'm not too surprised that utilities are doing well. We're seeing the Fed probably contributing a lot to that with keeping the interest rates low. And that benefits the utilities in two ways. First, they borrow a lot of money, so with the rates low, they can borrow money pretty cheaply. And then the other thing is, yield-seeking investors, they'll look for other opportunities when government bonds and CDs and things like that are lower, because Fed utilities are kind of a lower risk way that they can get yield. And so, they're kind of bidding up utilities searching for that yield, because 4% on a safe utility is better than 2% on a government bond. So, I think it's a lot Fed driven.

Sciple: Yeah. And that ties in right with our first question. Jeffrey wrote in, said, "First off, thanks for all that you do." He loves the show. He was hoping we could dive into the water utility industry. It seems that there's a huge amount of opportunity moving forward, since clean water is so important to living well. Additionally, a lot of infrastructure spending has been kicked down the road over the past several decades, however, he finds the opportunity to be compelling in this industry as a whole, but he's unable to differentiate between the many stocks which often have similar returns over the past three and five years.

Matt, if you look at the water industry, ETF has actually outperformed the S&P 500 over the past year. Any thoughts for Jeffrey on the water utility industry?

DiLallo: Yeah, well, just like the electric and gas utility industry, water is kind of drawing the same type of investors. So, you're getting the yield-seeking investors, and those are looking for low risk. So, they're going to move a lot in the same direction. And they're all growing the same way. They can't really raise rates on water supply to customers because of the regulations and things like that. So, you're going to get your steady growth out of most water utilities.

One of the big ones to look at is American Water Works, they're growing the earnings 7% to 10% per year over the next couple of years. And that's about what you'll get -- I mean, that's probably in the higher end for water utilities. And they can either acquire growth or they can build connections to new communities and things like that. So, it's not a fast-growing industry by any means. And that's why it's kind of a draw to income investors.

Sciple: Absolutely, Matt. I looked up a quote here from Deane Dray of RBC Capital Markets. He is the guy who focuses heavily on the water industry, and he talks about water utilities representing an important defensive growth part of the water sector. About 70% of the spending in this industry is break-and-fix. Meaning, you're replacing that infrastructure that's in place. Talk about, what Jeffrey said, about we've had years of underinvestment there. And the number that he puts out there is saying that there can be estimates of up to $1 trillion needed to replace existing infrastructure. So, there definitely needs to be investment there going forward.

Another area that I would look at, if you're looking at water outside of the utilities. We talked about -- almost a year ago -- I had John Rotondi on the show and we talked about A.O. Smith which is a water heater company, they also have exposure to water purification, particularly, in China, they've got some issues with that business. But that is an area where I think there's going to be a lot of growth, a lot of focus on clean water in countries in Asia and elsewhere. And I think that will be a growth opportunity for folks that are providing those kind of filtration systems. So, that's an area to look around. Danaher is a company that has exposure there. I mentioned AO Smith.

So, if you want to look to invest in water, that would be an area that maybe I would look at and think about paying attention to.

DiLallo: Yeah, I definitely agree. Those are different options, especially if you're looking for more of a growth... You know, somebody has got to supply all the things that go into water. Another thing that I've kind of been keeping my eye on is desalinization, and more overseas there's just some opportunities for infrastructure. And two companies that I've got my eye on are Atlantica Yield. They mostly focus on renewable energy, but they do have some desalinization plants that they've invested in. And they see desalinization being a $26.8 billion market opportunity over the next five years. And then, we talked about Brookfield in the past. Brookfield Infrastructure and then Brookfield Business Partners, they're both interested in water. Not big businesses, but they're making investments in that. And so that's kind of a sideway to play water.

Sciple: Absolutely. I think just fundamentally water is just -- if you look at Maslow's hierarchy of needs, it's pretty low-down on there. So, this is an important piece of infrastructure that we're just going to have to invest in and maintain. You know, nobody wants to be the next Flint, Michigan, that's for sure.

Moving on, Don asks, "Can you help me figure out how to play the natural gas/LNG oversupply?" He has some Brookfield Renewable Partners (NYSE:BEP). He says, he doesn't want to talk about shorting though, that the market can stay irrational longer than you can stay solvent. Matt, any thoughts for Don here?

DiLallo: Yeah, I definitely agree with trying to avoid shorting if at all possible, because I've been burned on shorting in the past. But, yeah, oversupplies in the commodity space, it's tough to get out of. You know, companies, they see the growth ahead and they almost always get ahead of themselves. And that's what we're seeing in natural gas. We know that there's an undersupply coming in LNG, probably in the next five years. And [...] is a company for investors to pay attention to, because they put out an annual outlook on LNG market. And they really see that we're going to need more gas, because countries like China are trying to get rid of coal and convert to natural gas.

However, in the near-term there's just this glut. And so, there's really two ways to kind of consider playing that glut. And that's looking at who's going to benefit, who's consuming gas? You look at demand. And your natural gas utilities, for example, petrochemical companies, the manufacturing, those are all companies that will benefit from low natural gas. There's other factors that play a role, you know, economic growth can impact those.

And then the other way is midstream. We talk about pipeline companies a lot on the show. And that's a good way, because it doesn't matter what the price of gas is, especially if they operate the long-haul pipeline. So, you know, kind of the interstate highway system of natural gas. So, your Kinder Morgan, your Williams Companies, TC Energy. They'll benefit as gas demand grows, which we see happening but there's risk there too. Williams has a lot of producer supply risk, because they gather a lot of natural gas. So, if there's bankruptcies that could be an issue. But they should benefit from no matter what happens with natural gas.

Sciple: Yeah. Natural gas has just been a really tough market. As you mentioned, Matt, with all this oversupply, it's driven the price down so low. And you've got all this flaring going on in Texas where it's cheaper to just burn the gas off than actually bring it to market. This is a tough place to be in. I think those are good places to look.

Our next question kind of touches on this market as well. Kenny asks, "Is Antero Midstream (NYSE:AM) a dividend play or a dividend trap?" He's very intrigued by the company, $0.30 per share per quarter in dividends, currently trading at $6.50 a share. "Is this a dividend trap? Will the dividend inevitably be lowered in the future?" Matt, any thoughts on Antero Midstream?

DiLallo: Yeah, I've been watching this company for a couple years now. And they were initially projecting that they were going to grow their dividend 30% per year for five years out in the future. And they have just been ratcheting down that outlook. It seems like every six months they're adjusting their outlook. So, my confidence in their management (inaudible 00:09:13) this forecast is, no shot right now. So, there's that, but the other thing I look at is the metrics for the dividend.

So, this year they expect to generate enough cash to cover it by 1.1 times. And that's a really tight coverage ratio. Right now, midstream companies are looking for 1.5 times to 2 times. And it's not looking good for the next two years, 1.1 times to 1.3 times is kind of what they're projecting. And that's well below what they initially thought. And a lot of that's because their parent company Antero Resources, keeps cutting back on what they're spending, so they're not growing as fast.

So, I would not be surprised to see a dividend cut here, if for no other reason, then they could use the buy back stock; which a lot of the companies are doing. So, I wouldn't buy for the dividend.

Sciple: Yeah, Matt, you mentioned this relationship between Antero Midstream and Antero Resources. You mentioned earlier, when we talk about some threats to midstream companies. When the E&P players, that are their customers have issues, when you look at Antero Resources, should we be worried about any of those concerns here in this case?

DiLallo: You know, it's really tough to tell what's going to happen with Antero. They projected one thing and it hasn't come to pass. One of their biggest issues, is they signed up for these long-haul pipelines -- which I really like long-haul pipelines, but they signed up for more space than they can handle. And so, they literally have to drill their way out of this problem. And so, they're actually contributing to the problem, because they need to grow their production, so that they're not paying for basically empty space pipeline.

And you've got a company that's really drilling themselves into a hole. And the question is, will gas prices support them in the future? And I'm getting really concerned about how these companies are operating? And I would be very careful with Antero.

Sciple: Yeah, to Matt's point. This is just a really tough industry right now. I would be very careful with any U.S. shale natural gas companies right now. Just really hard to see through those clouds on the horizon to see what the market looks like three to five years from now. So, just tread lightly and be careful.

All right, Matt, as we sit here today in 2020, we're looking back at a 10-year bull market. When you look at your portfolio today, would you say you have a lot of unrealized capital gains?

DiLallo: Thankfully, yes, it's been very nice being an investor for the past decade.

Sciple: Yeah, I think all of us, if you've invested over this time, it's been great. And that kind of ties in to what Stewart asked us. Stewart says, "I love your shows, I've had this question about stock capital gains and investing in real-estate opportunity zones. Is it possible to avoid stock capital gains tax by reinvesting them into real-estate opportunity zones?"

And I can answer this question. Yes, it is possible. I think for all these tax questions, I would talk to your tax advisor. We can't give personalized financial advice. But, with all that being said, if you look at opportunity zones, this is an incentive that was put in place with the tax cuts a few years back. Where state's governors were allowed to designate certain tracts in their state, up to 25% of census tracts in their state that met certain income requirements, as opportunity zones. And that allowed opportunity funds that either invested in real estate or businesses in those opportunity zone areas to create these opportunity funds. And what happens if you're an investor in an opportunity fund, you can rollover your capital gains from other investment gains into an opportunity fund and that allows you to defer capital gains on that original investment you sold and get a step-up basis as well. And in addition, the investment you make in the opportunity fund, if you hold up to ten years, you can end up paying no capital gains on that investment. Obviously, there's a lot of qualifiers in that, there's a lot of special rules about qualifying for an opportunity fund.

But, yeah, this is a huge opportunity that the tax cuts, back a couple of years ago, opened up. When you look at unrealized capital gains in the U.S. today, if I remember the number right, I want to say, it's in the trillions. So, large amounts of capital being opened up to invest in these lower-income areas. Obviously, there's a limited number of these areas and large amounts of capital, lots of folks want to take advantage of this being able to defer your capital gains. So, there's been a lot of competition for these investment funds. But this is an opportunity that folks can look into. And maybe we'll do a full show on this tax opportunity moving forward.

But, to answer Stewart's question briefly, yes, it is possible to avoid stock capital gains by reinvesting them into real-estate opportunity zones.

Okay. Moving on. Matt, our next question is from Amar. Amar asks, "What's the market for lithium producers, such as, SQM [Sociedad Química y Minera] (NYSE:SQM) and why has the market trailed the broader market by so much?"

You realize that SQM is not a pure lithium producer. Matt, do you follow the lithium market at all?

DiLallo: A little bit. It has a lot of overlay with the energy storage and renewable. So, it's definitely something that I'm trying to keep an eye on.

Sciple: Yeah. So, to briefly answer Amar's question, why has lithium producers as SQM trailed the broader market by so much. The brief answer is just oversupply. Morgan Stanley is forecasting the new supply from South America and Australia could add up to 500,000 tons of lithium to the market by the year 2025. That's about double the current annual supply. At the same time, we're seeing EV demand actually slow in the biggest market in the world, which is China, as they've slowed back on some EV incentives. That's why lithium, the metals' price has fallen about 40% in the past year. And so, this is just one of those instances where the demand drivers for the industry, EVs or storage batteries are growing at a slower rate than the supply is growing. So, that's really driven down the price of the metal.

Matt, when you look at lithium, obviously, there's been a massive oversupply. These suppliers have struggled. You know, it's obviously a play in this EV storage battery trend. When you look at that trend, is there another area of the market that you think, to play that trend, might be a more attractive investment or it might be less susceptible to these commodity swings than lithium?

DiLallo: Yeah, commodities are really tough. And I've been following oil and gas and metals for -- I think, I'm almost on ten years doing this. And it's very cyclical. And so, these companies, they get ahead of themselves and they see growth coming ahead and they start investing and it always gets ahead of themselves. And that's why I tend to like more of the infrastructure plays or your utilities. So, you know, kind of a backdoor way of playing lithium, if you want.

And we talked about NextEra Energy before, but they're really big. They're one of the leaders in energy storage. So, it's kind of the other side of that, they're consuming it. But they're almost banking that lithium prices and battery prices are going down because of all this overcapacity. So, it's going to improve their returns. And they're really seeing a big uptick, especially in solar plus storage and they see the cost of that coming down to being almost on par with efficient natural gas power plants in the next couple of years. So, that's my safe way of playing this whole area. Just because mining companies are just really tough, you have to have kind of an iron stomach to get through the booms and bust of it. And so, it's definitely not for everybody.

Sciple: Yeah. I think on these mining companies, you have to get a lot more things right to make money. So, you have to get right that demand is growing in that underlying market; so, in this case EVs and storage batteries. No. 2, you have to be right on the supply and-demand balance of other producers in the market. And No. 3, you probably have to time it right, because it's so cyclical. So, it's just really tough to make money in that market. An area that I would also suggest looking at is, when you think about the infrastructure that needs to go into developing these assets, if you're charging an EV or you're doing solar to charge these batteries. All of these need an inverter -- we've talked in the past about Enphase, SolarEdge, the inverters that they sell. I think that would be an interesting business to look at.

And then there's other businesses that make some of those products that go into EV. So, I would look into the components and I would look into the infrastructure, as Matt suggested.

Okay, Matt, last question for us, going away. Tomorrow is Valentine's Day. Love is in the air; do you have a stock that you love right now and why?

DiLallo: I've talked about my love for Brookfield several times on this show. And I'm just going to go with Brookfield Asset Management (NYSE:BAM), because I really couldn't decide between Brookfield Renewable or Brookfield Infrastructure. And Brookfield Asset Management is the parent of all these sub-companies. And they have renewables, they have infrastructure, they have real estate and then they have private equity. And so, you're getting into all these different businesses. But one of the things I really love about Brookfield other than they've been a fantastic stock, return very well, but their CEO and their management teams, they put out letters to investors every quarter. And they are second, in my mind, to Warren Buffett's letter as like a must-read for investors. They're very educational, they break things down, like, the economy and what's going on in different sectors. So, it's one of my favorite companies, just to learn about different parts of the economy and learn how to be an investor, and so I have a lot of affection for Brookfield.

Sciple: Yeah, Matt, I think Brookfield is a great one. As you mentioned, exposed to a lot of the trends that we talked about earlier on this show. And with as much as time as we spend talking about Brookfield and its underlying companies on this show, if we don't love it, you know, we're spending way too much time talking about it, Matt.

So, as always, thanks for coming on the show, thanks for sharing your insights and we look forward to having you again soon.

DiLallo: Thanks for having me.

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear.

Thanks to Austin Morgan for his work behind the glass. For Matt DiLallo, I'm Nick Sciple, thanks for listening and Fool on!