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Among the many features found in each week’s edition of Value Line’s Selection & Opinion is a list of the seven best and worst performing industries over the past six weeks. These rankings can be found on the inside back cover of Selection & Opinion. The 1,700 stocks in the Value Line universe are currently divided among roughly 100 industries. Notably, for the purposes of calculating these results, the performance of each stock is equally weighted to the others in its industry (i.e., irrespective of market capitalization).     

Our latest Industry Price Performance rankings still show the effects of the slump in the equity markets during late September and early October. Granted, stock prices rallied strongly in the final two weeks of our measurement period, which stretched from September 16th to October 28th, bringing most of the leading benchmarks back to within a percentage point or so of the heights reached in mid-September. In this unsettled environment, the volatile Biotechnology group was the top performing industry, rising 8.3% to edge out Restaurants (8.0%). Four of the next five slots, though, were held down by defensive industries: Natural Gas Utility (6.4%), Electric Utility-West (6.3%), Electric Utility-East (6.2%), and Water Utility (5.8%).      

In looking for investment ideas among the seven best-performing industries, we are focusing on Water Utility stocks. Income is probably the most prominent investment attribute of these equities. The nine water utilities that we currently follow all pay a dividend, with most paying out 50% to 60% of their earnings each year. And the yields for these stocks typically range between 2.5% and 3.0%, comfortably above the recent Value Line median of 2.1%. Other characteristics of the water utilities, such as well-defined earnings streams, low business risk, and relatively tame share-price movements, are also likely to appeal to more conservative accounts.    

Readers will probably note that water utilities share many of the same investment characteristics as electric utilities. At the moment, though, we think many investors, particularly those with a long-term orientation, will find that water utilities generally provide the more appealing options. The average yield for the water utilities is normally a bit below that of the electrical utilities (which is usually between 3% and 4%), meaning investors will have to sacrifice some income at the outset. Still, over time, we think the faster dividend growth and wider share-price appreciation potential offered by many of the water utilities will more than make up for this. In particular, valuations for many of the electric utilities appear to leave room for little upside in their share prices over the next 3 to 5 years.   

For those looking to dip their toe in the water utility space, we think investors would be well served taking a closer look at the U.S.’s two largest players, American Water Works Co. (AWK) and Aqua America (WTR). American Water is the largest investor-owned water and wastewater utility in the country, serving about 14 million people. The company generates roughly $3 billion in annual revenues. A quarter of this comes from its home state of New Jersey, though it also operates in about 30 other states and Canada. Aqua America, by comparison, has about 3 million customers. It generates more than half of its nearly $800 million top line in Pennsylvania, but also has sizable operations in Ohio, Texas, and a handful of other states.        

Of the two, American Water has the more appealing near-term earnings outlook, with 2014 share net likely climbing 14% over the prior year. Aqua America, on the other hand, has been finding it difficult to improve upon a very successful 2013 (when profits advanced more than 30%), and will likely have to settle for a low-single-digit gain on the bottom line this year. Looking into the second half of the decade, both companies should be able to keep earnings moving ahead at mid-single-digit rates each year, and dividends will likely rise at a comparable pace.        

In particular, acquisitions ought to continue providing opportunities for these two water outfits to further expand their profit streams. Across the U.S., many water systems are still run by local authorities and many of these entities can serve as appealing bolt-on purchases. (Aqua, for example, will likely complete about 20 tuck-in acquisitions this year.) In many cases, finding the funds necessary to perform needed maintenance on or replacement of aging pipelines is a challenge for these small operations. The larger water utilities, such as American Water and Aqua, are better able to access the capital necessary for these upgrades, while also creating sufficient synergy savings to generate a worthwhile return on their investment. Notably, the two companies make similar use of debt to fund their operations, with borrowings accounting for about 50% of total capital in both cases.    

From an investment perspective, AWK and WTR have a lot in common and both appear suitable for more conservative, income-oriented investors. Those looking to add some additional downside protection to their portfolio in the event of a recurrence of the recent broader market selloff may wish to take a closer look, as well. Overall, we would give the slight edge to Aqua America, as it has a slightly better track record of delivering return on shareholders’ equity (typically in the low-double digits versus the high-single digits for American Water). Too, we think Aqua is in a modestly better position to handle the heavy spending that water companies need to do to upgrade and replace their existing pipelines and facilities. In particular, the company’s strong operating cash flow means it ought to have less need for additional debt and equity to fund its capital spending requirements.  

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.