10 Mid Caps to Rule Them All

Seeking out the 10 mid caps to rule them all is the only logical follow-up to seeking the 10 small caps to rule them all. Unlike small-cap companies that offer investors the potential for high-risk, high-reward returns, mid-cap companies usually have significantly less risk built in because of their proven business track records. These companies either offer distinctive products or exceptional value to investors -- or possibly both.

For reference, here are the previous two weeks' choices:

This week I want to highlight a company that makes money from one of the most abundant resources on Earth, American Water Works (NYSE: AWK  ) .

What it does
As should come as no surprise by the name, American Water Works supplies water and wastewater services to residential, commercial and industrial sectors. The company's primary mode of growth throughout the years has been through acquisitions, but make no mistake that it is growing organically and increasing its operational efficiency.  Currently, American Water Works has operations in 35 U.S. states and 2 Canadian provinces.

How it stacks up
The primary draw of owning any utility stock is in holding a company that has a commodity that's in high demand -- the dividend that many pay is just frosting on the cake. Normally I would have veered toward electrical generation, but the demand for water is increasing at an equally impressive rate. Water is an underappreciated commodity that can add profits to your portfolio without adding the volatility inherent with other aspects of energy -- like oil, for instance.

The concern with American Water Works, as is common with most utility companies, is whether or not the cash flow is sufficient enough to cover the large debt load that it carries. The company is quickly nearing $6 billion in debt, but has thus far been able to not only cover the interest payments, but return a handsome 2.9% dividend to shareholders. I wouldn't go so far as to call this dividend lock-tight, but it seems to have plenty of earnings power to cover the payout to shareholders.

In fact, if you were to compare American Water Works' balance sheet against other companies in the water utility sector, its potential might surprise you:

Company

Price/Book

PEG Ratio

Dividend Yield

American Water Works 1.26 2.02 2.90%
Aqua America (NYSE: WTR  ) 2.59 3.68 2.80%
American States Water (NYSE: AWR  ) 1.69 3.04 3.30%
California Water Service Group (NYSE: CWT  ) 1.81 1.96 3.30%
Connecticut Water Service (Nasdaq: CTWS  ) 1.91 6.82 3.70%
York Water (Nasdaq: YORW  ) 2.39 3.79 3%

Source: Yahoo! Finance.

Note that American Water Works doesn't have the highest dividend of this bunch, or even the highest long-term growth rate (which goes to California Water Services Group), but it possesses the best all-around package of the group. York Water and Aqua America trade at the loftiest price-to-book ratios, while Connecticut Water Service and American States Water have significantly lower long-term growth rates. California Water Service possesses the greatest challenge to American Water Works, and even then the company falls short -- American Water Works is significantly cheaper on a book value basis and it sports a much healthier dividend payout ratio of 53%, compared to California Water Service Group's 65% payout ratio.

How it could make you money
Every water utility in that grouping above -- excluding American Water Works -- has a dividend payout ratio of 62% to 73%. This means that these companies are paying out a higher percentage of their earnings in the form of a dividend to shareholders. However, the higher the payout ratio goes, the more likely it is for a company to cease raising its dividend or perhaps even lower it. American Water Works' payout ratio of 53% leaves a lot of room for dividend increases without sacking its cash flow. Since relisting as a public company in 2008, the company's dividend has jumped by 10%, consistent with its long-term growth rate of 10.4%. Considering that the yield is still 2.9%, even after the stock's better than 50% one-year return, you can see why I feel future dividend hikes could be in the cards.

Another aspect to consider in this sector is consolidation. Normally you'd want to own the company being purchased, but this is one of those rare cases where I feel it makes more sense to own the buying company. American Water Works has made no secret that it's looking to grow through acquisitions and it'll likely need to be aggressive on th e purchasing front in order to maintain those double-digit long-term growth expectations. The more customers the company is able to service, the more pricing power it will have; and the better its pricing power, the more attractive it will be relative to its rivals.

Most importantly, owning a water utility gives your portfolio stability and nearly-guaranteed dividend income. With a five-year beta of only 0.38, you won't have a heart attack every time the market indexes nosedive 100 points. Water is an always-in-demand commodity and American Water Works' solid dividend growth coupled with its acquisition strategy could cause your portfolio to runneth o'er. For that reason, it belongs in the 10 mid caps to rule them all.

Do water utilities have you gushing with excitement? Share your thoughts in the comments section below and consider tracking the latest news on American Water Works, as well as your own personalized list of companies, with My Watchlist.

Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong. Motley Fool newsletter services have recommended Aqua America and California Water Service Group. The Motley Fool owns shares of California Water Service Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy that always wears a life vest in the deep end of the pool.


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