Why the Best Is Yet to Come for American Water Works Stock

American Water Works (AWK 1.69%) stock, along with its water-utility peers, has had a great run over the past few years. Moreover, it's crushed the S&P 500 and handily beat the performances of all other water utility stocks since the company went public in 2008.

After returning 414% since its IPO, versus the broader market's 116% return, through June 23, some investors might wonder if American Water stock's best days are behind it. While the stock may have more pullbacks over the near and intermediate terms, following are two major reasons I believe the best is yet to come for the stock of the largest publicly traded water and wastewater utility in the United States.

Image source: Getty Images.

1. Fresh water will probably become more precious (and costly)

The world has been in a long-term warming trend for some time. Whether this trend is due to our human activities -- what is generally meant by "global warming" -- or to natural cyclical factors, or perhaps to some combination of both, isn't material to this discussion. The fact is that average temperatures in the United States and many parts of the world have been rising. There are many ramifications of this warming trend, including that it could cause the supply of fresh water to shrink and demand to increase.

Economics 101 says decreased supply of and/or increased demand for anything that we have to pay for results in an increase in price when demand is inelastic to some degree -- and fresh water probably has the most inelastic demand of the gazillions of products on the market. There are no substitutes for fresh water, and most of us would perish without it in just a few days. 

As the commodity they provide becomes more and more precious, water utilities are increasingly going to be in positions of strength with respect to rates when dealing with regulatory boards, in my opinion.

Data by YCharts. American Water's acquisition advantage and prowess is one reason for its stock's superior performance. 

2. American Water has considerable room for growth by acquisitions

The water and wastewater utility industry in the U.S. is highly fragmented, with the vast majority of systems owned by entities other than investor-owned companies, such as American Water. Municipalities, of course, are big players in this country's water and wastewater industry.

The good news for investors in water utility stocks is that many municipalities are cash-strapped, so they're selling off their water and/or wastewater systems to publicly traded companies. And the even better news for investors in American Water is that the company has a considerable advantage over its peers when it comes to scooping up the increasing number of municipal systems that are coming on the market. In fact, 2016 was a record year for the company, in terms of acquisitions.

American Water's competitive advantage stems from two of its traits that are very unlikely to change over time -- which means the advantage should prove sustainable: its industry-leading size and geographic diversity. The following chart shows how much bigger and more geographically diverse it is than the next two largest water utilities operating in the United States.

Data sources: Yahoo! Finance and company websites. MRQ = most recent quarter.

American Water's size provides it with more resources than others in the industry to make acquisitions. Its top geographic diversity means that its pool of potentially attractive acquisitions is larger. Water utilities are unlikely to buy up smaller players at distances from where they currently operate, as it isn't cost-effective. 

The geographic diversity also helps limit American Water's risk from region-specific issues, such as droughts. Such adverse weather conditions can increase operating costs, which utilities then have to try to recoup after the fact, through requests for rate increases. 

Wrapping it up

With fresh water likely to become more precious because of the Earth's warming trend, water utilities will wield more power with regulatory agencies, in my view. This scenario, coupled with the fact that American Water is in the catbird seat when it comes to making regulated acquisitions, are two major reasons I believe the best is yet to come for country's largest publicly owned water utility and its long-term investors.