The water industry provides life's most basic necessity by supplying fresh drinking water to our homes and workplaces, while also taking away and treating wastewater and sewage. Demand for these services tends to be relatively stable and grows alongside population and the economy. Because of that, water utilities typically generate a growing stream of cash flow, which enables publicly traded water stocks to pay steady dividends.
That growing income stream has been in high demand by investors in recent years. In fact, they have bid up the stocks of large water utilities American Water Works (AWK 0.16%), Aqua America (WTRG 0.08%), California Water Services (CWT 3.18%), and American States Water (AWR -0.64%). Because of that, all have vastly outperformed the market, which pushed their dividend yields down to the point where most are right around the market's average of 1.8%. For example, Aqua America and American Water Works are just above that level at 2.1% and 1.9%, respectively, while American States Water and California Water Service either match or fall below the market average at 1.8% and 1.6%, respectively. Not only are those yields no longer appealing to income-seekers, but water stocks have become rather expensive, with this group selling for around 30 times earnings, which is pricey even in today's red-hot stock market.
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That said, there is one emerging water stock that stands out: Brookfield Infrastructure Partners (BIP -1.33%). Not only does it offer nearly double the current yield of most other water utilities at 4% but it has a much more reasonable valuation to go along with solid growth prospects and ample untapped upside. Here's a closer look at the factors that make it the top water stock to buy right now.
A well-diversified cash flow stream
Brookfield Infrastructure Partners is one of the largest global infrastructure operators in the world. The company currently makes most of its money by operating utility-like businesses, which includes a coal terminal in Australia, a natural gas transmission business in Brazil, and an electric and gas utility in the UK. In addition to that, the company also owns ports, toll roads, rail lines, and cell towers. These businesses generate very stable cash flow, which gives Brookfield the money to pay a lucrative distribution to its investors.
However, one place where it doesn't make much money at the moment is water. While it owns Poseidon Water, which is a leading developer of water treatment projects in the U.S., and Australian water utility Flow Systems, these businesses don't currently provide it with meaningful cash flow. Furthermore, while the company is in the process of acquiring a water irrigation system in Peru for $15 million, this investment won't move the needle either.
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Focused on making a big splash in water
That said, while small right now, Brookfield Infrastructure Partners expects its water business to be a meaningful contributor in the coming years. That's because it sees an enormous opportunity to make investments in critical water infrastructure. CEO Sam Pollock highlighted this in the company's second-quarter letter, writing that:
Our interest in water infrastructure exists because it provides arguably the most essential of services -- the provision of clean, fresh water for consumption and irrigation -- and is a critical input for many industrial processes. Water assets generally benefit from both scarcity and high barriers to entry, frequently producing stable, inflation-linked cash flows that are underpinned by either regulatory frameworks or long-term supply relationships with strong counterparties, such as municipal governments and industrial customers. As the world's population grows and development and urbanization continue apace, demand for water will follow, highlighting the need for considerable additional investment in water-related infrastructure. It is well-documented that developing nations require the build-out of new projects to provide access to safe water for drinking and agricultural uses. At the same time, developed countries face issues with aging and ineffective infrastructure, and the declining quality of existing water resources. Given this growing capital need and amid ongoing concerns regarding droughts, floods, and water quality failures around the world, we are observing growing interest in privately funded solutions.
To put this opportunity into perspective, the company pointed out that the gap between the investment needed to maintain and grow global water infrastructure and the currently projected government spending level would be a jaw-dropping $6.7 trillion through 2050. Because this is such a vast opportunity, Brookfield plans to focus on three areas to grow its water business: supply, transportation, and recycling.
On the supply side, the company sees the refurbishment of aging infrastructure and building desalinization plants as two avenues for expansion, with its investment in Poseidon Water potentially driving this growth. For example, the company noted that Poseidon could develop a $1 billion desalinization project in California, and that it's also pursuing similar opportunities in both the U.S. and Chile. Meanwhile, irrigation infrastructure such as reservoirs, channels, and pipelines could be among the transportation projects it invests in over the coming years, with it potentially building off the platform it's buying in Peru. That deal, which is part of a partnership with global water giant Suez, could lead to other investment opportunities with Suez in the future. Finally, the company also sees the potential to invest in greywater purification facilities, which would recycle water from sinks and showers for reuse in things like irrigation. Brookfield believes that there are more than enough opportunities for it to grow its water business into a multi-billion-dollar enterprise in the coming years.
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A larger, fast-growing cash flow stream for a much lower price
While Brookfield Infrastructure Partners expects water to be a significant growth driver in the future, it isn't factoring that upside into its current forecast. Instead, Brookfield's guidance banks on its existing portfolio of infrastructure assets, which should organically increase earnings at a 6% to 9% annual rate over the next several years, enabling it to raise its high-yielding payout by 5% to 9% per year. For perspective, that's right up there with American Water Work's industry-leading forecast of 7% to 10% compound annual earnings growth through 2021. However, Brookfield could easily trounce its guidance and grow much faster than American Water Works and other water rivals as it expands its water business.
That said, what tilts the scale firmly in Brookfield's favor as the best water-related stock to buy is its much cheaper valuation, with it currently selling for just 15 times cash flow. That lower price, when combined with its higher payout and equally compelling growth prospects, could provide Brookfield with the fuel to outperform most water stocks in the coming years, especially if it can quickly build out its water business and produce results well above the high-end of its guidance range.
