This article was originally published on April 18, 2015 and was updated on Sept. 15, 2016.

I'm going to gush about water stocks, which in my opinion will remain one of the best places to safely grow money over the long term, particularly as part of a dividend-reinvestment portfolio. Water-related stocks in general have been getting more attention recently due to California's epic drought and Flint, Michigan's horrendous water system crisis. But it still seems to fly under many investors' radars that the best water stocks, such as American Water Works Company (NYSE:AWK), sport a powerful combination of market-beating long-term returns at less-than-average volatility.

A word of caution: Water stocks have soared since this article was first published. The group is likely to continue to experience pullbacks over the near- and mid-terms, as valuations are high, but I believe the space still has the potential for outperformance over the long term. 

Water Droplet Timing Water Droplet Pixabay Least High

Source: Pixabay.

Spouting off the reasons to love water utilities

  • They're generally monopolies -- or at least primarily monopolies.
  • Fresh water supply is limited and demand should grow as the world population increases and as a greater percentage of the population moves into the consuming classes.
  • Water has no substitutes.

The publicly traded water utilities

The water utility industry in the United States is heavily comprised of countless small municipal-owned and operated systems. Only 12 water utility stocks trade on major U.S. stock exchanges, and only nine have market caps of at least $300 million, meaning they're small caps or larger. 

Water utility stocks with market caps of at least $300 million

CompanyMarket CapDiv. YieldForward P/EProjected Average Annual EPS Growth Next 5 Yrs.1-Yr Total Return 5-Yr Total Return
American Water Works   $13.7B  2%  24.2  7.6%  44.1%  183%
Companhia de Saneamento Basico (NYSE:SBS)  $6.7B  0.7%  2.3  35.1%  118%  16.5%
Aqua America (NYSE:WTR)   $5.5B  2.6%  21.2  6%  21.4%  95.2%
California Water Service   $1.5B  2.3%  22.4  9.1%  52.4%   97.1% 
American States Water (NYSE:AWR)  $1.4B  2.4%   22.3  4%  0%  156%
SJW Corp.
 $916M  1.9%   23.3  14%  51.1%  116%
Middlesex Water  $556M  2.4%  N/A  2.7%  51.1%  124%
Connecticut Water  $551M  2.4%  21.1  6%  38.8%  108%
York Water  $392M  2.2%  28.0   4.9%  38.2%  93.6%
S&P 500    2%       12.4%  101%

Data to Sept. 15, 2016. Div = dividend; P/E = price-to-earnings; EPS = earnings per share. Returns that have beat the S&P 500 are bold-faced. Data sources: Finviz.com and YCharts.  

Two of the nine stocks included in the chart were not included in the analysis:

  • Companhia de Saneamento Basico -- known as "Sabesp" -- operates in Sao Paulo, Brazil. It has some compelling features, but it's best suited for investors comfortable with higher risk due to the political turmoil in Brazil, fluctuations in foreign-currency exchange rates, and frequent water-supply concerns due to droughts. 
  • SJW Corp. is not a pure play -- it has significant real estate operations.  

Large relative size provides a competitive advantage 

Large size relative to peers/competitors provides water utilities with a major competitive advantage. This is a primary reason why American Water Works remains my favorite in the group. The water utility industry is extremely fragmented and capital-intensive, so the bigger companies are more likely to have the resources needed to acquire smaller utilities. 

1. American Water Works: The geographically diversified industry giant

Awk

American Water Works provides services to approximately 15 million people in 47 states and one Canadian province. Its regulated business provides water and wastewater services in 16 states, while its nonregulated segment primarily builds, operates, and maintains water and wastewater facilities for military bases throughout the country. In 2015, it acquired Keystone Clearwater Solutions, which supplies water and related services to natural gas exploration and production companies for hydraulic fracturing -- "fracking" -- in the Appalachian Basin. 

The Voorhees, NJ-based company's large relative size means it's likely to continue to have the resources to gobble up smaller water companies. Its geographic diversity allows for greater efficiencies, as it can often expand its operations without adding entirely new management teams.
 
Analysts expect American Water's earnings per share to grow at an average annual rate of 7.6% over the next five years, the second-highest growth rate (behind California Water Service's 9.1%) among the seven companies in our analysis. The company has increased its dividend every year since it went public in 2008. 
 
One thing to watch -- while American Water's debt-to-equity ratio has been coming down, it's still the highest among our group. It's 1.3, while most of the others are in the 0.7 to 1.0 range. This is OK in such a low interest rate environment, but could become a concern if rates appreciably rise.  

2. Aqua America: Relatively large & decent geographic diversity

Aqua America Logo

Aqua America provides water and wastewater services to approximately 3 million residents in the eight states of Pennsylvania, Ohio, Virginia, North Carolina, Illinois, New Jersey, Indiana, and Texas. Like American Water Works, it also has an unregulated market-based business, and has grown via an aggressive acquisition strategy. In 2012, as part of a joint venture with Penn Virginia Resource Partners, Aqua America began supplying water to energy producers for fracking in the Appalachian Basin.  

The suburban Philadelphia-based company sports the highest dividend yield in the group, making it particularly compelling for investors more concerned with current income than total capital appreciation. It's paid dividends for 70 consecutive years and has increased its dividend for 23 consecutive years. Aqua America's trailing-12-month profit margin is 25.4%, the second highest (behind York Water's 26.3%) of the nine stocks in the chart. As a benchmark, American Water's profit margin is 15.1%, which is in the middle of the pack among the stocks in the chart. 

3. American States Water: Great long-term record, but challenges abound 

American States Water Company Logo

American States Water primarily operates as a regulated water utility, with its Golden State Water subsidiary supplying water to approximately 260,000 customers in 10 counties in Northern, Coastal, and Southern, Calif. It also provides electric service to about 24,000 customers in the Big Bear Lake region. Additionally, it has a nonregulated business that operates and maintains water and wastewater systems on military bases throughout the U.S. 

American States is a long-term winner, reflecting the company's reputation as being very well run. Moreover, it's paid dividends every year since 1931, increasing the payout each year since 1954. Most investors, however, should probably hold off on investing in the company for now due to some considerable uncertainties and challenges.

A primary uncertainty involves its rate requests for 2016 through 2018; it's still awaiting news from the California Public Utility Commission (CPUC). A main challenge had related to declining revenue due to mandatory water restrictions in drought-stricken areas of California. While these restrictions were lifted on June 1, much of the state is still in a drought, so challenges remain.

 

Beth McKenna has no position in any stocks mentioned. The Motley Fool recommends Companhia de Saneamento Basico. 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.