J O Hambro Capital Management’s Bertrand Lecourt and Saurabh Sharma, managers of the Regnan Sustainable Water & Waste Fund, provide an overview of this niche but important area of sustainable investing.
Companies in the water and waste theme are affected by inflation, rising rates and market volatility, but they tend to be especially resilient. Their investment for growth is often ultimately driven by social and ecological need and regulatory compulsion, while they provide services that no one can do without. There is no economy without water, no sustainable economy without waste management.
See-sawing equity markets
After having a tough 2022, global equity markets started 2023 on a strong footing. Signs of easing inflation supported sentiment and the market started to weigh in on expectations of a peak in interest rates. Sentiment also got a boost from China dropping its zero-Covid policy. Given the backdrop, growth-oriented sectors like consumer discretionary and technology led the rally, significantly outperforming more traditional defensive sectors like healthcare, utilities, and consumer staples. This was a reversal trade of what had happened in the full-year 2022.
Water has outperformed waste
As a collective group, both integrated solid waste and industrial waste beat the broader market in 2022. Most of this outperformance came in the first three quarters of the year led by three fundamentals:
1. Pricing – where our companies could easily price through inflation
2. Good volumes – new business formation was better than forecast
3. Mergers and acquisitions – 2022 was another good year for corporate activity
What matters to the long-term investor is the fundamentals, which remain strong. We expect overall earnings and free cash flow to be up year-on-year for our companies in 2023. The current share prices are factoring in a slowdown, especially in the second half of the year. If we were to see a soft landing which is what the broader market expects, these stocks can rerate quickly.
Looking into Earnings Season
The overall earnings season for our companies was broadly in line with our expectations apart from a couple of surprises. Broadly, waste-related companies had a good calendar Q4 2022. Pricing was better than expected and opened strong for 2023. Sustainable investing capex plans were a key theme across multiple companies and will be a focus area in the coming years.
For water equipment companies, the last quarter was dominated by inventory reductions which were putting pressure on manufacturing demand. There were also tailwinds from carry-over pricing and productivity.
Companies like Watts Water and Pentair focussed on taking action on ‘cost structure’, which will offset potential moderation in demand. Guidance around capex spending for 2023 was also supportive of long-term growth plans with reshoring/supply chain investments taking strategic priorities.
Water utilities continued to have a tough run seeing multiple compression and facing macro challenges including higher inflation and interest rates. Nevertheless, their stable earnings model bodes well in an uncertain macro environment.
Purity back in the conversation
Our investors have always wanted us to have an elevated level of thematic purity both at a stock and portfolio level. A few of the stocks that have come up in conversations include Danaher and PerkinElmer, both of which have been in the news recently.
Danaher announced in late 2022 its intention to separate its Environmental & Applied Solutions segment (c 16% of the company) to create an independent, publicly traded company. The new company will be comprised of Danaher’s Water Quality and Product Identification businesses. As announced in February 2023, the new company will be named Veralto. We will be keeping a close eye on the development of this deal (expected to complete in Q4 2023) but in our view, had management decided to spin off just the water business as a stand-alone pure-play water business would have attracted suitors with buyout offers.
In the second half of 2022, PerkinElmer announced that it will be divesting its food safety, environmental testing, and industrial quality assurance divisions to focus on its core life sciences and diagnostics business. Any water focussed fund holding PerkinElmer became forced sellers of the stock as the company now had no water exposure.
Back to fundamentals
As difficult as it is to make a call on near-term macro-outlook, this year feels more difficult than average to provide a firm outlook. We are currently in one of the most aggressive hiking cycles in history and it hasn’t finished yet.
In this environment, where experts are split in their predictions between a ‘soft’ and ‘hard’ landing for the economy, we believe real assets and related core services with asset-backed cash flows are likely to present opportunities. In our view, the water and waste thematics continue to offer sound valuation, with favourable ROE, net debt and cash flow characteristics.
We stay diversified within our portfolio, focusing on bottom-up stock selection. Similar to last year, we expect volatility to create buying opportunities. Any reallocation in sizing and industries within our universe will emerge from the earnings seasons to remove uncertainties from the ‘real’ economics and reset valuation opportunities.
