How to invest in 2 “forever” themes

Life can’t exist without water and modern life would grind to a halt without waste collection and recycling services, making them some of the most defensive investment thematics out there.

Cities of the world evolved around oceans, rivers, lakes and effective sanitation systems. For example, the aqueducts and sewerage systems of ancient Rome were key to the empire’s success. And in the present day, we’re reminded of the essential role safe water, sanitation and waste management play in preventing and protecting human health during infectious disease outbreaks such as the COVID-19 pandemic.

In the following interview, Fidelity International portfolio manager Velislava Dimitrova discusses some of her team’s top picks in ESG and impact investing. These include North America’s largest solid waste management company; a US leader in water treatment; and a highly defensive American water utility.

What are the secular drivers of growth in the sustainable water and waste markets?

The story of water and waste is as old as the story of civilisation. Most settlements flourished around water bodies and have evolved into major towns and cities, with the most successful demonstrating great water and sanitation systems. There are five unique long-term structural drivers behind both these themes.

The first is urbanisation. As the global population grows it is moving to cities, including megacities of more than 10 million inhabitants. By 2050, 70% of the global population will be in cities. These will demand more intensive water and waste industries with higher standards.

The second driver is the acceleration of consumption as wealth grows. As you get richer, instead of buying two shirts you might buy four, and that also means more water because not only does a bigger population use more drinking water, everyt hing we buy uses water. Moreover, 90% of what people traditionally consume becomes waste in less than 3 years.

The third key driver is pressure on infrastructure. In the developed world, infrastructure is ageing. Pipes are getting old, so you need to repair them; and perhaps 50-60% of global waste is not even properly collected.

The fourth driver is regulation. Water and waste regulation is a positive thing because it ensures investment creates real value and that the consumer can afford it. That creates a supportive environment for investment, and tougher standards also give birth to entirely new markets. Companies engaging in sustainable goals are turning more and more towards enablers to achieve their goals of water efficiency and waste optimisation.

The final driver is resource and scarcity. There is a limit to the amount of fresh water in the world with various studies showing that a major water gap is developing between existing accessible supplies of fresh water and the amounts drawn off by humans for domestic, industrial and agricultural use. On the waste side, the places that we can dump waste without processing or reusing it are running out or being regulated away.

Why should Australian investors look at these specific thematics versus other defensive investments that are available such as electricity, gas or even consumer staples?

The goal of the fund is to reward long-term investors by building a highly visible, sustainable cash flow story with diversification benefits. We do this through a high conviction, global equity strategy focused on companies in – or connected with – water and waste management. Both themes in the fund are perpetual in nature and will exist forever. 

The combination of the two themes along with our strong bottom-up fundamental research and focus on sustainability, gives us the opportunity to create a portfolio that:

• offers long-term returns by providing access to an under-researched area
• has a clearly stated sustainability objective while investing in an environment-related theme
• serves as a great diversifier in portfolios through specific sector and stock exposures
• is global in nature, but plays out at a local level.

Both themes in the fund are perpetual in nature and will exist forever.

Microsoft co-founder Bill Gates owns very large stakes in Waste Management (a company you also hold) and Ecolabs. Did Bill’s conviction influence your views on this space?

Bill Gates is a true visionary and has been seeking secular growth opportunities and diversification. I have been looking at both Waste Management (NYSE: WM) and Ecolab (NYSE: ECL) for a long time and like the fundamentals of both these stocks. Currently I own Waste Management in the portfolio but have also held Ecolab in the past – we time investments strategically based on fundamentals and catalysts.

In a recent white paper, your team said the future of the waste sector lies “ultimately in the move to a circular economy” as opposed to a linear economy. What does this mean, why does it matter, and is it a positive or negative for companies operating in this sector?

Failing to transition from a linear economic model of take-make-consume and dispose is not feasible in the long term. For our world to be sustainable, we have no choice but to move away from a linear economy to a circular economy. Predictable structural drivers will all force the adoption of a circular economy. It is no surprise that a few of the United Nation’s Sustainable Development Goals including SDG 9 – sustainable industrialisation – and SDG 12 – sustainable consumption and production – are closely aligned to the circular economy.

Given the broader aim of creating a closed loop economy, we would expect to see greater use of initiatives to manage waste locally, such as reverse vending machines and pay-as-you-throw schemes, as well as more investment in local recycling facilities.

As the global economy becomes more circular, the opportunities to turn waste into value should only increase. And as a result, so will the investment opportunities. Recycling companies and waste-to-resource companies are certainly part of our universe.

Can you explain how companies in this sector generate returns? For example, we know that utilities are often assured of a minimum rate of return to recover costs and undertake capex (regulated growth). How does it work for waste and water?

Regulated utilities can indeed make minimum returns, but they can optimise to create shareholder value. Over time, regulated utilities have been excellent investments as they have a defined process of value creation for each capital expenditure and operating expenditure at play. There are limited or even no subsidies in these frameworks unlike for wind, solar or energy efficiency companies. This limits regulatory risk over time.

More importantly, it’s important to highlight that typical regulated utilities only account for 20% of the universe and these companies are accustomed to dealing with regulation. They are in continuous contact with regulators and the process has been working very well both for companies and consumers.

Both within water and waste themes, there is an entire value chain to invest in. In water, there are opportunities ranging from pump and valve manufacturers to water treatment companies, and from network companies to metering and billing companies. Similarly, within waste, there are interesting investment opportunities including waste collection companies, general waste utilities, and speciality waste treatment firms. Waste solutions, recycling and resource recovery are bringing new investment horizons. The companies work like any other listed company to maximise value.

What are two of your favourite stocks in the portfolio right now?

Waste Management is the largest solid waste management company in North America, serving more than 20 million customers in the US. The company has its own integrated operations, which provide a moat – or clear competitive advantage – and resilience. Its main focus is on collection, which represents 55% of the business. As waste volumes are now growing faster than GDP, this is a key growth driver over the long term.

Recycling also presents a huge opportunity for the company, having recently acquired Advanced Disposal – the US’s fourth-largest solid waste company. This move is expected to be accretive to both earnings and cash flow.

American Water Works (NYSE: AWK) is one of the largest listed water utility companies by revenue in North America, providing drinking water, wastewater treatment, and other related services. It serves 1,600 communities in 16 US states, its services spanning residential, commercial, and industrial customers.

The company generates income from regulated contracts with pass-through clauses for costs and investments, which provide for strong visibility of earnings and cash flows. Growth in the company is likely to stem from increasing outsourcing activity as municipalities struggle to keep up with stringent water regulations. Less than 15% of the US water market is currently outsourced. Meanwhile, the defensive nature of its business potentially provides for resilient returns.

How would you best describe the investment opportunity that you are pursuing?

We always say that there is no economy without water, and no sustainable economy without waste management. To reiterate, this is a perpetual, global, sustainable and under-researched theme with long-term growth opportunities.

There are currently about 340 global companies we can invest in, with a market cap of about US$1.5 trillion, and it is growing every year. To illustrate this growth, some 30 years ago there were only about 30 names in this space, so the growth in three decades has been tenfold. And we expect around 10 new names to be added to the list each year from IPOs or spin offs as the trend builds momentum. We look at visible cash generation streams, value creation and sound balance sheets. Some parameters can offset others and we attempt to have a balanced view for each company in which we invest.

What excites you most about your role?

I really enjoy building the strategy and associating finance, ESG, and engagement with companies. We assess the constraints of the real world in our lives and transform them into investment decisions with an impact on our lives and our children’s future. With technology we can measure the exposure of the fund’s investments to water and waste solutions, which makes our work more tangible and enjoyable.

Learn more

Click here to visit the Fidelity Sustainable Water & Waste Fund Profile to learn more about the fund, fees and performance.

Click here to visit the Velislava Dimitrova Contributor Profile, to discover her investment philosophy and content.