Stocks of companies active in the water sector are looking oversold given the strong fundamental outlook for the sector, Boenning & Scattergood said Thursday.
Many water stocks are trading well off their 52-week highs as they head into 2019, even though the industrial channel is on a strong upward trajectory that should last through the new year, while the municipal channel is back on a steady low-single-digit growth path, analyst Ryan Connors wrote in a note.
“We believe the disconnect creates opportunity, with the market selloff providing compelling entry points in a number of high-quality names where both the tactical fundamentals and strategic stories remain intact,” he wrote.
Boenning & Scattergood’s top picks in the sector include water and wastewater utility Aqua America Inc. WTR, +1.06% consulting and engineering services company Tetra Tech TTEK, -0.19% and water technology company Xylem Inc. XYL, +1.68%
The industrial sector is in good shape with production rising 3.9% in November from the year-earlier period, according to government data, continuing a recent growth trend. At the same time, capacity utilization is at 78.5%, below the 80% threshold that suggests capital expansion, but the rate should improve if industrial growth continues, said Connors.
While some expect growth to ease in 20189, Connors views the sector as being on solid ground, citing lower corporate tax rates, tightening capacity, and secular drivers in industrial water. Falling oil prices are risky for pure-play energy names, but should lower costs elsewhere, he said. He named Ecolab Inc. ECL, +1.45% and Xylem as two names expected to benefit.
Turning to agriculture and irrigation, Connors said trade remains the wild card, especially in the soybean market, which has been hit hard by tariffs that have deterred China from buying from U.S. farmers. But the USDA recently raised its 2018 farm income forecast to $66.3 billion from $65.7 billion and benchmark corn prices are nearing breakeven for the first time since May.
“While there are many moving parts and volatility should remain elevated, the reward/risk equation is favorable for selected agricultural names such as Lindsay LNN, +0.97% (which is undergoing an internal restructuring that should drive margin gains even absent a cyclical rebound,” the analyst wrote.
In the muni space, bond issuance rose 20% in November from a year ago, while municipal water and sewer utility payrolls remain on a positive track, up 1% year-on-year. Water prices rose 3.5% in November and wage growth should allow water systems sustain an above-trend rate of inflation—the consumer-price index was up just 2.2% in November.
“Given that many municipal water systems have not yet achieved full-cost pricing, ongoing tariff increases are key to demand in the Municipal channel sustaining its growth over the long-term,” said Connors. He named Tetra Tech as a stock uniquely positioned to benefit.
The construction sector, on the other hand, is “the cloudiest among the four demand channels,” with rising home prices and rising interest rates creating affordability concerns, said the analyst. Housing permits rose 0.4% in November, while housing starts fell 3.6%. In the commercial sector, engineering and construction companies are expecting a slowdown in 2019, although sustainable design is a growing trend that might support demand for water-efficient systems. But that would make only a small difference, said Connors. “As a result, we believe investors should avoid concentrated exposure to the Construction vertical entering 2019.”
Among individual stocks, Advanced Drainage Systems Inc. WMS, +0.17% has fallen 0.3% in 2018, American Water Works Co. AWK, +0.99% has fallen 4.2% and A.O. Smith Corp. AOS, -0.63% has shed 31%.
Aqua America has fallen 16%, IDEX Corp. IEX, +1.42% has fallen 8%, Mueller Water Products Inc. MWA, +2.79% has fallen 36%, Valmont Industries Inc. VMI, +0.54% has fallen 35%, Watts Water Technologies Inc. WTS, +0.61% is down 17%, Xylem is down 7% and York Water Co. YORW, +0.45% has fallen 9.4%.
Gainers in the sector include Badger Meter Inc. BMI, +0.43% which has gained 0.6%, Ecolab, up 5%, Lindsay up 5% and Tetra Tech, which is up 4%.
The Invesco Water Resources ETF PHO, +0.79% is down 10% in the year. The S&P 500 SPX, +0.86% and the Dow Jones Industrial Average DJIA, +1.14% are down about 9%.