China’s pollution problems are well known. A 2015 study linked pollution to nearly 1.6 million deaths each year, or approximately 4,400 deaths per day in the Asian nation. The international non-profit firm WaterAid estimates that nearly 4.5% of China’s population, or 63 million people, do not have access to safe water. When there is a problem, free market systems typically look to provide a solution. There could be a solution to China’s problem in the air, water and ground that will benefit investors who invest properly in the region, a July 27 Morgan Stanley research paper concluded.

Also see Michael Burry is focusing all of his trading on one commodity: Water

 

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China’s government engaging in fiscal spending designed to reduce pollution, better the lives of its citizens, and enter into a strong and long-lasting economic market

pollution photo
Photo by Ben_Kerckx (Pixabay)

As China’s water supply shortage increases while water quality deteriorates, there is a trend afoot in the communist nation that has embraced a slightly government-controlled version of capitalism. They look at “going green” from two primary standpoints: not only cleaning up their environment — considered a risk to Chinese ruling party control — but they also look at this as a method to point their economic engine into a profitable long term direction.

The Morgan Stanley report takes on one issue – capacity improvement, where stock market opportunity is identified – rather than the more societal-wide issue of supply easing.  With this in mind, a tipping point is upon the markets, Morgan Stanley’s regional equity analysts Joesph Lam, Simon Lee and Qin Zhang observe.

“Although capacity growth in China’s water segment is not a new idea to the market, we think it is now at an inflection point, with increasing government focus amid deteriorating water supply and quality, as well as China’s efforts to transform to a new economy, embracing green development,” the report says.

This inflection point is not only going to reduce pollution in the region, but may be an introduction into a globally hot market. As the emerging world emerges into increased wealth and discretionary spending capability, the strains on the earth will be felt in many areas. Depleted natural food stocks in oceans and fresh water – some of it a result of pollution – is one inflection point.

The other is the subject of Michael Burry’s core investment thesis: fresh, consumable water, a mostly taken for granted commodity in developed worlds, is a hot investment. Burry is not alone. Desperately dry Saudi Arabia has made an investment in water that points to a growing thesis the Chinese are beginning to harvest. The question is: who will be the regional winners and losers?

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Three value standouts Morgan Stanley picks

Considering the value chain, authors Lam, Lee and Zhang think the “sweet spot” is wastewater treatment. Given government support for investment in new capacity as well as existing upgrades, recycled water and sludge treatment could be the primary beneficiaries from China’s nascent green movement, as nearly 535 billion Chinese yuan could be devoted to the effort, Morgan Stanley estimates.

This government investment has not been fully factored into the market, the report observes, leaving opportunity available. What the market has been focusing on is receivables collection risk, which has led to a valuation mismatch since 2015.

Given their underlying bullish thesis on the market opportunity, Morgan Stanley initiated coverage on four stocks, affording overweight ratings to: Beijing Enterprises Water (BEW), Guangdong Investment (GDI), Beijing OriginWater (OriginWater) and affording equal weight standing to Beijing Capital (BJ Capital).

While short-term metrics are not conclusive in analyzing the success of this stock selection, Beijing Enterprises Water has nonetheless been trading higher nearly one month after Lam, Lee and Zhang made their initial picks. BEW was trading at 4.68 in Hong Kong July 27 when the report was released and has jumped almost 4% to trade at 5 HKD today.

Morgan Stanley likes the stock due to its positioning to capture growth, its government relationships as well as the financial management picture. From a valuation standpoint, the stock’s price-earnings ratio is trading at a standard deviation below its historical mean, the report observed, pointing to value.

Beijing OriginWater (OriginWater) is positioned to capture opportunity as water standards rise and the development of nontraditional water sources becomes an issue. The company is trading at a discount to peers and its management and employees are aligned with shareholders as far as owning stock and being given stock options as incentives, the report noted.

Guangdong Investment (GDI) is viewed as having meaningfully positive merger and acquisition opportunities with a strong cash flow. Given its stable business offerings, there is limited downside even if the anticipated merger activity does not materialize. The price earnings is low on a relative basis yet balance sheet and dividend are in line with peer mean performance.

There are of course risks.

A weak economy could impact the government’s commitment to spend on pollution infrastructure. While a risk, Morgan Stanley termed it “immaterial” given that government officials are measured in part based on environmental targets, they typically achieve these targets and investing in green energy is creating new markets.

Collection risks are also a problem, as the local governments have had difficulty reaching payment agreements in the past. Given this, Morgan Stanley maintains that, while payments have been slow in coming, default risk is low.