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While investing in stocks will never be entirely without risk, you can significantly limit your risk level by investing in certain kinds of stocks. In general, these are stocks of companies that provide essential products or services, are leaders in their fields, operate in industries that have high barriers to entry, and pay a dividend.
The great news is that, contrary to popular wisdom, you don’t have to sacrifice market-beating or even market-crushing returns over the long term when you invest in the right lower-risk stocks. Case in point is leading water utility American Water Works (NYSE:AWK), which fits the above profile perfectly and has left the market all wet over the long term.
Utility stocks aren’t all slow growers
American Water’s powerful long-term return throws water on the “widows and orphans stocks” moniker that many investment professionals have long used for utility stocks. Select utility stocks can make great core holdings for a wide variety of investors, including younger investors and so-called “growth investors.”
There’s a simple reason, in my opinion, why some investment professionals talk down utility stocks, or at least don’t talk them up: They don’t tend to make as much money off these types of stocks. Stockbrokers and some investment advisors make money when their clients make trades, and utility stocks tend to be stocks that many investors hold for the long run. Moreover, investors can often buy additional shares directly through companies’ dividend-reinvestment plans, or DRIPs.
Diving into American Water’s business
American Water — which is the best water stock for most investors, in my opinion — is the largest and most geographically diversified publicly traded water and wastewater utility in the United States. It provides water and wastewater services to about 15 million people in 47 U.S. states and in Ontario, Canada.
The bulk of its revenue is generated by its regulated business, which operates in 16 states. It also has several market-based businesses, including its military services group and Keystone Clearwater Solutions subsidiary. The former builds, operates, and maintains water systems at military bases throughout the country, while the latter provides water and related services to natural gas exploration and production companies operating in the Appalachias.
There’s considerable growth potential in the U.S. water-utility industry because it’s very fragmented, which means there are a ton of very small water and wastewater utilities. Many of these are municipally owned systems that are increasingly ripe to be acquired as the operating and maintenance expenses become more than many municipalities can afford.
American Water has a big competitive advantage when it comes to acquisitions, thanks to its size and geographic diversification. As to its size, it has a market cap of $13.8 billion and generated revenue of $3.32 billion over the trailing 12 months. The industry’s second-largest player, Aqua America (NYSE:WTR), has a market cap of $5.8 billion and took in $815.1 million in revenue over the last year.
This size advantage provides American Water with more resources to make acquisitions: The company had $83.0 million in cash on its balance sheet at the end of the first quarter, which dwarfs Aqua America’s $4.42 million. Granted, American Water’s debt level is somewhat higher — it has a 1.38 debt-to-equity ratio vs. Aqua’s 1.04, but this difference isn’t nearly enough to make up for the differences in these companies’ cash hoards, in my opinion.
American Water has regulated operations in 16 states, as previously noted, whereas the industry’s second most geographically diverse player — once again, Aqua America — has regulated operations in eight states. The other publicly traded companies that operate in this country have regulated businesses in anywhere from one to four states.
This geographic diversity provides American Water with a larger pool of acquisition candidates than its peers, as it’s not cost-effective for water utilities to scoop up small players quite a distance from their existing operations. Moreover, geographic diversity also better protects it from region-specific issues, including droughts.
Clear sailing on the financials front
American Water started 2017 on a strong note when it reported its first-quarter earnings in early May: Earnings per share (EPS) increased 8.7% year over year, when excluding the boost the bottom line got due to a new accounting standard for stock-based compensation.
Moreover, the company also announced that it was raising its dividend, which is currently yielding 2.13%, by a juicy 10.7%. The dividend was payable on June 1 to shareholders of record on May 5. American Water has increased its dividend every year since it went public in April 2008.
Looking ahead, American Water has a target EPS compounded-average-growth rate of 7% to 10% per year through 2020 (from the base year of 2015). Wall Street analysts project the company will grow EPS at an average annual rate of 7.7% over the next five years.
In short, American Water stock offers a top combination of lower risk and market-beating long-term return potential. I said “long-term” because the stock’s valuation has expanded during its price run-up over the last few years, so there could be pullbacks and/or underperformance on the near-term and possibly intermediate-term horizons. But investors with longer-term investing mindset should be nicely rewarded. As with all stocks, it’s best to dollar-cost average your way into your full position over time to avoid the possibility of investing all your money at or near peaks.