Regnan’s Sharma on water’s diversification benefits

As investors ponder their exposure to the market-leading but increasingly expensive ‘magnificent seven’ companies, the appeal of diversified global strategies with minimal technology exposure is evident.

One fund that claims to offer exactly that is Regnan Sustainable Water and Waste. As its name suggests, managers Saurabh Sharma and Bertrand Lecourt invest in companies whose primary business is water and waste management.

Despite having no direct exposure to tech names, the fund has kept pace with its IA Global peers since launching in 2021, returning 36.8% compared with 33.1% for the sector average over the past three years, according to FE fundinfo data to the end of June.

Sharma explains that water and waste management has a strong diversification profile, with no direct allocation to sectors that make up a significant amount of a typical global equity allocation, such as tech, financials and healthcare.

“We have 0% allocation to those sectors combined,” he says. “Our structural exposure is to industrials and utilities. Industrials is one of the most diversified sectors you can have, so this becomes a good diversifier within a global equity allocation.”

The water and waste universe also has a different makeup in terms of market cap exposure, with most of the companies in the Regnan portfolio more localised small and mid-cap players. “There’s no Amazon or Apple of the water and waste world. That stock doesn’t exist,” Sharma says.

“The generic profile of this portfolio tends to be good downside capture when the markets are falling and good upside capture when they are rallying, such that we keep pace with the market. That’s how we’ve generated alpha in the longer term, and that’s how quite a few of our investors are using this portfolio.”

Portfolio breakdown

No stock makes up more than 5% of the portfolio at any one time, while the end markets served by different water and waste stocks are also diversified.

For example, Sharma highlights water purification company Organo Corporation, which provides treatment services to semiconductor factories such as Taiwan Semiconductor Company (TSMC).

Over five years, the Tokyo-listed stock has risen more than 500% as it sought to expand its services to pharma, energy and environmental sectors.

“If you are a semiconductor manufacturer, you need ultra-clean, pure water. You cannot use the water we are using in the manufacturing process – you need it clean of all impurities. Organo is one such company providing ultra-clean pure water treatment services.

“When TSMC is building out a foundry, Organo will come and install this plant on the site, and will also provide maintenance.

“With the current semiconductor capex cycle – everybody’s investing in Nvidia and TSMC – Organo stock has generated a 41% annualised return over the past five years.”

The company offers similar services to pharmaceuticals and energy companies. “It’s a good business spread across different industries. The fact that the end market exposure is very different for each of these stocks shows our portfolio is a truly diversified global portfolio.

“Think about a UK water utility compared with a waste management company that treats recycling scrap coming out of cars. In the short term, even if they are operating in the same region, [the share prices] move very differently even though they’re being driven by the same long-term structural drivers.

“This creates another layer of defensiveness within the portfolio, because we don’t see multiple shocks coming at the same time. This is in contrast to a technology thematic, for instance, where if you have issues with TSMC or Samsung then you will see a domino effect across the entire value chain.”

Thematic purity

The managers only consider listed equities, meaning the investible universe consists of around 360 stocks. While water utilities may seem the obvious constituent, only about 12% of the universe are regulated water utilities. The rest of it is made up of everything from water filtration, agriculture and irrigation to general waste and recycling management.

In terms of the size of the universe, it is a lot deeper than it might initially appear. “When people start to think about water as an investment opportunity, the first thing that comes to mind are water utility companies. That’s a very small portion of the entire value chain.”

It’s a similarly broad field on the waste management side of the portfolio, with the managers investing in companies that handle everything from treatment to transportation, and the disposal of hazardous waste from hospitals.

“An important part of our process is to look at thematic purity,” says Sharma. “We are investing in the solution providers. At stock level, we want to see at least 40% of revenue coming from the theme. At the portfolio level, at least 70% of revenue on an aggregated basis should be coming from the theme.

“This is one of the parts of the process where we are different, as we see a lack of thematic purity in certain peers. The most important aspect when one is managing any thematic portfolio, in our view, is to make sure you stay on top of the universe,” Sharma adds. “Do not fall in love with your companies, and have a very strong buy and sell discipline.”

UK market sinking

In the home market, water utilities have faced reputational issues in the past few years following Thames Water’s struggles, which has seen the water company building up £20bn debts.

Sewage spills have only worsened the reputational issue with leakages into rivers and seas by water companies increasing to 3.614m hours in 2024, up from 3.606m hours the previous year, according to the Environment Agency.

The Regnan portfolio has limited exposure to the UK, only owning three stocks in Severn Trent, United Utilities and Genuit, though their exposure is overweight compared with the global benchmark.

According to Sharma, Thames Water’s issues, combined with negative headlines for the sector around leakages, almost turned into a “domino effect” for other water utility names in the UK. The managers emphasise engagement as core to their process.

The Regnan portfolio has never had exposure to the privately owned Thames Water.

“First, given Thames Water was in private hands, the management of that particular business certainly could have been better, and that has played out when it comes to its leverage. The water companies tend to get a bad reputation and that’s why we have heavily engaged with the water utilities we hold.”

“Last year, I did a site visit to Severn Trent’s sewage water treatment plants and we were quite happy to see what they were doing,” Sharma adds. “The biggest takeaway there was the management of the company is incentivised on how those water sewage plants are operated. All employee incentives are tied to the water treatment plants, which is also a very positive sign for us.

“We saw the background work that goes on, how the company monitors for spills and makes sure any leakages are dealt with in time so that the company is not penalised.”

This article originally appeared in the July/August issue of Portfolio Adviser magazine