(By James Brumley) You can laugh at water utility stocks (and their presumed lack of potency) all you want. Just know that the people who have owned them since late April have been laughing too -- all the way to the bank.
See, while the rest of the market has given up about 6% of its value during the past six weeks, water utility stocks have gained 6% during the same time. The advance makes them the second-highest group in the period, trailing only the sharp rebound in gold-mining stocks.
Better still, water utilities have plenty of room for more gains, whether or not the market lends a hand. In fact, the worse the market does, the better it could get for big water stocks such as American Water Works Co. (NYSE: AWK) and Aqua America Inc. (NYSE: WTR).
Let me explain...
Charts reflect opinion
It's a pattern rarely seen anymore, because the broad market's normal volatility now tends to break them up before they can fully develop. But, the S&P 1500 Water Utilities Index has been working on a cup-and-handle reversal and breakout pattern since the big pullback from 2008.
The pattern gets its name because it forms the bowl-shape of a tea cup, followed by the formation of a smaller handle. More important, once the brim of the cup is hurdled by the upward thrust that completes the handle, all the work that went into forming the chart pattern is unleashed, and can send that chart skyrocketing.
And that's exactly what happened on Tuesday, June 5. Though the index had been toying with a move to new highs for a couple of weeks, the smallest of nudges sent this group to new multi-year highs on Tuesday. Now that the cat's out of the bag, further gains become much easier to muster. And while the technical pattern makes a compelling argument, it's not like the move lacks a certain logic. Few would argue the global and domestic economies aren't slumping. The ensuing "flight to safety" each time such fears surface tends to favor safe-haven stocks, such as gold and utilities.
Two viable choices
Investors mulling a new position in a water utility stock should know that Aqua America and American Water Works are largely responsible for the recent bullish shape of the S&P 1500 Water Utility Index. It's a cap-weighted index, meaning it mostly reflects the behavior of the biggest names in the bunch. But this also means these stocks could become overbought quickly, as I think is the case with both.
This is a theme-based trend though, so investors would greatly benefit to look into several smaller, low-impact water names that are also gearing up for a big rally.
One of them is American States Water (NYSE: AWR).
This is a solid, reliable small-cap utility averaging earnings growth of 10% for the past five years, and expected to grow income by 7% in each of the next five. Recessions generally haven't posed a problem for earnings, either.
The sweetest part about this stock is the dividend. American States Water is yielding 3.1% and has increased the payout every year since 2003. The quarterly payout was $0.08 then, and has more than doubled to a current $0.17. Considering the nature of the business hasn't changed one iota in decades, more dividend increases are in the cards.
American States Water shares are developing some bullish momentum as well, but aren't starting out at the disadvantage of being overbought like is the case with Aqua America.
Another off-the-radar water stock worth considering is Connecticut Water Service Inc. (Nasdaq: CTWS). The admittedly-challenging aspect of Connecticut Water is its valuation: The stock is priced more like a growth stock at more than 20 times trailing and projected earnings . In addition, shares are up 20% in the past 12 months, making it the top performer within the group. But, like most of the water utility stocks right now, I think there's still lots of room for shares to continue rallying.
Risks to Consider: Although they're falling into favor now, a strong renewal of economic optimism could renew the market's love for riskier stocks and take investors elsewhere.
Action to Take --> While Aqua America may be the stock that pulled the rest of the industry over the hump, it's not necessarily the best pick because -- along with American Water Works -- it's priced at overbought levels right now. Instead, the better move is to utilize the broader water idea and choose a stock that fewer investors are considering. This puts American States Water at the top of the list.
In terms of a price-to-earnings (P/E) ratio, it's the cheapest of the four companies mentioned in this article, and has dividend reliability that's second to none. Connecticut Water Service may have more momentum firepower, but it's accordingly volatile -- not to mention more expensive -- than American States Water at this time.
-- James Brumley
James Brumley owns shares of WTR.StreetAuthority LLC does not hold positions in any securities mentioned in this article.
This article originally appeared on StreetAuthority
Author: James Brumley