Warren Buffett's Unusual 'Commodity' Investment

This week, Warren Buffett's Berkshire Hathaway revealed a new position in Nalco Holding, a stock I've liked (and recommended) for a long time.

With a $1.6 billion market cap, Nalco is a small-cap stock... but it's actually one of the world's largest water-treatment companies. It's my favorite pure play on water filtration. Customers use Nalco's products and services to prevent corrosion, contamination, and the buildup of harmful deposits.

Buffett picked up 8.7 million shares. That makes Berkshire the second-largest shareholder in the company, with a little more than 6% of the shares.

It's easy to see what Buffett likes. Nalco generates a steady stream of free cash flow – $142 million in its fiscal year ended September 30. Today, the market cap is about $1.6 billion. So you're getting nearly a 10% free cash flow yield. Put another way, you're only paying about 10 times free cash flow. Not earnings, but cash flow.

On the downside, Nalco has a leveraged balance sheet with $3.1 billion in net debt. However, its business model ensures steady cash inflows from service contracts, which is less of a risk than it might seem. Also, the first significant maturities don't come until November of 2010 – plenty of time for the credit markets to return to some friendlier state. In any event, the debt was not enough of a risk to put Buffett off the scent.

There is also a nice backdrop to the Nalco thesis. Water is a scarce commodity... and we live in an age in which, for better or worse, people of all kinds are obsessed with reducing their "carbon footprint." Now there are more footprints to worry about: water footprints.

The Wall Street Journal recently gave some examples of this sort of thing:

It takes roughly 20 gallons of water to make a pint of beer, as much as 132 gallons of water to make a 2-liter bottle of soda and about 500 gallons of water, including water used to grow, dye and process cotton, to make a pair of Levi's stonewashed jeans.

Other examples include the nearly 35 gallons of water behind every cup of coffee, the 700 gallons behind the typical dyed T-shirt, and the 630 gallons to produce a single hamburger.

So a water footprint is basically how much water you use to produce a given consumer good. There is a lot more attention focused on reducing this water footprint, especially since water-scarcity issues are cropping up a lot more these days.

You may be familiar with these numbers: Two-thirds of the world's population face water shortages by 2025, according to the United Nations. And according to the U.S. Government Accountability Office, about 36 states face water shortages by 2013.

These issues may not seem so pressing to you, since every time you turn on the tap, the water flows. And you can get all the bottled water you can buy at any grocery store. Unless you live in the Western states, where water rights are more of a concern, you may not appreciate water-scarcity issues.

But it is an important issue for industrial users of water all over the world. Nike, Pepsi, Starbucks, Levi's, and about 100 other companies recently held a conference in Miami on reducing water footprints. So this is serious business.

It's not just an attempt to be eco-friendly, either. It's nothing but good old-fashioned greed that compels companies to think about their water usage. If you are Coca-Cola, you need a good water supply. And you can't have locals railing at you for depleting their already low water supply to make fizzy sugar water. Coca-Cola either finds ways to use water more efficiently or the locals will shut production down.

The Journal notes in passing SABMiller's experience in Tanzania. SABMiller makes Miller Lite, Peroni, and Pilsner Urquell. Its factory in Dar es Salaam depleted local aquifers, causing them to grow increasingly salty. Meanwhile, the city has water shortages already. SABMiller has to find a way use water more efficiently or it will go out of business in Tanzania.

These kinds of stories repeat themselves in different settings all over the world. As one manager for the Freshwater Footprint Project for the World Wildlife Fund said, "Three billion more people are going to be on this planet" by 2050. "Somehow, we're going to have to use the same amount of water we use today."

Nalco is right in the heart of this issue. Nalco's customers are industrial users. Nalco's services improve water efficiency. The company also offers services to reduce air pollution, treat industrial wastewater, and more. In this, Nalco is the global leader, with a 17% global market share. It's bigger than GE in water.

As a long-term investment, Nalco is among the more compelling ideas out there. Certainly, it's more compelling than trying to figure out Citigroup's balance sheet... or guessing whether or not – and when – Tiffany's sales will come back.

In fact, the entire water spectrum looks attractive as a long-term investment theme. It's going to be an issue we're going to deal with for years yet... and Warren Buffett's purchase of Nalco is further confirmation of the idea.

Regards, 

Chris Mayer 

Editor's note: Chris Mayer is the editor of Mayer's Special Situations – one of our favorite investment advisories at DailyWealth. Chris is onto an interesting special situation right now involving gold and silver. In short, he's found a unique kind of security that allows investors to receive cash flows from some of the world's most productive mines. The higher gold and silver go, the higher your "royalty" payments. To learn more about the Chaffee Royalty Program click here.