Outlook: Water Stocks

WATER SHARES have proved some of the most resilient to the stock market turmoil of the last three months. At 1136p, shares in Thames Water are close to their all time high and nearly 20 per cent up on the year as a whole. This despite being whacked for more than pounds 200m in the windfall profits tax and New Labour's pledge to punish the water industry ""fat cats"" by imposing a fair deal for customers.

In part this is down to the present flight to safety among investors. However beastly the regulator is to the water companies, it is figured, the risk to this monopoly source of profits cannot be worse than the markets are imposing on the rest of commerce and industry by racing headlong into a self inflicted recession. The City doesn't in any case believe Ian Byatt, head of OfWat, is going to be unduly hard.

This might seem just a touch complacent since Mr Byatt won't want to be remembered for being too soft on the water companies. He's going to be as tough as he dares in his preliminary findings on the price review, now with the printers and due for publication at the end of the month. We know roughly what the parameters are, since Mr Byatt has already set out some thoughts on what he believes to be a fair return on capital. According to Mr Byatt, 5 per cent after tax ought to be easily sufficient.

However, since he originally suggested this figure the game has changed. Over the last three months the equity risk premium - that is the premium investors demand for the risk of holding equities over bonds - has widened markedly. Investors now require a much bigger premium. So we should be allowed more, say the water companies.

Ingenious though this argument is, Mr Byatt is unlikely to go for it. The risk premium for water shares has not risen by nearly as much as for other stocks, and in any case, Mr Byatt will argue that since water companies have a guaranteed source of monopoly revenue, their shares are in truth quite similar in their risk profile to bonds.

So he'll stick to his guns and if the water companies are particularly unlucky, he might even go further, since the return on bonds has fallen even as it has risen on equities.

Even so, there remains huge scope for cost cuts within water companies, so the opportunities for bettering the assumed rate of return should be considerable. Furthermore, if the Government were to allow regional water companies to merge, even greater efficiencies could be squeezed out of the system for the benefit of customers and shareholders alike.

Already, the ten are jostling for position in anticipation of a merger free for all. Thames Water for one is determined to play a key role in any such restructuring. All of which should ensure that one way or another, water companies continue to deliver on behalf of their shareholders.