With interest rates beaten into the ground by the U.S. Federal Reserve, investors have been flocking into higher-risk assets to generate income. One of the most popular destinations has been utility stocks, as they provide income-starved retirees with some yield while offering more stability than riskier growth stocks.

This dynamic has attracted billions of dollars of investment into utilities in the past few years. Case in point: the Vanguard Utilities ETF (NYSE: VPU), which is currently trading at a multi-year high while still carrying a nearly 4% dividend yield. That’s almost twice the yield of the 10-Year Treasury note‘s 1.9%.

Take a look at the steady gains below.

But even though utilities are a great place to find yield and stability, there is one segment of the utility market that stands out in both categories. These companies are exclusive distributors of the most precious resource on the planet, benefit from almost inelastic demand and their product can never be replaced.

I’m talking about water utilities.#-ad_banner-#

There are a number of forces driving the bullish trend in water utilities right now. The first is a simple matter of population growth. With a growing domestic and global population, limited water resources continue to be strained. The United Nations suggests that fresh water withdrawals have grown three times in the past 50 years, as demand increased by 16.9 trillion gallons annually. It also estimates that more than 1 billion people worldwide lack access to clean water.

In the United States, nearly every region of the country has had to contend with water shortages in the past five years, according to the Environmental Protection Agency (EPA). The massive droughts in 2012 were a big part of that, where the Midwest experienced the worst drought in 100 years. That led to a banner year for water utilities, with record amounts of water produced and distributed.

Looking forward, the water-shortage prognosis doesn’t get any better. Even with no droughts, the EPA estimates that at least 36 states will suffer local, regional or statewide water shortages in 2013.

Domestic water utilities are also benefitting from surging industrial demand, with the booming farming sector creating irrigational demand for water and the shale gas revolution creating record demand for water used during the hydraulic fracturing process, commonly referred to as “fracking.”

[See also, “A Little-Known “Pick and Shovel Stock for the Shale Revolution”]

Water utilities offer very unique exposure to the most precious commodity on Earth. This has created stability in share prices and produced outsized yields, both attractive to investors frozen out of the fixed-income markets.

With this in mind, here is a list of seven of my favorite water stocks.

From the list, I have chosen to highlight American Water Works Co. (Nasdaq: AWK) because of its market dominance and Connecticut Water Works (Nasdaq: CTWS), because of its yield and growth potential as a small-cap company.

American Water Works Co.
American Water Works Co. is a powerful water conglomerate that operates in the United States and Canada, offering water and wastewater services to 1,500 communities in 16 states. That makes American Water Works one of the largest water utilities in the country, with a market cap of $7.3 billon. It also owns 80 surface water treatment plants, 500 groundwater treatment plants, 1,000 groundwater wells, 100 waste-water treatment facilities, 1,200 treated water storage facilities, 1,300 pumping stations and 46,000 miles of mains and collections pipelines.

Shares have been strong, jumping 48% in the past two years and 22% just in the past year. Looking forward, analysts are projecting earnings growth of 3% in 2013 to $2.22 a share and 6% in 2014. In the next five years, analysts are projecting annual earnings growth of 8%, ahead of the industry average of 7.8%. The company’s dividend yield of 2.5% is also better than the 10-Year Treasury note.

Connecticut Water Services
With a market cap of just $313 million and an eye toward growth, Connecticut Water Services provides water to more than 90,000 customers in 55 towns in Connecticut. But in the past year, with two strategic acquisitions in Maine that grew its customer base by 35%, the company is in the process of transforming itself into a regional player in the lucrative New England market.

Analysts are calling for earnings growth of 3% in 2013 to $1.46 a share and 6% in 2014. That has shares trading with a forward price-to-earnings (P/E) ratio of 19, directly in line with its 10-year and peer average. The company’s dividend yield of 3.4% is also better than any Treasury bond, and with a beta of just 0.49, this is another water utility with a compelling combination of yield, stability and growth.

Risks to Consider: The country’s water pipeline system is suffering from old age, which could require water companies to make capital investments with state and local governments to upgrade the infrastructure.

Action to Take –> Water is one of the most stable and inelastic markets in the world. That’s a great place for investors looking for stability to pick up some extra yield. These are seven of the highest yielding water utility stocks in the market. My favorites from the group are American Water Works Company because of its dominant market position and Connecticut Water Services because of its yield and growth potential.

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