IT IS easy to see why investors like water companies. Regulated cashflows and assets that do not go out of fashion routinely lead to decent profit rises.

Take Northumbrian Water. It posted a 17% rise in interim profits in December and is expected to announce equally solid full-year figures next month.

Water has lost its dull status. The sector became exciting when infrastructure funds decided to pay astonishing prices for dependable cashflows and load up the businesses with debt. Anglian Water Group was snapped up for a 25% premium to its regulatory asset base, the value put on the assets by regulator Ofwat. The story was similar with Thames.

So the fact that Northumbrian is trading on just a 12% premium to its regulated assets looks curious – especially when you consider that the £1.7 billion company is one of the best-run in the sector and could yet be a juicy takeover target. Investors also appear to be underestimating the value of a government contract to run Kielder Water, Britain’s largest reservoir.

The big fear is that Ofwat will be tough in the next price review – due in 2009 and implemented in 2010 – and that allowed returns will fall sharply from the current 5.1% in order to lower prices. Certainly, utilities have benefited from a lower rate of borrowing than forecast in the current regulatory period. But research by Morgan Stanley indicates that the market may be too pessimistic. The bank argues that allowed returns must be at least 4.5% if companies are to pay for the huge infrastructure investment needed. By most measures the market is betting on just 3.25%.

John Cuthbert, Northumbrian’s managing director, is pretty pragmatic, admitting last year that the enormous interest of infrastructure funds meant any water company could be taken over. Northumbrian has some protection in the Ontario Teachers’ Pension Plan, which holds a 25% stake and has indicated it is a long-term investor, but everyone has a price. But it may not just be infrastructure funds that are on the prowl. The Competition Commission’s decision to approve the merger of Mid Kent Water and South East Water has raised the prospect of a new wave of mergers, probably between water firms and water and sewage groups.

Even if Northumbrian is not involved, the shares look cheap for a well-run business on track to deliver the lowest water bills by 2010.

Paragon Group

THE Paragon Group is one of those companies that is disproportionately buffeted by sentiment. As a specialist buy-to-let lender, any rise in interest rates can lead to jitters among investors. With interest rates at a six-year high and rental yields half what they were seven years ago, there is a strong argument that the sums no longer add up for many amateur property investors.

Unsurprisingly, Paragon shares have been dragged down, losing 17% since the start of the year. This looks harsh. The group focuses on professional landlords rather than punters obsessed with property.

Interim results this week are expected to show a 12% rise in profits, a strong increase in lending with broadly stable margins and credit quality – hardly the hallmarks of a company on the slide.

The shares trade at 8.8 times 2008 forecast earnings against 10 times for retail banks. It may take a while, but the shares are due a rerating.

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