Watts Water: A Value Investor's Choice in a Challenging Industrial Cycle

The industrial sector in 2025 has been a story of sharp swings, not steady growth. After a promising start, the environment turned volatile. The S&P 500 Industrials Select Sector SPDR (XLI) delivered a year-to-date return of 16.1% by July, but its 12-month performance was 20.6%. Yet this rally masked underlying instability, as manufacturing activity itself contracted. By July, the S&P Global Manufacturing PMI had fallen back into contraction, dropping to 49.8. This pattern of optimism, followed by cooling demand and tariff-related stress, defines the current cycle.

For a value investor, this volatility is not a reason to flee, but a test of character. The true opportunity lies in identifying companies with the operational moat and strategic discipline to not just survive these headwinds, but to turn them into advantages. The sector's challenges-tariff costs, reshoring efforts, and policy uncertainty-are significant. Tariffs have acted as a national tax increase of $1,100 per U.S. household, pressuring margins and forcing firms to adjust. Yet, this same disruption can benefit companies with resilient supply chains and pricing power.

This is where Watts Water Technologies presents a compelling case. Its long history of manufacturing proximity to customers, a 150-year heritage, creates a durable competitive advantage. This vertical integration allows it to act as a strategic weapon, enabling rapid cost pass-through and market share gains when competitors face supply chain disruption. In a sector buffeted by tariffs and reshoring, Watts' model is built to transform geopolitical risk into competitive advantage. The investment thesis, therefore, is to find the few companies that can compound value through these cycles, using the sector's turbulence as a catalyst for their own strength.

Contrasting the Portfolio: Watts Water vs. Two Industrials to Avoid

The industrial sector's recent rally has spotlighted a stark divergence between companies built to endure and those struggling to adapt. While some firms are quietly compounding value, others are showing clear vulnerabilities. Watts Water Technologies stands in the former camp, its competitive moat forged over 150 years of manufacturing proximity to key markets. This vertical integration is not just a historical asset; it is a strategic weapon in today's tariff-laden environment. When competitors face supply chain disruption, Watts can rapidly pass through cost increases, protecting margins and even gaining market share. This demonstrated pricing power was evident in the third quarter, where the company achieved 180 basis points of segment margin expansion in the Americas while mitigating $40 million in direct tariff costs.

In contrast, the vulnerabilities of companies like Regal Rexnord are laid bare by a weak operational foundation. Its core business has underperformed for two years, with flat earnings and low returns on capital signaling management's struggle to allocate funds effectively. Without the strategic advantage of manufacturing proximity, Regal Rexnord lacks the operational leverage to navigate tariff headwinds or cyclical downturns. Its model leaves it exposed to margin compression, as it cannot easily pass costs through to customers or defend its market position during supply chain stress. The company's 14.9x forward P/E multiple may look cheap, but it reflects a market pricing in stagnation, not resilience.

The lesson for a value investor is clear. In a sector where volatility is the norm, the width of a company's moat determines its ability to compound. Watts Water's moat-built on regulatory expertise, a durable repair-and-replace base, and manufacturing proximity-allows it to transform geopolitical risk into competitive advantage. Regal Rexnord's thinner moat, coupled with a history of underperformance, leaves it vulnerable to the very forces that Watts can manage. One company is positioned to thrive through cycles; the other is struggling to simply hold its ground.

Analyzing Watts Water's Competitive Moat and Financial Resilience

The true test of a value investment is how it performs when the going gets tough. Watts Water Technologies has just delivered a textbook example of operational excellence in a challenging environment. The company's intrinsic value is being built on a foundation of pricing power, manufacturing leverage, and a resilient repair-and-replace business model.

The most compelling evidence is the third-quarter performance. While the broader industrial sector grapples with tariff costs, Watts achieved 180 basis points of segment margin expansion in the Americas, pushing the margin to 23.7%. This expansion was not a fluke; it was a direct result of the company's strategic moat. Management explicitly noted it successfully mitigated $40 million in direct tariff costs. In other words, Watts didn't just absorb the hit-it passed it through to customers and even improved profitability. This is the hallmark of a durable competitive advantage: the ability to convert external headwinds into margin gains.

This operational strength flows directly to the bottom line. For the trailing twelve months, revenue stood at $2.35 billion, demonstrating steady growth. More importantly, management has raised its full-year outlook, now guiding for an adjusted operating margin of 19.1% to 19.2%. This guidance implies a significant step-up from the prior year, turning top-line growth into enhanced earnings power. The key to this leverage lies in the company's manufacturing footprint. With capacity utilization that includes second shifts and few third shifts, Watts has the operational flexibility to ramp production without a proportional increase in fixed costs. This creates a powerful margin expansion engine where incremental sales flow almost directly to the income statement.

The bottom line is that Watts Water is compounding value through a difficult cycle. Its 150-year heritage of manufacturing proximity isn't just a historical footnote; it's the operational bedrock that enables rapid cost pass-through and margin expansion. In a sector where many are struggling to hold margins, Watts is widening them. For a value investor, this is the setup: a company with a wide moat, a resilient business model, and a clear path to higher earnings that justifies its premium valuation.

Valuation, Margin of Safety, and Key Risks

The investment case for Watts Water hinges on a clear near-term catalyst and a durable margin of safety, even as it navigates a known risk. The company's operational leverage and pricing power provide a cushion, but the path to realizing its full value depends on managing regional headwinds.

The most immediate catalyst is management's raised guidance. For the full year, the company now projects reported sales growth between 7% to 8% and an adjusted operating margin of 19.1% to 19.2%. This outlook, delivered after a quarter of strong execution, sets a tangible earnings target. It implies a significant step-up from prior-year profitability, turning the company's top-line momentum into enhanced bottom-line power. This guidance is the near-term signal that the strategic moves-pricing, acquisitions, and supply chain management-are working as intended.

Yet, this positive trajectory faces a clear headwind: the continued weakness in the European market. Management explicitly notes the Europe segment contracted by 4.0% year-to-date, a drag on overall growth. This regional vulnerability is the primary risk to the outlook. The company's ability to offset this with strength in the Americas is a testament to its geographic diversification and operational discipline. However, the margin of safety here is not in avoiding the risk, but in the company's demonstrated ability to manage it. The very moat that provides pricing power in the Americas is the tool used to mitigate the drag from Europe.

This brings us to the core of the margin of safety. It is not found in a cheap stock price, but in the company's operational resilience. The evidence is compelling: Watts achieved 180 basis points of segment margin expansion in the Americas while simultaneously mitigating $40 million in direct tariff costs. This dual feat-expanding margins while absorbing a significant external cost-demonstrates a powerful combination of pricing power and manufacturing leverage. It is the operational equivalent of a wide moat: the ability to convert adversity into advantage. This intrinsic strength provides a buffer against volatility and gives the company the runway to execute its strategic plans.

The bottom line is one of managed risk and clear catalysts. Watts Water is not immune to European weakness, but its operational model is built to withstand it. The raised full-year guidance offers a near-term earnings target, while the demonstrated ability to expand margins despite tariff costs provides a tangible margin of safety. For a value investor, the setup is about patience: backing a company with a durable competitive advantage through a cyclical challenge, confident that its operational excellence will ultimately compound value.