Is This Sector the Hidden Bottleneck of the AI Boom? (Hint: It's Not Semiconductors.)

Data centers are driving economic growth in the U.S. Without the immense capital investments in artificial intelligence (AI), some analysts estimate that gross domestic product would have been flat in 2025.

All these data centers require electricity and computer chips to operate. But they also require one commodity that is little discussed by the market: water. This is critical for cooling data center hardware, which generates a lot of heat. So the transportation, filtration, and cooling of water are a huge undertaking for the data center market, and a few companies will benefit from this aggressive expansion.

Increased capital spending and innovations in water cooling are going to be a boon for water-related stocks like American Water Works (NYSE: AWK) and Xylem (NYSE: XYL). But does that mean you should buy them for your portfolio today?

A water infrastructure supplier

Xylem sells water-focused products to customers that include the military, data center providers, and water utilities. These products range from transportation and treatment systems to pumps and measurement equipment, helping efficiently manage water at an industrial scale.

For example, in data centers, Xylem is advancing cooling technologies and recycling. This will not only make AI data centers more efficient but also more environmentally friendly.

Last quarter, the company's revenue grew 4% year over year to $2.4 billion. More importantly, its net orders grew 9% year over year. With plans across the entire AI sector for huge spending on data centers in the years to come, Xylem should be able to grow consistently with its smart water technologies.

Right now, the stock is trading at a price-to-earnings ratio (P/E) of 32.6, which looks a tad expensive for a company with a history of slow revenue growth. However, if you are a believer in the water usage and technology boom, Xylem is the perfect stock for you.

Image source: Getty Images.

A utility that will benefit from increased water consumption

On the utilities side, American Water Works will benefit from regulated increases in returns on its capital investments, which are necessary to expand and refurbish water infrastructure in the U.S. As a regulated monopoly, if American Water Works invests more in municipal water infrastructure, its earnings will grow.

Last year, operating revenue was $5.1 billion, up from $4.68 billion a year prior. The company makes small acquisitions across the fragmented market for municipal water utilities in the U.S., and it recently announced a merger with one of its largest competitors, Essential Utilities.

Combined, they will be a major player among water utilities and should drive regulated industry growth if demand for water continues amid the AI boom.

American Water Works has been a steady dividend growth stock in the last 20 years or so. Since 2008, its dividend per share has grown by over 300%, with annual increases. Right now, the stock has a yield of 2.4%, an entry point for dividend-growth investors ahead of the AI infrastructure boom.

Should you buy water stocks?

It is clear that if water usage increases significantly due to the data center spending boom, both American Water Works and Xylem will benefit. However, investors need to consider a couple of factors before making this thematic bet.

For one, AI data centers are only a small segment of water users in the U.S. Other sectors, such as farming and golf courses, use more water than data centers, requiring greater investment from companies like American Water Works and Xylem. Just because water consumption by AI data centers is growing does not mean it will have an outsize impact on the entire industry.

Second, investors should be wary about a potential AI bubble, with companies like OpenAI burning a ton of cash ahead of initial public offerings (IPOs). It is unclear whether this pace of data center investments will continue in the years ahead.

For these reasons, investors should be cautious about investing in Xylem or American Water Works just because they are bottlenecks to the AI revolution. The stocks may do just fine for you, but they are unlikely to be home runs for your portfolio.

Brett Schafer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Xylem. The Motley Fool has a disclosure policy.