This ETF Is Poised to Benefit From an Inevitable Trend

By Brian Shaw - March 13, 2013 | Tickers: CWT, SBS, CWCO, ITRI, PHO | 0 Comments

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For the sophisticated investor, exchange traded funds are often looked down upon. After all, part of the benefit of taking control of your personal investments is to cut back on as many performance-deflating expenses as possible. Plus, the diversification that ETF creators tout comes with a corresponding negative: both the best and worst companies in a particular industry or index are part of the ETF. So why would an in investor that is knowledgeable enough to handpick stocks ever want to pay annual expenses for a basket of stocks including industry laggards?

The trend behind the ETF is too powerful to ignore

Some investment theses are so universal that every company in the industry stands to benefit. Such is the case with water -- nothing is as essential to the basics of human life, and the statistics around water scarcity are quite clear. Currently, a billion people do not have sufficient access to fresh water. This alarming statistic is projected to compound both as populations continue to swell and developing countries continue to increase the use of water for agriculture and industry. Based on a World Water Assessment Programme study, 70% of fresh water usage goes towards irrigation, while another 22% is consumed by industry. Only the remaining 8% of fresh water being used is for domestic use.

This isn’t intended to be a public service announcement or political statement. Instead, these facts point strongly towards a water shortage that will cause water to live up to the nickname “blue gold” that has been increasingly used in recent years. Quite simply, the necessity of water and a convergence of several inevitable trends will make fresh water a more valuable and strategic resource in the future than most consider it to be today.

How to invest in the coming water shortage

There are a number of different approaches to investing in water-related businesses. The most obvious is an investment in utilities that provide water to consumers and businesses. For investors more focused on steady performance and income, California Water Service Group (NYSE: CWT) provides growing returns in a regulated environment. Layering on emerging market growth to the water utility investment thesis, Companhia de Saneamento Basico do Estado de Sao Paulo (NYSE: SBS) has outperformed the market in recent years as population and industry growth in Brazil has driven an ever-increasing need for water.

If the standard water utility is too boring, investors looking to think outside the box might consider Consolidated Water (NASDAQ: CWCO), a Cayman Islands-based water utility that is a leader in developing desalination technology. Desalination converts salt water into fresh water, which potentially opens a huge opportunity to meet growing fresh water needs with the ample water found in oceans across the world.

In addition to the provision of water, companies that make the infrastructure that moves water and improves efficiency are also worth a look. For example, pump manufacturer Flowserve and smart meter provider Itron (NASDAQ: ITRI) address the growing need to transport water, track consumption, and improve efficiency.

Not sure which investment is best? Try them all!

Each of the five companies mentioned above stand to benefit from the growing demand for, and scarcity of, fresh water. Perhaps one jumps out as the clear long-term winner. If the decision isn’t so clear, it makes a lot of sense to consider PowerShares Water Resources (NYSEMKT: PHO). PHO is an ETF devoted to tracking the NASDAQ OMX US Water Index. Among its 37 holdings, SBS and Flowserve are the two largest holdings.

PHO has a nice mix of industrial, utility, and other water-related businesses. Additionally, there is a good mix of small and mid capitalization companies as well as geographic diversity. Even at all-time highs near $23 per share, PHO offers a reasonable valuation with an average P/E of 16. However, while the expense ratio of 0.6% is lower than most actively managed mutual funds, this represents a much higher rate than the 0.1% expense ratio for SPDR S&P 500.

Will PHO outperform the S&P 500

The big question for investors is whether PHO will outperform the market. Over the past 5 years, PHO has slightly outperformed the S&P 500 as noted by the chart below:

Note: the chart above depicts a sharp decline in the share price of SBS; this is the result of a 2:1 stock split that occurred in January 2013 and not a dramatic decline in the performance of an investment in SBS.

What stands out in the chart above is that some of PHO’s holdings have significantly beaten the market, while others have lagged substantially. Last summer, I made the case that Itron was poised to outperform the market; thus far, that has not come to fruition as the market has rallied and Itron's stock remains stagnant.

This is an excellent example of how the broad long-term investment thesis makes sense and has not changed, but the individual performance of a particular company has not lived up to expectations (thus far). For investors that would rather ride the larger trend rather than try to pick out the single biggest winner, PHO is a solid alternative worth considering.

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