The ETF of The Business of Water: PHO

The Business of Water: An ETF For Tomorrow
Friday November 10, 1:31 am ET
By Jonathan Bernstein, ETFzone Trading Specialist

Clean water has long been a problem for world populations. Now it is becoming a problem for businesses serving these populations as well. The combination of a global environment strained by pollution and an increasing business focus on clean water may spell opportunity for investors. One way to play the water theme is a new ETF: PowerShares Water Resources (AMEX:PHO - News).

PHO tracks the Palisades Water index, which invests in the common stocks of companies in the water industry. PHO is heavily weighted to the industrial sector (41%), with utilities (24%) and business services (21%) also important. Although PHO has international holdings such as Companhia Sanea (NYSE: SBS - News) a Brazilian utility, and Suez (NYSE:SZE - News), a $60 billion water management behemoth, many holdings are small cap water infrastructure companies. The chart below compares the 1-year return of PHO with a small-cap benchmark, the iShares Russell 2000 Index (AMEX:IWM - News) and a large cap benchmark, the Standard and Poor's Depositary Receipts (AMEX:SPY - News).

As the chart above shows, since its inception about this time last year PHO has traded closely with the small-cap index IWM, outperforming the market benchmark SPY.

The Water Story

The economics of water is historically a commons problem: like air, it is a good we all share and all use it but lack incentive to protect. The result of course is the degradation of the resource. Its becomes scarce and a commodity to be bought and sold.

Water is already scarce and a commodity. The U.N. estimates that over 1 billion people lack easy access to drinking water. By 2025 that number is expected to be 2.7 billion. Water quality is worst in some of the world's fastest growing economies. Water in China is threatened by industrialization, water in India largely by agricultural development. A legacy of poor environmental controls threatens water supply in fast-growing areas in the former Soviet states and Central Asia.

As globalization forces corporate expansion into these and other emerging market areas businesses are forced to deal with local water problems. In a recent example, Coca Cola and Pepsi, two of the most successful companies ever to operate in the global arena, find themselves banned in five Indian states because of pesticide residues found in soda drinks. Coke and Pepsi weren't doing anything exceptional. They were producing according to the same methods as in the U.S, using the same water as other local drink providers. But they were not of course producing beverages with water of the same standard as in the U.S. For Coke and Pepsi to operate in India, clean water must be found-- or cost-efficiently made.

And this is where investment in water and water infrastructure become important. Among PHO's holdings are a number of small cap companies that supply treatment facilities like Layne Christensen (Nasdaq:LAYN - News), purification, pollution control and monitoring devices like Franklin Electric (Nasdaq:FELE - News), water diagnostics firms, like IDEXX Laboratories (Nasdaq:IDXX - News) and infrastructure such as pipelines, valves and hydrants, like Mueller Water Products (NYSE:MWA - News). The chart below shows the top ten holdings in PHO.

COMPANY TICKER % of ASSETS
Mueller Water Products MWA 3.8%
Franklin Electric FELE 3.8%
Watts Water WTS 3.7%
Danaher DHR 3.7%
Layne Christensen LAYN 3.7%
Companhia Sanea  SBS 3.6%
Insituform  INSU 3.6%
IDEXX Labs IDXX 3.6%
ITT Corporation ITT 3.5%
Millipore MIL 3.5%

But as appealing as it may seem to invest in water and water infrastructure, it is worth mentioning that PHO's weakness may be the Palisades Water Index, which is even more idiosyncratic than many other indexes upon which ETFs are based. The genie in the Palisades water index bottle is a man named Steve Hoffman, who adjusts the index quarterly according to a complicated, albeit profit-seeking, methodology. The very similar weightings in the top ten companies in the table above reflects Mr. Hoffman's commitment to diversity of holdings.

Water is plentiful, but clean water increasingly scarce. Regulation and subsidies have kept water relatively clean and inexpensive for consumers domestically. Globally this is much less true. Emerging economies, the premiere growth area for business, have some of the worst problems. As businesses in these areas grow and find ways to secure water, the market for water (already a 400 billion dollar per year business) will expand. This may represent an opportunity for investors. Investing in water is not as easy as investing in other commodities but PowerShares Water Resources is a good place to start.

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