Global Investor
Oct. 21, 2009, 1:09 p.m. EDT
Uncharted waters
Does your portfolio need exposure to the world's most vital commodity?
By Barbara Kollmeyer, MarketWatch
MADRID (MarketWatch) -- One of the biggest IPO stories of the year has been China-based water-treatment-equipment company Duoyuan Global Water Inc., whose shares have nearly doubled since a heavily oversubscribed and highly successful debut in New York on June 24.
The success of Duoyuan (NYSE:DGW) reflects a growing desire among global investors to hold specialized commodities, in particular a commodity -- water -- that many in the U.S. may not even think of along with gold, oil or soybeans. Duoyuan offers a direct play into the core themes of water investing: growing global populations and dwindling supplies of a vital commodity.
"Water is simply the most valuable resource of the 21st century," said Steve Hoffmann, director of Palisades Water Index Associates LLC and principal architect of the index, on which exchange-traded funds PowerShares Global Water (NYSE:PIO) and PowerShares Water Resources (NYSE:PHO) are based.
"The value of water across a broad range of socio-economic aspects will rival oil. By most accounts the water industry is the third or fourth largest industry in the world (behind electricity, oil and gas, and perhaps tourism)," said Dallas, Texas-based Hoffmann in an email interview.
For investors who want to dip into the water, there seven actively managed and exchange-traded funds to choose from, all of which were started in the last two years.
PowerShares Global Water, which launched in mid-2007, is among those. It saw net outflows from September 2008 through March of this year, but has seen steady inflows since, and is up 49% on a one-year basis, versus 21% for Water Resources.
Also launched in 2007 were Kinetics Water Infrastructure No Load (FUND:KWINX) , Sustainable Asset Management's (SAM) Sustainable Water (FUND:SMWNX) and First Trust ISE Water (NYSE:FIW) . Those funds are up a respective 21%, 36% and 18% in the last year. Joining the water space for 2008 were Allianz RCM Global Water (FUND:AWTAX) and Calvert Global Water (FUND:CFWAX) , up 20% and 25%, respectively.
Over the same period, the MSCI All-Country World index gained 22%.
What these funds generally offer is exposure to the provision of potable water, treatment of water and the technology and services directly linked to global water consumption in sectors such as industrials, information technology, materials and utilities.
Funds and ETFs vary to the degree in which they are exposed to emerging markets, though that has helped performances in some cases, such as that for PowerShares Global Water.
The ETF's top holding is Dutch-based Arcadis NV (AMSTERDAM:NL:ARCAD) , an engineering and consulting provider that has worked on flood protection in New Orleans, according to a company prospectus dated Oct. 20. French-based utility Suez Environnement SA (PARIS:FR:SEV) (NQB:SZEV.Y) , which operates largely in the water-treatment and waste-management sectors, and Malaysian water specialist Puncak Niaga Holdings (MYX:MY:6807) are also holdings.
Money flows to water
So why choose water over clean technology or other environmental funds? Hoffmann said water has compelling supply and demand fundamentals. Those numerous drivers include population growth, institutional change, contamination, climate change, agriculture and resource sustainability, he said.
"Relative to alternative (clean) energy, for example, water is less risky and more profitable; there is no substitute for water," said Hoffman. He adds that it can be viewed as a long-term play, but "as a very dynamic industry, investing in water must take into consideration the changing landscape."
Along with political and regulatory issues, there are also liquidity concerns related to small and mid-cap companies in the water space, and issues related to water supply and infrastructure.
Capital expenditure of industrial companies such as pump and pipe producers or water-network builders plummeted as residential, commercial and industrial demand dropped over the financial-crisis fallout, pointed out Urs Schön, Zurich, Switzerland-based senior analyst at Sustainable Asset Management.
That was somewhat offset, he said, by the better performance of utilities in the water space, defensives such as the U.K.'s Severn Trent (LSE:UK:SVT) , or Aqua America (NYSE:WTR) . When the market bounced back, the situation reversed: industrials outperformed the market due to stimulus programs focusing on infrastructure investments and defensive utilities underperformed.
Still, Schön said investors have to see the longer-term picture. He points out that the $500 billion global water market is growing faster than the global economy, where companies are expected to average earnings growth of 7% per year against 10% per year for companies in the water space.
"The average valuation of a company in the MSCI is higher than the water universe when comparing share price to earnings ratios. Furthermore, expected growth of water companies is higher. Both indicate that share prices of water companies are likely to grow faster than the MSCI, which will produce a better return on investments," he said.
He said water-infrastructure growth will come obviously from developing countries where there is growing need for clean drinking water. "In developed countries you would see infrastructure renewal...and also an increase in regulations that means the quality of water has to be increased and treatment technology has to be improved in Europe and the U.S."
Jens Peers, Dublin, Ireland-based portfolio manager of the Calvert Water Fund, said that, globally, less than 1% of all water is available as fresh water.
"We see a demand problem, a supply problem and we think a lot of our water companies are poised to improve their management of water," said Peers.
He and other managers say their funds held up fairly well through the meltdown owing to the low-risk profile of water. "Unlike basics such as grain, oil or other commodities, water isn't traded on a commodity market. There are no price fluctuations. It's just a basic infrastructure play. During the crisis, there was still absolute demand from governments to spend on water projects."
Political risks
Michael Herbst, Chicago-based fund analyst with Morningstar, said investors should remember that just because there is a need or a shortage for water, it doesn't necessarily translate into a profitable investment. And politics have historically weighed heavily into how water resources are managed.
"I'm not saying that governmental impact will totally eliminate any investment potential, but that's certainly a risk we've seen with infrastructure-related investments. In the energy space, it's a similar story," he said.
He said most investors probably don't need a water fund, and could perhaps get water exposure through companies already in their own portfolio. Or, they could go with an environmental fund that offers water exposure, such as Pax World Global Green fund (FUND:PGRGX) , up 35% on a one-year basis.
If they do want that extra water concentration, he advises keeping it to around 5%, so that potential volatility won't have a dramatic effect on the overall portfolio.
"Water funds are dedicated to a narrower slice of the natural-resource part of the market. In the sector funds, typically what we've seen is that they're fairly concentrated in a relatively small number of stocks," said Herbst. "Often times they can be much more volatile, and as a side effect of that volatility, investors don't tend to use sector funds too effectively because they tend to buy and sell at the wrong time."
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