Best ETFs for 2018: The Invesco Water Resources ETF Justifies Its Premium

water ETF - Best ETFs for 2018: The Invesco Water Resources ETF Justifies Its Premium

This article is a part of InvestorPlace’s Best ETFs for 2018 contest. James Brumley’s pick for the contest is Invesco Water Resources ETF (NASDAQ:PHO).

As I suggested at the very beginning of this year, the Invesco Water Resources ETF, i.e. the water ETF, is the simplest way for investors to exploit the scarcity of water and the need for water infrastructure. That is still the case.

Water Is Becoming Scarcer

Most people outside of El Paso, Texas likely don’t know it, but earlier this year the nearby Rio Grande River — which supplies the city with water — reached its lowest level in 70 years. The Colorado River is also abnormally low, setting the stage for an outright water crisis for the entire state of Arizona by 2019. Even Lincoln, Nebraska, which is well out of the nation’s arid zone, is struggling to meet its water needs. And it’s not like those areas are outliers. Many, many major cities within and outside of the United States are facing a major, worsening water crisis.

It’s tragic, but it’s also an opportunity. The American Water Works Association, a nonprofit organization, estimates that $1 trillion needs to be spent in the U.S. alone over the course of the coming 25 years to repair and improve the nation’s water infrastructure. But how can investors tap into the opportunity?

A Water ETF? Seriously?

A water ETF is a lot of things, but sexy isn’t one of them. Though nobody can survive more than a few days without water, almost everyone who is reading this article takes their access to it for granted. As a result, many investors aren’t in love with companies in this sector.

Stock pickers have taken notice of the need to spend more on water resources, though.

Raymond James analyst Pavel Molchanov is one of them. His firm initiated coverage on Xylem (NYSE:XYL), Invesco Water Resources’ biggest holding, in early September on the basis of the growing and underappreciated scarcity of water. Molchanov particularly lauded the company’s diverse revenue streams. All told, Raymond James rates XYL an “outperform,” and started coverage of the shares with a $90 price target. That’s 12% above the stock’s current price.

It’s an uncomfortable target for some, given the stock’s trailing and projected price-earnings ratios. At last check, Xylem is already trading at 23.4 times next year’s expected profits. Molchanov makes a valid point, however, when he says that XYL has earned a “reasonable scarcity premium.”

It’s a premium that’s built into most of the other key names that make up the Invesco Water Resources ETF too. Roper Technologies (NYSE:ROP), the water ETF’s second-biggest position, is priced at 29 times its trailing earnings. The water ETF’s third-biggest holding is Ecolab (NYSE:ECL), and it’s valued at 29.5 times its trailing income and 26 times next year’s earnings estimates.

That’s rich, but the market has mostly shrugged off these frothy valuations that wouldn’t be acceptable for companies in most other industries. The Invesco Water Resources ETF is up 5% for the year thus far, which trails the broad market’s performance, but not by much. For the past two years, PHO is up 32%, and the S&P 500 is only up a bit more than that with its 35% gain. Maybe that’s because the fund’s three biggest holdings are going to grow their top and bottom lines this year. All three are also expected to increase their top and bottom lines next year.

Not bad for water stocks.

The Outlook of the Water ETF

Market crushing? Not in the least, though I suggested that the water ETF would crush the market when I made the call back in January and updated the call in late March. But this was a true buy-and-hold kind of position, meant to plug into a secular trend rather than a mere cyclical one. It needs time to pan out… maybe even more time than the year allotted to our ETF contest.

Still, all things considered, its performance through the first three quarters of the year is solid enough, and the environment for oversized growth is still in place.

In this choppy, confused market, PHO continues to be a name that won’t keep anyone up at night yet is still making forward progress. That in itself is a breath of fresh air, even if most investors continue to look past it in search of something a little more scintillating. Sometimes excitement is something you want, but the last thing your portfolio needs.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities. You can follow him on Twitter, at @jbrumley.

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