The Invesco Water Resources Portfolio ETF (NASDAQ: PHO) is yet another thematic fund focused on water conservation that I would like to discuss. The purpose of my article today is to analyze its factor exposure, carefully examining its value, growth and quality characteristics by leveraging Quant data to come to a conclusion as to whether it makes sense to buy into the ETF at current levels.
Before moving on to analyzing the key metrics of concern, let me briefly recall the key findings from my two previous articles on water ETFs published earlier this year, namely the Invesco Global Water ETF (PIO), as well as Invesco S&P Global Water Index ETF (CGW).
What I mean is that water is an undoubtedly precious resource, and the growth in demand over the decades, supported by global population expansion, offers a lucrative opportunity. However, as I concluded in my October note on PIO,
… capitalizing on this trend via equity investments is not necessarily feasible, because distilling a pure-play portfolio of water is almost impossible.
What is SPO’s investment strategy?
With $1.5 billion in net assets accumulated since its inception in December 2005, PHO tracks the cash-weighted NASDAQ OMX US Water Index. The index is in many ways similar to the one its counterpart PIO adheres to, targeting companies involved in water purification and conservation for both residential and industrial end markets.
However, there is one main difference, namely the geographic footprint. The latter has significant exposure to international equities, unlike the former, as it must be listed on a US stock exchange to be included. As expected, according to PHO’s holdings dataset, it has only one ADR in the portfolio, Cia de Saneamento Basico do Estado de Sao Paulo (SBS), a Brazilian provider of water and sewer services, with a weighting of 1.86%.
Over the past few years, overshadowed by high currency volatility amid the trade war that rocked supply chains and then the coronavirus pandemic that exaggerated already existing problems, heavy exposure to the yen, the pound sterling, euro, etc. has been a major detractor of PIO. performance. This year, FX headwinds from interest rate hikes in the US also appear to be a plausible reason why it has significantly underperformed PHO.
Meanwhile, the flip side is that the PHO fund would be unable to reap the benefits of the inevitable weakening of the USD if interest rate hikes were to end at some point next year, mainly in depending on CPI dynamics, employment trends and recession. risk. The pivot from the Fed, if it materializes, could also contribute to the rebound.
Somehow, even considering that a rally in developed country currencies will eventually be staged in the medium term (especially assuming the energy crisis in Europe is resolved), I am skeptical whether PIO is the best choice to play this.
The product of PHO’s strategy is a portfolio of 36 stocks, more than 60% of which is spread across the top ten. Investors looking for large-cap baskets with all the quality benefits they offer would likely be disappointed here, as the median market cap of the fund’s holdings is only around $4.6 billion, with a value median business of about $5 billion.
Still, a weighted average figure is substantially higher at over $29 billion, by my calculations, so it should offer some comfort. Either way, 40% of net assets allocated to mid and small cap stocks is an issue to consider. Below, discussing the profitability and quality factors, I will explain why this is a vulnerability.
In terms of sectors, it is an extremely industrial game, with a 48% share distributed disproportionately among 20 holdings. Utilities come second with 17.7%. Health is last in the key trio, at 15.4%. Other sectors favored by the fund are information technology (11.1%), with Roper Technologies (ROP), an application software company, being its main investment with approximately 8.1% of net assets allocated, and materials (7.6%); the latter is only represented by Ecolab (ECL), a company with a portfolio of water, hygiene and infection prevention solutions.
Analyze value, quality and growth
In my notes, I always encourage my dear readers who have a particular interest in ETFs to look beyond a promising investment theme and instead focus on the factors. Valuation, quality and growth prospects are what count.
And when it comes to exposure to the PHO factor, there’s a lot to criticize. First, it’s priced horribly. The quantitative data for the top 20 holdings (~88% of net assets) speaks for itself.
An 85.5% share of stocks trading at a significant premium to their respective sectors is what I would expect from a tech hedge fund. Still, this is an industry-focused ETF geared towards mid-caps. And I don’t like this mix.
For better context, a table with selected valuation metrics for the top 20 stocks is shown below.
Additionally, looking at the weighted average multiples, the WA EV / EBITDA (Last Twelve Months) of 18.67x is clearly expensive (especially considering that the industry sector median is around 11.76x), with a weighted average Enterprise Value / Sales of 4.9x is also overstretched.
As a further indication of overvaluation (thus, little or no safety margin if the hawk-led sell-off continues) is a large presence of stocks with a D-Yield rating and worse, around 72.5%. Clearly, buying a PHO at 30 basis points for a value or dividend-oriented investor is just plain nonsense at these levels.
However, are these multiples justified by the better quality of PHO’s holdings? Only in part. He owns around 76.5% of the shares with at least a B- Profitability rating, with only a few names being negative for cash flow, as shown in the chart below. However, this is not ideal.
Also, stocks with growth characteristics such as Global Water Resources (GWRS) represent less than 13.5% of net assets, so I wouldn’t say the premium valuation is warranted.
How has PHO worked in the past?
Since its inception (excluding December 2005 and October 2022), PHO has failed to beat the iShares Core S&P 500 (IVV) ETF, with a CAGR of only 7.39% compared to 8.63% for the IVV, with an upper standard deviation of about 4%. Nevertheless, it should be noted that the lower CAGR was likely the consequence of higher expenses; at the same time, annual performance looks robust overall, especially in recent years.
This year (October included), PHO has slightly outperformed IVV, by around 25 basis points, more likely since the latter has been dragged down by weak technology indicators this earnings season.
In closing, I wouldn’t say it makes sense to invest in a large midcap fund with an utterly horrible valuation. The quality is certainly not entirely dismal, with a relatively large share of highly profitable stocks being a solid positive. However, a bullish thesis could not be built on this premise alone.
Obviously, PHO has a few advantages. For example, it is inherently less sensitive to the global macro economy assuming it only invests in US-listed companies. Similarly, it could underperform other water games that have lower dollar exposure when the US up cycle is over.
That said, it should be kept in mind that FX sentiment will influence its returns in one way or another, due to its holdings having globally diverse trading patterns. For example, as Xylem (XYL), the fund’s holding with a 4.4% weighting, mentioned on slide 18 of its Q2 presentation, a 5% drop in the euro’s key interest rate for l fiscal 2022 of 1.01 would remove $42 million from revenue and $0.13 from EPS. .
In sum, all of the above indicates that PHO is at best a restraint.