Water fund thrives on a thirsty world

By Tim Middleton

Add these to the list of resources being gobbled up by fast-growing China: Water meters.

In the rest of the world, the market for new and replacement water meters is rising at a tepid 3% annual rate, according to Industrial Water World, a trade newspaper. When China is added, however, global growth zooms ahead at an 8.4% clip.

That's good news for companies like Itron (ITRI, news, msgs), Badger Meter (BMI, news, msgs) and Roper Industries (ROP, news, msgs), which compete in this obscure but vital marketplace. And because all three are in the portfolio of PowerShares Water Resources Portfolio (PHO), the only pure play on water available to mutual-fund investors, their positive outlook is positive for the fund.

The argument for investing in water is fairly straightforward. About two-thirds of you is water. You need to replace 2.5 quarts of the stuff every day just to live, and a quart of bottled water costs more than a quart of gas at the pump. The Environmental Protection Agency projects that the United States will spend $500 billion over the coming two decades to refurbish public water supplies. The rest of the world needs to spend vastly more.

The Palisades Water Index, which the new PowerShares fund mimics, climbed an average 18.7% in the five years ended March 31, compared with a 4% advance for the S&P 500 ($INX). PowerShares Water Resources is up 7.4% this year, as of June 26, more than 6 percentage points ahead of the market.

Up until now, the only way fund investors could play the water theme was in a utility fund. By their nature, utility funds both are dominated by other industries -- electric power and telecommunications -- and pay relatively high dividends.

This fund is very different. It's the only one focused exclusively on water. And while it's too new to calculate a real yield, dividends paid so far have been negligible -- equal to less than half a percent of the share price.

So this fund would best fit into the growth portion of an investor's portfolio. In time it might earn itself a significant place in investors' hearts, but for now I would limit it to 5% of my equity assets or less -- not least because of its risks.

A flood of assets

The fund had been up nearly 20% earlier this year, and the steep decline it has suffered over the last three months illuminates two important risks:

• The water sector is small and so are the companies in it: Badger Meter has a market capitalization of $336 million, among the smallest 10% of public companies. Small caps are among the riskiest stocks.

• The fund's largest holdings are in Brazil, an emerging market. Developing-country stocks are even riskier than domestic small caps. But if you can tolerate this outsize risk, PowerShares Water Resources seems likely to deliver outsize returns.

Investors certainly have embraced the fund. PowerShares Water Resources is by far the most-popular new exchange-traded fund (ETF). Since it was introduced in December, it has attracted roughly $1 billion in assets -- four times the average haul of other ETFs launched at the same time.

The Palisades Water Index is a group of 37 companies, five of them foreign, that trade in the U.S. market. (The foreign stocks trade as American Depositary Receipts.) As of early June, the five largest holdings were:

Palisades Water Index's 5 largest holdings

Company
Companhia de Saneamento Basico (SBS)			4.49%
Consolidated Water (CWCO)			4.47%
Franklin Electric (FELE)			4.31%
United Utilities (UU)			4.26%
Nalco Holding (NLC)			4.19%

"We created (the index) to satisfy a need for some criteria by which to follow the broad water industry," says Stephen Hoffmann, president of WaterTech Capital, a consulting firm in Dallas. The index comprises the sector's most widely held companies, and at least 80% of them get at least 50% of their revenue from water.

There are several exceptions. General Electric (GE, news, msgs) gets a small percentage of sales from equipment used to treat potable and waste water, but is still a huge player in this small group. Its stock has a weighting of around 1%, as does 3M's (MMM, news, msgs).

Water treatment is the largest industry weighting within the index, accounting for 23% of its market capitalization. Other large industries are infrastructure, such as local water companies (16.5%) and resource management, such as engineering and construction firms (17%).

The largest publicly owned American water company is Aqua America (WTR, news, msgs), whose market cap is $2.9 billion. Consolidated Water (CWCO, news, msgs), the ETF's second-largest holding, is a Cayman Islands-based desalinization company with a cap of $318 million.

My colleague Jon Markman wrote at some length about Consolidated and this theme last year in a piece called "Invest in the coming global water shortage." Jim Jubak has repeatedly endorsed the theme, most recently in a piece called "Five water infrastructure bets." Four of the stocks he touted are held by this fund.

Buying the suppliers

Globally, only about 5% of water utilities are privately owned -- that is, open to investment. In the United States the percentage is higher, but only about one in five; most water companies are municipally owned. Typically, they are tax-subsidized, making it impossible for for-profit companies to compete against them.

Fortunately for PowerShares investors, even these government-owned companies have to buy their equipment and supplies from the private sector.

Fund returns will be reduced by fund expenses, which are 0.6%. That is low for a mutual fund but very high for an ETF, particularly one with so many assets. Excessive expenses are the only really big negative overhanging PowerShares' funds. Of the 50 ETFs with the highest expense ratios, all but 14 are PowerShares portfolios.

But investors drooling at the prospect of double-digit returns do not begrudge PowerShares its windfall profits. The fund has defied a difficult market, and that always attracts attention.

Meet Timothy Middleton at the Money Show

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At the time of publication Timothy Middleton didn't own any securities mentioned in this article. Middleton is the author of "The Bond King: Investment Secrets of PIMCO's Bill Gross," and a former mutual-funds columnist of The New York Times. He works from home in Short Hills, N.J.