PHO - FIW: Supply Chain Valuation Concerns A Threat To This Long-Running Water ETF

2023-07-16 21:12:47 ET

Summary

• FIW holds 36 securities that derive substantial revenue from the potable water and wastewater industry. Fees are 0.53% and FIW has outperformed SPY over the last 16 years.
• The water industry faces several long-term challenges as identified by the American Water Works Association. In particular, supply chain issues related to the Build America, Buy America Act are concerning.
• FIW remains an expensive fund to own based on forward earnings and trailing cash flow. Wall Street analysts also don't appear bullish on FIW's constituents either, indicating possible short-term headwinds.
• FIW has lagged behind SPY this year, and based on my latest analysis, I don't see any significant opportunities for outperformance moving forward. Therefore, I've reiterated my "hold" rating.

Investment Thesis: What's Changed Since April

This is my fourth time covering the First Trust Water ETF ( FIW ), with my most recent review in April describing the water industry's challenges, particularly concerning the significant infrastructure spending required to meet consumer demands. I concluded that those challenges, along with FIW's high valuation and low profitability, warranted only a "hold" rating, and I did not recommend investors buy FIW despite its impressive long-term track record against the SPDR S&P 500 ETF ( SPY ). Since that review, the American Water Works Association published its 2023 State of the Water Industry report, highlighting persistent supply chain problems facing the industry as it relates to the Build America, Buy America Act. This article reviews the results of key survey questions provided by the AWWA that I hope will give readers pause before buying FIW. Additionally, I'll explain how the FIW's fundamentals, particularly growth, valuation, and earnings momentum, are tough to swallow, and I now recommend even more caution than before. I look forward to taking you through my reasons why in more detail below.

FIW Overview

Strategy Discussion and Exposures

FIW tracks the ISE Clean Edge Water Index, selecting 36 companies that derive a substantial portion of their revenues from the potable water and wastewater industry, as determined by Clean Edge. Key areas include:

• water distribution
• infrastructure (pumps, pipes, valves)
• water solutions (purification, filtration)
• ancillary services (consulting, construction, marketing)

Security weights are based on their relative market caps at each semi-annual rebalancing in March and September, as follows:

• Securities 1-10: 4%
• Securities 11-15: 3.5%
• Securities 16-20: 3%
• Securities 21-30: 2%
• Securities 31-36: 1.25%

FIW's top 10 holdings are listed below, comprising 40% of the portfolio. Advanced Drainage Systems ( WMS ), Ecolab ( ECL ), and IDEXX Laboratories (IDXX) are the three largest holdings and are up 46.36%, 28.32%, and 28.86% in 2023. WMS, a corrugated pipe manufacturer, beat analyst earnings expectations by an astounding 43% in May, then raised its dividend by 17%.

I've also listed FIW's sector exposures alongside PHO and SPY. As shown, FIW is 53% Industrials, followed by Utilities (20%), Health Care (11%), and Technology (9%). PHO has a similar composition.

Performance

FIW launched in May 2007 and has delivered an annualized 10.21% gain since. PHO and SPY gained 7.11% and 9.00%, respectively. The two water ETFs were more volatile than SPY, but FIW's risk-adjusted returns (Sharpe Ratio) are identical to SPY. It also declined as much as 46% month-to-month through the Great Financial Crisis, 5% better than SPY.

In the 15 complete years between 2008-2022, FIW outperformed PHO 12 times, or 80% of the time. It had a big beat in 2016 (18.14%), and in the three times it lagged behind PHO, it did so by 1.29% on average. The median beat was 1.82%, so I'm confident it's the superior water ETF. The argument against SPY is less clear. FIW outperformed SPY 9 times, or 60% of the time, between 2008-2022. It also outperformed by 10.19% in the last seven months of 2006 but has lagged by 5.30% for the first seven months of 2023. If the trend continues, that will snap FIW's four-year win streak.

FIW Analysis

State of the Water Industry

The American Water Works Association is a lobbying organization representing 50,000 members. Each year, it publishes a " State of the Water Industry " report, and this year's top challenge was the renewal and replacement of aging water infrastructure. As I covered previously, AWWA's decade-old " Buried No Longer " report estimated the U.S. needs a $1 trillion investment over the next 25 years to service a growing population. Other top challenges include long-term water supply needs and the ability to finance capital projects.

The U.S. Infrastructure Investment & Jobs Act was signed into law in November 2021, estimated to provide approximately $55 billion to the water, wastewater, and stormwater sectors over five years. However, more might be needed. This year's survey respondents in the Utility sector reported that a combined 24.4% are either "slightly able" or "not at all able" to cover the full cost of providing services through regular customer rates and fees charged. For the question, "full cost pricing" includes annual operating and maintenance expenses, capital costs (debt service, other capital outlays), and adequate working capital and required reserves.

Respondents' future outlook is more pessimistic, with a combined 36.9% either "slightly" or "not at all" able to cover the full cost of providing services. Furthermore, there are potential negative consequences from the Build America, Buy America Act , which "focuses on maximizing the federal government's use of services, goods, products, and materials produced and offered in the United States." Specifically, the Act zeroes in on iron, steel, manufactured products, and construction materials used in federally funded products, and roughly half of the respondents expect sourcing problems. Finally, 90% of respondents reported supply chain delays in 2022, the most significant negative impact on the sector.

My takeaway is that although water is essential, critical infrastructure problems are unlikely to be solved in the short- or mid-term. Water Utilities, which comprise 17.5% of FIW, appear particularly vulnerable, as they must balance rising costs with the ability of their customers to tolerate those costs. As shown in the performance chart below, these Utilities have primarily been a drag on FIW over the last three years. For reference, FIW is up 60.44%.

FIW Fundamentals

The following table highlights selected fundamental metrics for FIW's top 25 holdings, totaling 84% of the portfolio. One area of concern is FIW's relatively poor 6.68/10 Profitability Score. It's not uncommon for a portfolio comprised of mostly small- and mid-cap stocks, but investors usually receive a valuation discount. Instead, FIW is pricy, trading at 28.35x forward earnings and 28.91x trailing cash flow, or 1.20 and 5.54 points more than SPY.

FIW offers better earnings growth potential than SPY, but Seeking Alpha's 5.59/10 EPS Revision Score indicates Wall Street is cautious. One significant change was Morgan Stanley's downgrade of Advanced Drainage Systems based on a high valuation relative to historical norms. Another stock with a poor EPS Revision Grade is Danaher ( DHR ), downgraded by Bank of America analyst Michael Ryskin three months ago. However, Ryskin's concerns were specific to emerging biotechnologies, not water. Danaher's Environmental & Applied Solutions segment, including its water quality division, represented 17% and 14% of sales and adjusted operating profit in Q1 2023 . It's a reminder that companies need only derive a "substantial" portion of their revenues related to water to qualify for FIW.

Investment Recommendation

FIW has a solid track record, and I'm tempted to invest in the water industry, given how it's receiving substantial government support and how essential a commodity it is. However, I'm discouraged by FIW's valuation and profitability score each time I review the ETF. In addition, FIW now has weak earnings momentum and has potential supply chain challenges related to the Build America, Buy America Act. Therefore, it's difficult to recommend allocating dollars away from a low-cost fund like SPY and into FIW for diversification purposes, so I've decided to keep my rating at "hold." I hope you found this analysis helpful, and as always, I look forward to any questions in the comments section below. Thank you for reading.

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