Investing in the Basic Necessities

There is a growing sense that the basic provisions for human life—food, water and energy—will become increasingly dear in growing world. Competition for scarce resources is compounded not only by world population growth but also by the masses of newly-minted middle class consumers.

Add to this the belief by many that traditional resources are running out and new, more environmentally friendly resources must be found, and you have the makings of an incredible bull market in the basic necessities. So, as surely as night follows day, fund companies have rolled out products designed to give investors exposure to these hot markets (click all charts to enlarge):

Table 1: “Basic Necessities” ETFs

We don’t deny the bull market in these basic commodities nor the secular case that scarcity in a growing world could push prices even higher over the long-term (although reasonable people can disagree on that). However, the important question for our purposes is: are these ETFs, which hold stocks of companies somehow connected to the basic necessities, good investments? We found three reasons to be cautious:

1. “Exposure” is a relative term. Many of the constituents in these funds are engaged primarily in businesses other than the fund’s namesake. For example, Applied Materials (AMAT), a member of the Clean Energy portfolio, may be developing technology with applications in the field of clean energy, but for the foreseeable future its profits and most likely its stock price will be determined by the company’s fortunes in the market for semiconductor equipment. Similarly, General Electric’s (GE) water treatment products are only a sliver of its overall business, and therefore it isn’t likely to drive share prices for the Water Resources portfolio of which it is a member.

To be fair, these two well-known examples make up relatively minor portions of the holdings in each fund. But the fact that exposure in these target funds just isn’t that narrowly targeted can be illustrated by the sector breakdown. Figure 1 shows the sector breakdown of holdings in the Water Resources fund, many of which have little to do with water. PBW and MOO provide similarly diverse exposure to a range of sectors that are not necessarily driven by what happens in the clean energy and agribusiness industries.

2. Prices don’t always equal profits. At the risk of belaboring the obvious, rising prices don’t always translate into profits. A good example of this is in energy, where the price of oil averaged 7.2% higher in Q3 of this year versus the same quarter last year, while the profits of firms in the Energy Sector (XLE) declined 9% YoY (Figure 2).

In emerging technologies such as these it can be particularly difficult to find the winners. A year ago ethanol seemed like a sure bet, yet making the stuff has become a break-even proposition at best, and construction of several planned production facilities has been put on hold. Meanwhile shipments of good-old-fashion coal are soaring. The fact is that consensus profit forecasts for firms in these ETFs are little more than a guess at this point.

3. Valuations are expensive. Given all the uncertainty one might still be able to make a good investment case if stocks were a bargain. But like many hot sectors, by the time a target fund becomes available the stocks are already selling at nose-bleed valuations. In fact, we can’t even calculate valuation multiples for the Clean Energy portfolio because firms in PBW have, in aggregate, never earned a profit.

Our rating of an ETF’s overall investment merit, the ALTAR™ score (see endnote), illustrates this as well. Both the Agribusiness and Water Resources have historical profitability that is fairly low as measured by Return on Equity, yet sell at lofty price-to-book value multiples. The result is an ALTAR™ score roughly half the levels of the average Sector & Industry ETFs we follow (the higher the better). Meanwhile, firms in the Clean Energy fund have been destroying shareholder value with a negative Return on Equity, making calculation of the ALTAR™ score meaningless (Table 2). In other words, investors in PBW are really acting as venture capitalists.

Table 2: Calculation of ALTAR™ score

Note: For more information on the ALTAR™ score go to www.etfresearchcenter.com/altar.htm

Of course, we couldn’t end this discussion without a hedge clause: none of this means investors should avoid these funds altogether. In fact, for exposure to these areas ETFs are the perfect vehicle because of the extreme risks in trying to pick single-stock winners in emerging technologies—and it’s quite likely there are big winners (i.e., the next Microsoft) somewhere within each of these funds, along with more than a few losers. However, investors need to recognize these funds for what they are: speculative. So use them sparingly.

Note: The AltaVista Long Term Annual Return forecast (ALTAR™ score) is AltaVista’s proprietary measure of an ETF’s likely return to new shareholders in the coming years, based on historical profitability over the business cycle, current valuations, and fund expenses. For more information go to www.etfresearchcenter.com/altar.htm

Comments

[danno:]

This is good, point #1 about exposure is particularly good. And yes, a lot of these index funds have investments in a lot of over-hyped and lousy companies. The litany of companies dropped from their indexes each quarter is also telling that many of them (the index managers and the investors themselves) know little about the companies in which they have invested. The former results from incompetence, the latter just from laziness. Do your homework!

Author should look at 2 alternatives:

1 Invest in a composite index in the sector such as those from Ardura or NEF, or
2) Go with an ETF that focuses on picking only the best companies in the sector such as the PowerShares Cleantech Portfolio (PZD) and have high exposure. On the other hand, PZD doesn't provide a pure-play investment in either energy or water. It looks to me more like diversified growth stock mutual fund.

I would differ with the author on one point, however. There is no justification for investing in stocks that are destroying the environment such as coal mining companies. They profit while the public has to absorb the huge negative costs created by coal mining, transportation, and combustion.

2007 Dec 27 01:14 PM

[NO DooDahs:]

If you look carefully at the composition of PHO, you will find that there are very few - if ANY - pure plays on water in it.

Lots of utilities, technology companies, and suchnot, but very few companies that make a majority of their revenue finding and delivering water.

Just an FYI.

2007 Dec 28 04:09 PM