PHO: Swimming Against The Tide – A Bearish Perspective On The Water Industry (NASDAQ:PHO)

Investment Thesis

Water investments have been very popular in recent years, driven by growing demand for ESG investments, as well as increased awareness of the developing water scarcity issue. Investors have piled in the sector like never before, driving valuations higher in the process. While I tend to agree with the fact that water will become a very valuable commodity in the future, I find the timing very uncertain and don’t see any major catalyst in the short term, all while valuations are pricing double-digit growth ahead. Moreover, there have been very few analysts that openly disputed the bullish case on water stocks, which reinforces my conviction that water stocks are at a make-or-break moment, where the odds are favoring the bears.

About PHO

The Invesco Water Resources ETF (NASDAQ:PHO) invests in companies involved in the water industry. The water industry encompasses a wide range of sectors including water utility, water equipment and materials, and water infrastructure. This includes companies that provide water treatment and distribution services, as well as those that manufacture and sell water-related equipment and technology. Below is a list of the top 10 holdings:

Valuation-wise, PHO trades at higher multiples compared to its category average. The fund currently has a TTM P/E ratio of ~24x and a P/B ratio of ~4x. The fact that PHO is trading at more than twice the category’s average makes it a good vehicle to place a short bet on water stocks.

For further details on PHO, please consult the fund’s prospectus.

What Is The Current Narrative: Identifying Fallacies

In my opinion, there is currently a lot of bullishness around water stocks, driven by increasing demand for clean water and water-saving technologies. Bulls are touting the long-term growth potential of water stocks, and how the water industry is expected to experience significant growth in the coming years as the population continues to grow, urbanization increases and the need for clean water and water-saving technologies becomes more pressing.

Famous investors in the sector include Michael Burry, who famously turned bullish on the sector in the aftermath of the Global Financial Crisis, and Bill Gates through his investment firm, Breakthrough Energy Ventures. ESG funds were the newcomers to the party post-2015 and started allocating funds based on a company’s environmental and social impact, oftentimes with total disregard for the multiples paid for the stock. This created a situation where valuations for water-related companies skyrocketed, and since the sector remains one of ESG’s favorites, there is no reason to believe that the current investment framework would change anytime soon.

However, as it’s often the case with very crowded trades, market participants are probably overestimating future growth expectations for the water industry. This has happened countless times in the past, with the GFC (mortgage sector) and Dotcom crash (Tech sector) being the most recent examples to date. I personally believe the water scarcity issue, but I consider it to be a longer-term problem, rather than something that we will have to deal with over the 5-10 years. Therefore, I believe there is an opportunity to be exploited by astute investors, who can take advantage of the timing differential.

Three Simple Reasons For Shorting PHO

Below are my three reasons why I think PHO is a good short in a pair trade against the S&P 500 (SPY):

Slowing Economic Growth

While still on solid grounds, I believe the odds of seeing the US economy cool down over the next quarters are high. Water infrastructure projects will be affected by economic conditions, which will ultimately feed into the PnL statement of water companies. Hence, I expect lower revenues and profitability during an economic downturn. I also believe the S&P 500 is in a bear market since Q4 of 2021 and while water stocks generally tend to do better at the beginning, I expect them to quickly catch up with the rest of the index once the economy shows clear recessionary signs. Below is PHO vs SPY during the GFC.

Capital-Intensive Sector

The water industry is capital-intensive, which means that companies need to invest large amounts of money in order to build and maintain water infrastructure. This makes it difficult for companies to generate high returns on investment, which will ultimately make them less attractive to investors over the long term.

Higher interest rates will only make it harder for water companies to finance new projects and grow while maintaining the same bottom-line profitability. Higher interest rates make it more expensive for businesses to borrow money, whether it’s for operations, expansion, or new projects. At the same time, capital-intensive businesses often have high fixed costs, such as debt service on loans and leases, which are sensitive to interest rate changes. As interest rates rise, the cost of servicing this debt increases, which negatively impacts profitability.

Expectations, Valuations, and Risk Premium

We’ve previously discussed how crowded the water trade is at the moment. This is a gift to the bears in my opinion, as any issue with the narrative will generate a massive mean reversion trade. Short interest in PHO is near historical lows, which is another great sign for the bears. I expect the combination of cheap borrow, aggressive pullbacks, and low short covering to be the perfect setup for shorts.

Meanwhile, long-term investors are paying over 22x earnings at the moment for PHO, while growth estimates are uncertain. Where is the equity risk premium in all of this? Assuming an earnings yield of 4.5% for 2023 (1/22 PE), you’re left with a lower yield than what the government is paying you on Treasury Bills. If you replace bills with 10-year notes, your equity risk premium is ~1.2%. Talk about mediocre returns! It goes without saying that I expect the equity risk premium to widen in the current market environment.

Setting Up The Trade

PHO is a good short in my opinion now, but I could see markets going higher in the first half of 2023 thanks to the Fed pausing interest rate hikes. As a result, I would short PHO in a pair trade against SPY, where I would be long an equal notional amount of SPY for every amount of PHO sold short. The strategy did well over the last decade, and while there is no guarantee that it will repeat, I find SPY’s valuation more attractive relative to PHO. For more details on SPY’s valuation, you can click here.

Key Takeaways

Water investments have grown in popularity in recent years, owing to rising demand for ESG investments and increased awareness of the developing scarcity issue. Investors have poured money into the industry like never before, pushing up multiples to what I believe are unsustainable levels. Since the economy is likely to slow down in 2023, I can see valuations mean reverting in the water sector, setting the stage for opportunistic bears that will take advantage of the decline. I would short PHO using a pair trade where I simultaneously buy the SPY and sell PHO.