FIW: Popular Investment Theme Trading At Elevated Valuations
4 min read
Bilanol
I recently came across the First Trust Water ETF (NYSEARCA:FIW) with an impressive 5-year compounded annual return of 15.0% (Figure 1).
Figure 1 – FIW has strong historical performance (ftportfolios.com)
FIW’s 5-year performance is better than that of the SPDR S&P 500 ETF Trust (SPY), an ETF tracking the S&P 500 Index. What is behind FIW’s amazing returns, and is strong performance likely to continue in the coming quarters?
Although I like FIW’s exposure to the water treatment and distribution theme and believe the companies would do well in the long term, I am hesitant to recommend the ETF as a buy at the moment due to the elevated valuations of the stocks, with FIW’s portfolio trading at a 29.3x trailing P/E.
Fund Overview
The First Trust Water ETF is a thematic ETF from First Trust that focuses on investments in the Freshwater industry.
Water is one of the world’s most valuable resources and is vital to all forms of life. As a commodity, freshwater is essential for agriculture, manufacturing, and energy production, but its supply is limited. According to the U.S. Geological Survey (“USGS”), readily available freshwater represents ~1% of the global water supply (Figure 2).
Figure 2 – Available freshwater represents 1% of global supply (USGS)
Freshwater’s scarcity makes investments in the treatment and transportation of freshwater attractive investment opportunities. The FIW ETF provides exposure to companies that derive a substantial portion of their revenues from water treatment, distribution, infrastructure, and ancillary services such as consulting and metering.
The FIW ETF tracks the ISE Clean Edge Water Index (“Index”), an index that identifies and filters the universe of U.S.-listed water companies meeting the fund’s size and liquidity requirements (Figure 3).
Figure 3 – FIW index methodology (ftportfolios.com)
The FIW ETF has $1.8 billion in assets and charges a 0.53% net expense ratio (Figure 4).
Figure 4 – FIW fund overview (ftportfolios.com)
Portfolio Holdings
Figure 5 shows an overview of FIW’s investment portfolio. FIW’s portfolio holds 36 securities with a median market capitalization of $10 billion and trades at a P/E ratio of 29.3x.
Figure 5 – FIW portfolio overview (ftportfolios.com)
FIW’s sector allocation is shown in Figure 6. Industrials are the largest sector weight at 55.9%, followed by Utilities at 16.8% and Health Care at 10.7%.
Figure 6 – FIW sector allocation (ftportfolios.com)
Although the FIW ETF only has 36 holdings, it is fairly diversified, with no single security accounting for more than 5% of the portfolio (Figure 7). The top 10 holdings account for 39.3% of the fund.
Figure 7 – FIW top 10 holdings (ftportfolios.com)
Water Theme Should Last For Foreseeable Future
As mentioned above, freshwater is essential to life and the world is quickly running out of this scarce resource. According to UNICEF, more than 4 billion people in the world, or 2/3 of the world’s population, experience severe water scarcity for at least one month each year.
According to data compiled by First Trust, the global water infrastructure repair market is expected to grow by 40% from 2021 to 2026, reaching a total of $141 billion (Figure 8). By 2030, spending on water infrastructure is expected to reach more than $900 billion per year.
Figure 8 – Water spending is forecast to continue to grow (FIW factsheet)
For long-term investors, water treatment and distribution appears to be a key investment theme for years to come.
But Beware Extended Valuation
However, like most popular investment themes, the water investment theme appears extended at the moment, with FIW’s portfolio trading at a 29.3x trailing P/E. Historically, we know that forward returns tend to be inversely correlated with valuations, i.e. investors experience stronger returns when investments are made at low valuations and vice versa.
For example, if we look at the valuation of FIW’s largest holding, Veralto (VLTO), the company is currently trading at a 34.1x P/E, the highest in its short history (Figure 9).
Figure 9 – VLTO is trading at 34x P/E (Seeking Alpha)
Similarly, the other top holdings like American Water Works (AWK), Ecolab (ECL), Xylem (XYL), and Agilent (A) trade at 28.9x to 42.1x P/E (Figure 10).
Figure 10 – FIW top 5 holdings valuation and growth (Seeking Alpha)
Furthermore, these stocks’ elevated valuations do not appear to be justified by their growth rates, which range from -0.2% to 17.9% respectively for 2024.
While I like the water investment theme, I am personally hesitant to pay 29x P/E for companies growing revenues at low-to-mid-single digit rates.
Risks To Cautious Stance
Of course, I could be overly cautious, and the water investment theme could continue to deliver strong returns. In particular, if we look at these stocks’ valuations over time, we can see that their valuations were even more elevated in 2021 (Figure 11). So there is precedent for valuations to continue rising.
Figure 11 – FIW top 5 holdings valuation over time (Seeking Alpha)
However, in my opinion, the margin of safety in the water investment theme is simply not present, and I would prefer to wait for a better buying opportunity.
Conclusion
The First Trust Water ETF gives investors a convenient way to gain exposure to the water infrastructure and treatment theme. I believe this theme should be in high demand for years to come, as the world’s growing population continues to increase the strain on water infrastructure assets.
However, I am hesitant to recommend the ETF at the moment as its investment portfolio is trading at a trailing 29.3x P/E, elevated compared to the equity markets at 24.1x. I rate FIW a hold and would look to revisit the ETF in the event of a market pullback.
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