PowerShares WilderHill Clean Energy (ETF) (PBW): This ETF Is a Case Study in “De-worsification”

Recently, I made the argument that PowerShares’ Water Resources ETF is poised to beat the market thanks to inevitable trends in demand for fresh water. However, the benefits of owning a diversified basket of stocks that can take advantage of global trends will only lead to market outperformance if you take time to develop an understanding of the ETF’s components, the weighting of specific companies (or particular niches within an index), and the sensitivity to risks that can adversely impact an entire industry.

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Investment in clean energy

The world’s growing emphasis on, and use of, clean energy has been a long-followed story that most people believe will continue in the future. Does this qualify as the basis of a broad investment thesis similar to the growing demand for water? Perhaps, but further analysis is warranted. With this in mind, here is a deeper look into PowerShares WilderHill Clean Energy(ETF) (NYSEARCA:PBW). To start, here’s a five-year chart showing PBW’s performance in relation to the S&P 500:

PBW Total Return Price data by YCharts

Ouch! This chart shows why PBW represents my personal worst CAPS call of all time with a current score of -122. For those that haven’t tried it, CAPS is a great way to learn valuable investing lessons while keeping score, yet without risking real money.

So what caused the gap between a solid big-picture thesis and actual results?

Sometimes the big picture isn’t enough

In hindsight, a lot went wrong to drive PBW’s massive underperformance. At the top of the list, macroeconomic conditions and government budget crises put many clean energy projects on hold as subsidies dried up and more cost-efficient (and less green) energy projects were chosen. With the pressure of budget constraints and lack of government subsidies, green energy projects focused on solar, wind, and other sources quickly lost momentum.

Clearly, clean energy initiatives have not gone away; however, the funding behind many of the projects has either been postponed or reduced. Energy efficiency solution provider Ameresco Inc. (NYSE:AMRC) is an excellent example of how delays have plagued PBW’s holdings; the company reports an ever increasing backlog, yet has struggled to convert this backlog into revenue (and earnings).

Competition in the larger energy industry has further pressured clean energy providers, resulting in pricing pressure that has significantly hurt the sector’s ability to increase profits. Solar module maker First Solar Inc. (NASDAQ:FSLR) is a well-publicized case study in how competitive pressure combined with overcapacity can result in disastrous investment returns.

Another important consideration for investors contemplating an investment in a focused ETF like PBW is a thorough understanding of how the ETF’s holdings are weighted. At the ETF’s peak in late 2008, the ETF and the Wilderhill clean energy index that it seeks to track were heavily weighted towards solar-related businesses, with most of the top 10 holdings focused exclusively on solar. While this may not have seemed to be cause for concern at the time, it certainly should have been; the performance of First Solar and other top holdings such as Trina Solar Limited (ADR) (NYSE:TSL), JA Solar Holdings, Ltd. (ADR) (NASDAQ:JASO), Suntech Power Holdings (NYSE:STP) , and Yingli Green Energy Holding, which collectively accounted for 20% of the ETF’s holdings as of May 2008, are the primary reason PBW has performed so poorly as illustrated below:

FSLR Total Return Price data by YCharts

Is PBW worth consideration today?

After dropping from over $28 per share to $5 per share with the long-term investment thesis that clean energy will continue to grow still intact, a contrarian investor might consider buying PBW today. While there is certainly tremendous upside potential, caution is warranted. Many of the companies within the index have either never been profitable or are struggling to resume profitability. For example, Suntech plunged by 24% in a single day last week on fears that the company will be forced into bankruptcy; this company still represents almost 2% of the ETF, and it is unfortunately not the only PBW holding in this position. Additionally, the competitive and budgetary pressures that popped the clean energy bubble still remain, so even the companies on more solid financial footing will not have an easy climb back to profitability.

It pays to be selective

Rather than rolling the dice on a bet that clean energy stocks are coming back as a group, it is more prudent to take a look at PBW’s current holdings for ideas for a profitable investment. A number of solid, profitable companies with big market opportunities remain in the index. For example, despite Ameresco’s recent struggles converting backlog into revenue, the company remains solidly profitable and occupies an enviable position of managing projects where the customer and company’s interests are closely aligned. Any sign that potential clients are finally willing to let Ameresco save them money over the long term by helping improve energy efficiency (as measured by conversion of backlog into active projects) could provide 100% upside just to get back to the valuation assumptions behind this year’s 52-week high. This won’t happen overnight, but a patient investor stands to benefit significantly based on current prices once the company demonstrates that projects are underway.

A less risky investment in clean energy is transmission company ITC Holdings Corp. (NYSE:ITC) . ITC is often overlooked because it operates in the “boring” world of electricity transmission, but connecting clean energy projects to the grid while enjoying favorable government regulation has proven to be a profitable business for ITC and its investors, as illustrated by the chart below:

ITC Total Return Price data by YCharts

All indications point to ITC being able to continue its recent growth for the foreseeable future. As a result, the company represents a relatively low-risk way to profit from the growth in clean energy without the drag of the higher-risk holdings in PBW.

The article This ETF Is a Case Study in “De-worsification” originally appeared on Fool.com and is written by Brian Shaw.

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