The Dow Jones US Water Utilities Index has quietly put together a 20% rally over the last month. During that move the index has broken a year-long downtrend and is now a viable sector for investment again. What is even more surprising is this move comes as the Dow Jones Utility Index has fallen. This can be seen in the exchange traded fund (ETF) iShares Dow Jones US Utilities (NYSE:IDU).

The Case for Water Utilities
The argument against the water utility stocks has been the stagnant revenue growth over the last couple of years and the underperformance versus the overall market. The revenue remained an issue this past quarter, but the outlook is certainly changing for two reasons. For starters, many of the large water utilities have begun to pass alone rate increases, which will increase their bottom line. Due to regulatory issues this is not always the easiest process.

The second reason to be bullish on the future outlook is the state of the water market. Demand for water has been increasing, especially in areas that have been experiencing above normal drought conditions. Water will be one of the next great commodities. (For more on opportunities to invest in this scarce resource, check out Water: The Ultimate Commodity.)

Blue Gold
Aqua America
One of the country's largest water utilities provides water and wastewater services to nearly 3 million customers with its largest concentration in Pennsylvania. The company continues to expand through acquisitions and is now in 12 states. During its most recent earning report the company reported flat revenue growth due to what the company called an economic slump and wet weather in certain areas of the country. The good news is that Aqua America is beginning to receive approval for rate hikes for their services and this will eventually go right to the bottom line. The company also boasts a 3.1% annual dividend yield.

American Water Works Company (NYSE:AWK)
Similar to Aqua America, the American Water Works Company is one of the largest water utility companies in the U.S. and reported disappointing earnings last quarter. The company reported a 5.4% increase in revenue over last year, but this was generated from higher rates and not water consumption. In the first six months the company has received $47 million in revenue due to rate increases, if this trend continues it could be a boost to the net income. If you are not familiar with American Water Works Company it is because it was spun off by RWE (a German utility company) in 2008 and just began trading on the NYSE in April. The company declared a quarterly dividend of 20 cents in July to be paid on September 2, 2008 to holders of record as of August 15.

American States Water Company (NYSE:AWR)
Not quite as large as the first two utilities, American States Water was the only one of the three to report a solid increase in earnings last quarter. However, the majority of the increase came from an unrealized gain of purchased power. What the company does have going for it is the location of its business - California and Arizona. These are two states that are often in dire need of water and American States Water is here to provide it. The dividend yield is 2.5%.

PowerShares Water Resource ETF (AMEX:PHO)
Not rallying quite as much as the water utility index, PHO has had a solid run and is within a few percentage points of a new all-time high. Despite what many investors believe, PHO is not the best investment for the water utilities sector, with only 11% of its asset invested in the sector. Of the top-10 holdings, only one is a utility and it is based in France. The majority of the stocks in the ETF are considered industrials, but should still offer exposure to the water industry as a whole.

Sustainable Rally
Whether the most recent breakout in the sector is a sustainable rally is anyone's guess, but given the bullish factors discussed above and the long-term outlook for anything water-related, I have to lean on the bullish side of the argument. Before investing in the sector, however, you have to consider if you want to go directly into the water utility stocks or diversify with a water ETF that is not a true investment vehicle for the utility sector. Of course there is always the option of going both ways.

For more on the utilities industry, read The Industry Handbook.