ARKK Is Starting To Sink Into Value Territory (NYSEARCA:ARKK) (2024)

Thesis

ARK Innovation ETF (NYSEARCA:ARKK) is becoming undervalued, secondary to the classic overcorrection phenomenon that occurs to an equity based security, after a period of overvaluation. ARKK has fallen out of favor with traders who’ve anticipated the market rotation from growth to value as inflation, and the Federal Reserve’s response to such in the form of projected rate hikes and quantitative tightening, has become a concern. Further traders who used ARKK as a pandemic related safe haven seem to be continuing to abandon that position as the worst of the pandemic’s ability to create uncertainty seems to be behind us.

The market is often inefficient, and too much negative focus on ARKK’s pandemic related stocks, such as Roku Inc. (ROKU) and Teladoc Health Inc. (TDOC), as well as their currently unprofitable smaller holdings, who’ve yet to prove themselves in a higher interest rate environment, is overshadowing the strong projected earnings growth of their profitable holdings, as well as the strong revenue growth of the majority of the fund’s holdings.

Based on my conservative sum of parts calculations, which are a function of projected earnings growth and eventual reversions to fair values of the individual holdings, Cathie Wood seemed optimistic when she said in late December of 2021 that ARKK could see 30-40% CAGR long-term price appreciation (when the fund was sitting a little below $100 per share) - but there is still room for considerable price appreciation at this point.

Strategy

Those wishing to invest long in ARKK should take advantage of the current Russia/Ukraine related volatility to start positions well underneath my calculated fair value, buying incrementally into the negative momentum as the likely overcorrection unfolds.

ARKK’s financial strength, based on my calculated weighted average financial strength of its holdings, is significantly weaker than the more famous large cap growth companies like Amazon (AMZN) or Meta Platforms (FB), but is comparable to many market stalwarts, like International Business Machines (IBM) and Prudential (PRU). Thus it is investable, but one should not YOLO a significant portion of their portfolio into it, regardless of my projected CAGR and price target, for the purposes of managing risk.

I personally started a position last week, to which I will add up to 0.5% of my portfolio over 2022, if Russia or the Fed gives me that chance. But because of its weaker financial position, I recommend staying safe and striving to buy at or under 85% of price to fair value to garner a margin of safety.

The Classic Overcorrection From Overvaluation to Undervaluation

Altria (MO) is a good example of the overcorrection phenomenon, since its projected future earnings are relatively easy for analysts to predict. Analysts are correct the majority of the time regarding future earnings calls, so we can see when traders are being overly pessimistic on a price and earnings generated time series:

We can see on the FAST Graph that MO was overvalued in the 2014 to 2017 range, then ultimately reverted back to its historical average P/E of 15.4 and subsequently fell further into undervaluation territory. On the day this graph was captured, MO was at $40.12 and its fair value, based on this average, was around $64.

Traders were discounting the stock relative to analysts and historical averages for reasons not novel to the general risk profile of the company: 1) regulatory risk; 2) declining cigarette volumes, even though the company has decades left of pricing power to override this concern; and 3) concern about poor execution of growth of reduced risk product revenue. Momentum turned a justified correction into an unjustified one.

The same phenomenon has started to happen to ARKK which, after its massive sell-off, is holding mostly undervalued companies with a handful of still grossly overvalued ones that are upwardly skewing its weighted average price to fair value ratio, making it seem as though it’s still vulnerable to permanent and significant downside.

My calculated price to fair value (P/FV) for the fund is based on a weighted average, with the weighting being a function of each individual holding’s capital weighting in the fund. Tesla (TSLA) therefore has a lot more influence on the final P/FV than Roblox (RBLX) does.

Fortunately, Morningstar covers most of the heavily weighted holdings in ARKK, and I was able to incorporate their published fair values for these companies into my calculation. Morningstar is focused on long-term value investing and uses living, breathing analysts to formulate their fair values, which are often conservative with regard to growth companies. This gives me confidence my averaging calculation won't return an excessive result.

For any of the smaller holdings that weren’t covered by Morningstar, I deferred to GuruFocus’ real-time quantitative fair values, which again are value investing focused, and in the rare case where Guru didn’t have enough data, I performed a back-of-the-envelope fair value calculation, based on the Peter Lynch model that PEG = 1 at fair value, or out of desperation, looked at forward EV/Sales against the sector median in cases where the company was still far from profitability.

Data Captured March 4, 2022 after closing.

Calculating the fund’s capitalization, were all its holdings to return to their fair values overnight, where all the overvalued holdings crater and all the undervalued ones rise, again shows us that traders are too focused on the negative aspects of the fund.

And let's not forget that most of these overpriced outliers have strong growth ahead of them, so their EV/Sales and P/S ratios are going to drop significantly relative to today’s prices for the companies, which will alleviate the skewing effect in ARKK’s valuations published above. The six publicly traded companies of this set are shown below:

Data Captured March 4, 2022 after closing

Too Much Negative Sentiment at This Point

Certainly, the theme to the first quarter of 2022 is get out of growth and get into less rate and inflation sensitive equities, especially energy, as the Russia/Ukraine war unfolds:

There’s nothing wrong with this; it’s one of the basic tenets of market dynamics, with regard to what the Fed and inflation are doing. But it tends to drag down all growth companies, regardless of their quality or projected future returns, at least in the short term. We can see evidence for this in examining the price to fair values of some of the highest quality growth companies on earth:

Data captured March 4, 2022 after closing

And a lot of emphasis is being placed on ARKK’s unprofitable, or apparently overvalued companies, which is further lubricating its sell-off in the broader rotation context. For example, in the February 28, 2020 SA article ARKK: More Trouble Ahead, the author states that:

Despite significant corrections this year, all of ARK Innovation ETF's top ten investment holdings are likely still overvalued, as they all trade at inflated sales multiples. Companies that lack fundamental profitability are at risk of further valuation adjustments as the great rotation away from growth and toward value accelerates.

The author is correct in that it could take up to 18 months from the first rate hike in a series for the entire growth to valuation cycle to complete, based on past rotation cycles in the face of rate increases. So it is likely we are just getting started. The author doesn’t explicitly state what information they are comparing the current price to sales ratios against, but just looking at them on their own, or against the sector median, is not enough to say anything substantial about the value of these companies. The sector might not be as innovative as the company itself. For example, does anyone believe that Tesla is sitting at 11x its actual fair value and should really just be worth $80, especially if it’s growing revenue at almost 4 times the sector median it’s being compared to?

Data captured on March 2, 2022. M = Morningstar FV; G = GuruFocus FV; L = Lynch FV

What we actually have is a few bad dogs sitting amidst several undervalued companies in the top ten, according to Morningstar, and that’s after the analyst has recently adjusted the fair values significantly downward for a few of these companies, now that the pandemic effect is wearing off, per the author’s concerns.

And to be fair, even one of those dogs, Unity Software, is set to achieve profitability in 2023 and see steep earnings growth from 2022 to 2024, meaning that its fair value is set to rise between 4 and 5x in 2023 if analysts' predictions hold true. So Intellia Therapeutics is the only real dog here, but such is to be expected from a pharma company whose products, by their nature, ride or die. It will take a few years to see if Wood’s bet pays off or not, as its share dilution funded pipeline runs the gauntlet of clinical trials, regulatory approval, and market adoption with the prize only at the very, very end.

As I previously stated, this phenomenon of a few bad dogs swimming in a sea of undervaluation is fairly hom*ogenized throughout the entire fund. Let’s also take note that the top ten list is not an unprofitable one. Per my table above, 50% of the top ten is currently profitable, while 70% are projected to be by 2023.

Growth and Price Targeting

Let’s run through some growth scenarios but let’s first acknowledge the strong growth happening throughout the fund:

Of the profitable companies in ARKK, 71% of them are expected to grow earnings at or over 30% per year! That’s even after analysts have had time to adjust their forward earnings growth estimates with concern to rate hikes and tightening.

Of a recent, late February sampling I did of the broader holdings in the fund, which included 32 companies, representing 87% of the fund by capitalization, encompassing both profitable and unprofitable companies, 69% of them had forward revenue growth of 20% or more, and half of them had growth of 30% or more.

So let’s not get into the mindset that the Fed raising rates will certainly sink the ship, especially since Wood was able to achieve a 4-year, 33% CAGR during the multi-year rate hike environment between 2016 and 2020:

Ignoring the pandemic and rate cuts, if we were to extend that 33% growth trend out to the beginning of 2022, we’d be sitting at $93.50 right now.

Let me say that again. If there were no pandemic, and rates had meandered around the 1.75 and 2.5% range like they were, and like everyone is afraid of happening again in the near future, then there is some likelihood ARKK would be sitting around $93.50.

At the time of writing, the fund is currently sitting at $60.23. That’s a 35% drop from the extrapolated price. So it wouldn’t be that farfetched to assume a significant amount of that 2022 rate hike pain has already been felt and everything below it is less justified:

Above is a list of rate hike scare scenarios ARKK has sailed through between 2015 and the middle of January 2022. It’s a bit notable that in the scenario marked in red, which starts on 12/3/21, a little over a week before the Fed meeting that put us on a quicker rate hike path, incidentally has ARKK plunging 22.73% up to 1/19/22. If we were to extend that out to today, the plunge would have been 35%, which is very similar to the difference between my extrapolated price and today’s March 4, 2022 price.

Further, we see ARKK sailing through several other rate hike scares with not much fear or pain happening, lending to the idea that a significant portion is already baked in.

With that in mind, I’ll provide a few 3-year price targets under different scenarios. Three years is long enough that the growth to value rotation, and initial negative sentiment around rate hikes, matters less, but is still short enough that the analysts’ projections are still meaningful.

There Was No Pandemic Case: ARKK just continues on its 33% CAGR path as it was before the pandemic.

Normal Conservative Case: Today’s profitable companies return to fair value and grow at the rate of projected earnings growth while unprofitable companies merely return to fair value. The overvalued dogs fall; the undervalued phoenixes rise. I’ve modified my mini-Gordon model to work on an ETF or mutual fund as seen below. The three-year cap sum is divided by the current capitalization to get the multiple to find the 3-year target.

This is a conservative model for several reasons:

1. It assumes no overvalued companies that are yet to be profitable become profitable, or are near profitability in 3 years, which would justify a jump in their fair values, and growth in those values driven by earnings or cash flow;
2. It fails to take into account earnings growth for three companies, ROKU, SPOT, and IRDM, which are showing projected growth, yet I couldn’t find good 3-5 year growth projections, and thus they only return to their present fair values;
3. It assumes no growth in fair values of the unprofitable companies; and
4. The share price appreciation of the profitable companies tracks earnings, instead of sales or cash flow, like one would expect from a growth story.

Normal Conservative Case, But Today’s Outliers’ Prices are Justified in the Three-Year Time Period: Same deal as above but the six outliers that are skewing ARKK’s fair value just trade flat for 3 years.

Normal Conservative Case, But Outliers Don’t Participate in the Calculations: This one is just for perspective and not a real price target.

Bearish Fair Value Hair Cuts Case: Profitable companies return to fair value and grow at the rate of projected earnings growth while unprofitable companies suffer a bearish 20% correction in fair values, and return to those fair values. This is the ‘pain has not been baked in’ scenario as explained by the bearish author in the SA article I referenced earlier.

From data captured on March 3rd, 2022, after closing

Stay Safe Out There

Back on February 21st, similar to how I calculate my weighted P/FVs, I ran a weighted GuruFocus financial strength score for the 32-company sampling I did at the time, to get an idea of ARKK’s investability. Keep in mind each industry has its own debt/EBITDA that’s considered safe, but as a rough reference I’ve published several safety scores of well-known companies alongside ARKK’s below.

ARKK’s companies weigh in at 5.52 out of 10, and such cannot be explained by the individual scores of the top ten companies, as those own a very similar average score to the rest of the fund; in other words, the individual safety scores are fairly hom*ogenized throughout the fund.

GuruFocus Financial Strength Sample (not ARKK’s):

Data Captured February 21st, 2022

This is not an ETF you’d want to YOLO a lot of your portfolio into to get at that 3-year, 2 to 3x your investment, based on the safety score. I’m personally comfortable committing 0.5% of my portfolio to it at the right price throughout 2022.

If one blends my two best fair value estimates of the fund, such results in a $71.50 price; and if you put a good 15% safety margin onto that, we’re down to $60.77, which is very similar to last Friday’s closing. I would say this number or below is a good place to start a position and HODL long, while adding bit by bit into negative momentum if it continues to occur.

Limits to This Analysis

I’ve tried to notate the dates in which my data presented throughout the article were captured, as the components of ARKK are constantly changing in weighting either due to volatility, or through active rebalancing and trading. The top ten holdings one day may be different on the next.

Also I’m looking at the fund through the lens of a buy and hold, long-term value investor of ARKK’s individual holdings, and this active rebalancing somewhat confounds this viewpoint, though one would assume it should outperform it, given that ARK’s team of dozens of people should be more savvy in their forecasting than one retail investor with less precise tools, issuing their opinion.

Andrewfez provides mathematically driven insights into value related investing. He is the author of the book, How to Calculate How Much You Overpaid for Your Home During or After the Housing Bubble: A Guide to Quantifying Your Short, Middle, and Long Term Losses, written under his pen name, Thomas Smyth. Another niche area he cares about is calculating fair values of ETF's and mutual funds using his proprietary weighting formula. Andrewfez is also a classical music composer, a healthcare professional, a woodworker, an Airbnb host, and the occasional writer of fiction and non-fiction.