The ARK Innovation ETF (NYSEARCA:ARKK) run by Cathie Wood was once one of the most popular and high flying ETFs. The exchange-traded fund ("ETF") has dropped almost 80% from its early-2021 peak despite its continued expectations for outlandish valuations and returns from its peer companies. As we'll see throughout this article, despite recent weakness, we expect continued poor performance.
ARKK Holdings
ARKK has a fairly concentrated portfolio despite massive shifts recently, making it more reliant on the top holdings and their performance.
The company's top 5 holdings make up 34% of its total portfolio. That makes it heavily reliant on the performance of these holdings. Tesla, Inc. (TSLA) is an electric vehicle ("EV") pick in a competitive market that's already the most valuable car company in the world by a factor of 2 (although not the largest manufacturer). With Toyota (TM, OTCPK:TOYOF) half the size and selling 10% of cars, where's the potential?
Some argue that self-driving, etc., could change the thesis, but the company isn't leading there. Waymo and Cruise are both well ahead of the company in self-driving miles and performance, and Chinese car companies are also performing incredibly well. The company's solar market share is in the low single digits and it's given up here.
Zoom Video Communications, Inc. (ZM) is a pandemic pick that had great growth during the remote office. However, with an increasing requirement to return to office for work, competition from Webex and Microsoft Teams which are well-versed in business-to-business spending, and more, the company's growth days are behind it.
Roku, Inc. (ROKU) is another example of an individual standalone company with less growth in a competitive market. The company is competing with Amazon (AMZN) Firestick and Chromecast. However, its competitors are poorer-subsidized businesses. Intellia Therapeutics (NTLA) and Exact Sciences (EXAS) are exciting biotech companies, but anyone with experience in biotech investing knows what we're about to say.
The business is incredibly high risky, as 90+% of Phase 0 ideas never hit consumers. Those that do cost billions of dollars to ever bring them to market. Larger competitors eventually figure out the technology and join the scene for the most part or make an acquisition. But multi-billion dollar biotech companies with an established rapidly growing product is one of the riskiest investments.
ARKK has given no indication of their ability to pick winning biotech investments or to know the business better than other investors.
The Innovator's Dilemma
"The Innovator's Dilemma" (1997) by Clayton Christensen is both a great book and a solid theory.
It investigates why the companies that seem best-positioned to capture innovation, the leaders in their field, don't. That's because the factors that a startup needs to be successful normally counteract directly with what an established company does and what it needs to operate. The only alternative is to operate startups within the company, which is expensive.
Even then, a company might not be able to pick up the latest technology, and if it does, it's competing with plenty other startups within the field.
A Flawed Premise
Unfortunately, The Innovator's Dilemma doesn't mean that startups are likely to succeed.
Not only is it an incredibly competitive business, but being the first with a new technology is arguably less important than timing that new technology. That's visible through Meta Platform's (NASDAQ:META) VR/AR operations. The company has pivoted completely here, putting legacy products on the back-burner, hiring tens of thousands of workers, of spending $10 billion / year.
What does it have to show for it? Realistically, nothing. Could VR/AR sometimes be a large and popular business? Of course. Will it grow to the expected levels needed to justify Meta's business? Unlikely. At least in the near future. At least so far, it appears that the company has mistimed the entry into the business.
The same could be seen in 3D printing when it first starting to become popular almost a decade ago. So how does this relate to ARKK?
ARKK is focused on chasing companies that it believes are working on exciting innovative tech. The company is expecting incredibly strong returns as a result. However, we don't see the company actually investing in companies near fair value, and we think that the company is underestimating the combined effects of the above and how they could cause bankruptcies.
Outlandish Claims
So why do we struggle to even treat ARKK as an ETF? There's a few reasons.
The first is fees. If you want an ETF, invest in an ETF. The fund has a 0.75% expense ratio, 10x any good Vanguard Fund. For a $100k investment, that's an extra $700 you're paying versus a good Vanguard Fund. So why do it? Especially with a concentrated portfolio that you can easily replicate and invest in yourself.
The second is forecasts. The company has a number of price forecasts that we see as completely outlandish, removing any credibility. The company has a $1500 price target on Tesla (split-adjusted) for 2026. That's enough to give Tesla a market capitalization of almost $5 trillion, making it the largest company in the world.
It also would make it worth 10x every other car company combined. Assessments are that self-driving etc. could change that, but with the company not leading in any of those fields, why think that?
The last is its investments are still overpriced. We've discussed this in more detail in our other articles, but we still see the company as being substantially overvalued at its current level. Investors who got in at higher prices and "believe in the ARKK thesis" like ARKK itself (which still owns 0.1% of the company) are not selling. That's keeping prices higher.
This combination of 3 factors is why we expect ARKK to continue underperforming.
Invest
ARKK has underperformed the S&P 500 by 300% YTD. So how do you take advantage of this. You can sell ARKK obviously. You can short it but then you have unlimited downside. You can purchase PUTs but then you have susceptibility to theta decay. Or you can put it all together and purchase SARK - Tuttle Capital Short Innovation ETF (NASDAQ:SARK). That investment moves with the inverse of ARKK, offering a substantial opportunity to take advantage of ARKK's decline.
Thesis Risk
The largest risk to our thesis is sometimes you get lucky. ARKK has a bunch of what we'd call "gambling" investments, and the company's positioning in 2019 led to outperforming in 2020 due to the unexpected factors of the COVID-19 collapse on the technology markets. There's always a chance that some other black swan even leads to the company outperforming unexpected.
Conclusion
ARKK has become a classic example of how things can change, substantially underperforming the markets in 2022, and being set up for continued underperformance. It's a stunning reversal of the fund's celebrity status in 2020. However, despite that, we don't think the fund has hit undervalued status, we think it still has substantial room to drop.
In our view, the ARKK fund is a mixture of poor investments. Many of those investments are overvalued, and the fund's overall portfolio of assets are overvalued. We expect that to cause long-term underperformance, and as a result recommend investors look at SARK instead of ARK.
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