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The Ark Innovation ETF (ARKK) has performed very well in 2018, going up a decent 26%. In light of this recent rise, and the fact that ARKK has many other problems, we believe it is now quite overvalued and should be sold.
What is ARKK?
ARKK is one of several funds run by ARK Invest, an ETF sponsor that focuses on “disruptive innovation”. ARKK invests in innovative industries like 3D printing, autonomous vehicles, and more.
Why ARKK is a bubble
ARKK claims to be “venture capital-like”, investing in “disruptive technology”. However, most venture capitalists try to identify these companies in their startup stage, and therefore, can invest at a lower valuation. ARKK is investing in these technologies after the companies have gone public and received a sky-high valuation.
This had worked out well for ARKK in the past few years, but then, we have been in a middle of a multi-year long technology bull market. The fund has never experienced a prolonged bear market.
What’s more, in many cases in the past, these technologies quickly became obsolete in a few years. Spotify (SPOT), an ARKK holding, for example, had much less value after Apple Music (AAPL) launched. Netflix (NFLX), another ARKK holding, may be about to face the same fate after Disney (DIS) and other media companies launch a competing streaming platform.
Why a bear market would be devastating for ARKK
ARKK’s holdings can be primarily divided into 3 areas: mature tech companies, fast-growing companies, and biotech companies. Most of its holdings are in the latter two.
The first class, mature tech companies, make up a fairly small % of the fund’s portfolio. They do decline somewhat in bear markets, but they’re not really a major risk.
The second class, fast-growing tech companies, is what we’re concerned about most. These companies, like Square (SQ), Zillow (ZG), or Tesla (TSLA), are fast-growing but make very little money or lose money, and ARKK is stuffed full of these stocks. These stocks have multiple problems: no margin of safety, extremely high valuations, excessive stock-based comp, etc. They frequently trade at high P/S multiples and have little to no earnings despite high revenue growth. These stocks do very well in a bull market, but all these gains and more could be wiped out in a single major bear market due to the weak fundamentals of these companies. In fact, many of ARKK’s tech holdings fell by 50% or more in the December market correction, significantly more than the market.
Again, these are valuations that are supported by nothing but a fragile thread of hope that some day these companies may grow into their valuation. As David Einhorn put it:
“The current market view is that profitless companies with 20-30% top-line growth are worth 12x-15x revenues, while profitable companies that lack that level of opportunity are worth only 5x-8x after tax earnings. As an arithmetic exercise, if you pay 12x revenues for a company that eventually makes a 10% after tax margin and trades at a 20x P/E, the company has to sustain a 25% growth rate for 8 years for you to break even, and for 12 years for you to make an 8% IRR (requiring 15x revenue growth). If the company is increasing the share count by paying employees in stock, the math gets worse.
Tech bulls respond by asking, “What if the margins turn out to be 30%?” We looked for examples of companies that spent years with profitless topline growth that developed into 30% net margin businesses. It turns out that businesses that matured into very high margin businesses generally demonstrated strong margins at relatively low revenue levels. We think that right now the market is valuing a large group of stocks on nothing more than a hope (sometimes termed “management’s long-term guidance”) of 30% margins someday, with an emphasis that no one can be expected to know when someday arrives. We think someday sooner these stocks will de-rate.”
(Source: Greenlight Capital Q3 letter)
During the December correction, ARKK added significantly to some of these holdings, with Teladoc Health (TDOC) and Square, two profitless companies, being some of the main additions. Doubling down usually isn’t a bad strategy – well, for healthy companies anyway. ARKK, however, is buying companies that trade at multiples many times the market multiple. In the end, mean reversion will occur however fast these companies grow, and when that happens, the fund will find that its sizable portfolio of richly valued stocks will become much cheaper.
How much exposure does ARKK have to these stocks? We calculated that it had roughly 30% of the fund in stocks that have a P/E greater than 80 and are non-biotech. Even a modest 50% correction for these stocks would mean a 15% decrease in the value of ARKK’s holdings, not including additional declines in value from its other stocks.
ARKK’s biotech holdings
The fund holds many biotech stocks, with most of them developing medical solutions in the genetics space. ARKK believes that these innovative genetics companies will be worth much more in the future.
It is quite odd why ARKK invests in biotech at all. Biotech, however innovative, is very different from technology companies and requires a completely different skill set and knowledge base. This is why most biotech investors are focused and concentrated only in biotech – and even then, they may do poorly. One successful biotech manager had this to say:
(Source: Institutional investor)
While most biotech funds have multiple MDs and PhDs, ARKK has one analyst, Simon Barnett, whose previous job was as a finance and operations intern. It doesn’t seem to have any sort of competitive advantage over specialized hedge funds in this field.
Overall, it seems quite unlikely that ARKK, with its one biotech analyst, can outperform the market in the long run.
It also does not help that many of its biotechs frequently raise capital to cover cash burn, diluting the fund’s stake in the process. While the recent run-up in these biotechs has limited the dilution, if these stocks were to correct, ARKK would have no choice but to watch its ownership stake slowly dilute away or sell at a much lower price. NanoString Technologies (NSTG), for example, raised equity at $12.50, 50% lower than the current price of $24.
Tesla
ARKK’s biggest position is Tesla, at nearly 9% of the fund’s holdings. Catherine Wood, ARK Invest’s founder, famously had a $4000 price target on the stock, with most of the price target stemming from the robotaxi business Tesla supposedly will enter. Ignoring the fact that the company still has not announced plans for robotaxis and does not have the resources to launch a fleet of robotaxis, let’s discuss Navigant’s recent autonomous vehicle report.
In March, Navigant did its usual annual autonomous driving report. In it, Tesla ranked lower than every other company other than Apple. Honestly, this is not surprising, considering the company has been cutting R&D and capex for a while now. With Tesla having fallen drastically from its original position in 2017, it may be time for ARKK to lower its price target.
Tesla’s other fundamentals aren’t looking good either. Multiple SA authors have talked about a likely Q1 sequential delivery drop. Elon Musk has now been held in contempt by the SEC, and executives continue to leave. Either way, this spells trouble for ARKK’s largest holding.
Takeaway
In the end, the fund holds a significant amount of highly valued stocks that will drop significantly upon any bad news appearing. It has little competitive advantages in analyzing biotech stocks, which make up another significant portion of its holdings, and many of the stocks it owns dilute shareholders frequently by either issuing stock to executives or by conducting stock offerings. Tesla, ARKK’s largest position, has a CEO charged with security fraud, and ARKK’s bull case has pretty much been demolished. Overall, investors should sell or avoid ARKK in the short-to-medium term.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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