ARK Innovation ETF: The Plot Thins (NYSE: ARKK)

Marco Bello

Investment thesis

Intrepid investors like to chase huge returns, and there’s no better example than Cathie Wood, CEO of ARK Invest. The exceptional performance of its flagship fund, the ARK Innovation ETF (NYSEARCA:ARKK), earned him the title of Bloomberg’s Stock Picker of the Year in 2020. Unfortunately, ARKK’s price crashed dramatically, underperforming the SPDR S&P 500 ETF (TO SPY) by 40% since the start of the year, and is now trading near March 2020 levels. While Wood continues to collect high management fees, I sincerely doubt that shareholders like to pay them.

And so the plot thins out.

I write this because it is not difficult to see what is happening. Most of ARKK’s holdings share four characteristics: high growth potential, high valuations, high volatility and low profitability. These speculative stocks have an exceptional odd year that 40 years of data confirms. However, until now, they have not been cleverly wrapped up in the guise of thematic investments. I think ARKK ended up hitting hard, but that doesn’t make it a good product. For me, the Invesco QQQ ETF (QQQ) is far superior, and I look forward to demonstrating why in this article.

ARKK Snapshot

To start, I want to highlight the volatility, growth and price returns of ARKK’s top 25 holdings, which total 94.49%. I’ve also included each company’s Seeking Alpha Factor ratings and normalized them on a scale of 1-10.

Company overview ARKK

The Sunday Investor

First, ARKK’s holdings are generally much smaller. The weighted average market capitalization is still $104 billion, but this is mainly due to Tesla (TSLA) and NVIDIA (NVDA). The median market capitalization is just $5.2 billion, so it’s mostly small-cap stocks.

ARKK’s five-year beta is 1.50, which means it is 50% more volatile than the broader market. However, several companies were not listed five years ago, so this figure could be higher. The two-year betas of ARKK and QQQ are 1.89 and 1.19, so generally ARKK investors should prepare for nearly double the volatility.

Estimated sales growth over the next year is about double that of QQQ at 32.05%. To control outliers like CRISPR Therapeutics (CRSP) and Beam Therapeutics (SHINE), I applied a cap of 50% per security to arrive at the figure of 32.05%. However, I don’t think it matters much. ARKK holds fast-growing stocks in spades, and it’s all about valuation. Price returns over the past one and three years help illustrate how difficult it is to answer this question. Voters are down 58.11% on a weighted average from the previous year, but have increased 262.99% over the past three years. A closer look reveals that Tesla generated most of these returns since the three-year median return for the remaining constituents is a loss of 21.25%.

Finally, Seeking Alpha’s factor ratings reveal that ARKK is marginally better than QQQ in terms of value and growth, but lacks momentum and has a dismal profitability score of 5.76/10. US stocks that I follow, this score puts ARKK in the bottom 10%. Other ARK ETFs (ARKF, ARKW, IZRL, ARKQ, ARKX, ARKG) have profitability scores ranging from 4.64 to 6.21, which pales in comparison to QQQ’s 9.70.

Assessment: where to start?

You may have noticed that the previous table did not include any evaluation metrics. The reason for this is that most operations have negative earnings and in many cases negative operating cash flow. Instead, consider these stats for ARKK’s 34 holdings:

  • 19 have a negative operating cash flow (44.37% total weight)
  • 28 reported negative earnings per share last quarter (74.30% total weight)
  • 27 have a negative 1-year return on total capital margins (72.41% total weight)
  • 11 analysts missed earnings per share estimates (29.40% total weight)
  • 12 analysts missed sales per share estimates (37.08% total weight)

These statistics mean that the rating metrics provided on sites like Morningstar aren’t helpful. Excluded are stocks with negative earnings and cash flow, suggesting a low-value ETF. This is not a problem with QQQ, as only two holdings (0.46% total weight) have negative operating cash flow, and ten have a negative return on total capital margin (2.34% total weight).

ARKK Value and Growth Metrics

the morning star

ARKK performance

ARKK has had two incredibly successful years since its launch in October 2014. In 2017 it gained 87.34% against 32.66% and 21.70% for QQQ and SPY, and in 2020 it outperformed these benchmarks of 104.42% and 134.45%. However, ARKK has lagged QQQ by 50.80% and 30.63% in 2021 and 2022 year to date.

ARKK vs. QQQ vs. SPY Annual Reports

Portfolio Viewer

For long-term shareholders, annualized returns were still strong since inception (11.12%), but well below QQQ’s 15.65% pa gains with much higher volatility.

ARKK Performance vs. QQQ vs. SPY

Portfolio Viewer

This chart suggests that with ARKK you need to know when to sell. Although the ETF itself doesn’t have a lot of history, this cautious move seems to be selling out after a year of extraordinary gains.

Unprofitable or profitable stocks

Based on past metrics showing that ARKK mostly holds unprofitable stocks, readers may find the historical performance of these stocks helpful. In the absence of sufficient history for ARKK, we can turn to the results of the portfolio constituted by the operational profitability of the Kenneth French Data Library. Here’s how equally weighted portfolios of unprofitable and profitable stocks fared alongside ARKK and QQQ from January 2015 to July 2022.

ARK/QQQ vs profitable/unprofitable returns

Chart source: The Sunday Investor; Data source: Kenneth French Data Library, Portfolio Visualizer

In my opinion, ARKK has become a more extreme version of the unprofitable wallet in recent years. The following graph illustrates this by comparing the annual return differences of ARKK and QQQ with the return differences of the unprofitable and profitable portfolios.

ARKK vs.  QQQ vs.  Unprofitable vs.  Profitable Portfolio performance

Chart source: The Sunday Investor; Data source: Kenneth French Data Library, Portfolio Visualizer

With the exception of 2018, ARKK has outperformed every time unprofitable stocks have outperformed, and vice versa. 2017 was an anomaly, but it was a year where the price of Bitcoin jumped 1,338%. ETFs Annual Report noted how the portfolio benefited enormously from its position in GBTC.

The main contributor to Fund performance was The Bitcoin Investment Trust (OTC:GBTC), a bitcoin-backed investment trust. The cryptocurrency market entered a phase of exponential growth from April 2017, as bitcoin acceptance improved worldwide with Japan’s approval of bitcoin as a legal form of payment. .

Here is a history of the two equally weighted portfolios dating back to 1985. The unprofitable portfolio (blue bars) consistently underperforms after a year of extraordinary gains, and ARKK’s performance in 2021-2022 follows this trend well.

Equal weight portfolio 1985-2021 by earnings/price

Chart source: The Sunday Investor; Data source: French Kenneth Data Library

Here are some interesting stats you might be interested in:

  • The unprofitable portfolio did better on average (15.89% vs. 15.52%)
  • However, the two-year moving average returns lagged (12.12% vs. 13.78%).
  • Three-year moving average returns lagged more (10.21% vs. 13.45%)
  • Five-year moving average returns lagged even further (9.59% vs. 13.41%).

These statistics confirm the importance of cashing out quickly after a year of big gains. The chances of you outpacing the much safer profitable portfolio, of which QQQ is a great indicator, are low.

Can technical analysis help?

I don’t think so, mainly because ARKK has a high portfolio turnover. From 2016 to 2021, turnover rates were 110%, 70%, 89%, 80%, 80% and 71%, depending on the latest annual report. These figures indicate that each year ARKK’s holdings are very different. Continuing with the previous example, why would an analyst consider ARKK’s price chart from 2017 when Bitcoin was the primary reason the ETF outperformed? GBTC is no longer held by ARKK, no more than 80% of the holdings of that year.

ARKK derives its value from its underlying holdings. It benefits when stocks like Tesla gain, and the ETF does not trade at a significant premium or discount to net asset value due to its structure. Analysts can still perform technical analysis on the current portfolio, assuming it remains relatively stable and appropriate rebalancing is applied. However, I have yet to see this with ARKK.

Technical analysis has merits, but analysts should apply it to individual stocks or passive index ETFs with low portfolio turnover. SPY and QQQ are two good examples, with turnover rates of 2% and 9%, respectively. With these ETFs, we have reasonable assurance that current holdings are similar to what they were during the valuation periods. Hence, analysts can make more accurate predictions about future price movements.

Investment recommendation

ARKK returns match the performance of unprofitable portfolios for almost 40 years, maybe more. The difference today is that Cathie Wood has cleverly packaged these unprofitable and highly volatile stocks into an easy to trade product. Bitcoin drove its gains in 2017, pandemic stocks defined 2020 and ARKK launched in 2009, when unprofitable stocks outperformed 81%, Wood’s flagship fund would likely have at least doubled in value.

It’s only a matter of time before ARKK strikes again. It could be this year or five years from now, and it won’t make much sense to fundamental investors. However, a better strategy is to stick with highly profitable stocks in a low-cost ETF like QQQ. Historical data indicates that such an approach is preferable even for those with time horizons as short as two years.

Remember that extraordinary gains for unprofitable stocks occur regularly every 5-7 years. The rise and fall of ARKK was bound to happen, and if you pull it off big, I suggest you cash in fast. That’s not my style, and since I don’t see a catalyst for a huge risk environment yet, I’m classing ARKK as a sell today. Thanks for reading, and I look forward to discussing more in the comments section below.

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