Is Cathie Wood’s ARKK a good buy?
The goal of this article is to examine the bullish as well as the bearish arguments surrounding the ARK Innovation ETF (NYSEARCA:ARKK). Unfortunately, in the end, I feel the positive and negative forces are equally strong under current conditions. As a result, I expect the fund price to struggle in a definite direction in the near future and rate the fund as a hold.
The remainder of this article will elaborate on the main positives and negatives, and I will start with the positives. First, the fund’s prices suffered a large correction in the past 1~2 years, making the fund more attractively valued now. The top panel of the chart below shows the price-to-sales (“P/S”) ratio for the top holdings (more on this in the second section) in ARKK. As seen, these holdings’ P/S ratios have corrected from truly lofty levels (all above 20x) in early 2021 to the current single digits. Such a large decline in valuation ratios has dissipated most of the bubble risks.
Second, the fund is managed by a team of experienced investors. Cathie Wood, the founder of ARKK, is a well-respected investor with a good track record of success. The team’s strategy is focused on disruptive and innovative companies, and their high-risk-high-payoff bets certainly cater to a group of investors.
Now come the negatives. To better discuss the negatives, we need to dive into the specific holdings and see the trees a bit closer.
As aforementioned, ARKK focuses on companies that are disruptive and innovative. The technology and healthcare sectors are obvious places to look for such companies today. Indeed, as shown in the chart below, these are the two most heavily weighted sectors in ARKK. Technology is the largest sector in ARKK, accounting for more than 34% of the fund’s assets. Healthcare is a close second, accounting for more than 24% of the fund.
The top 5 holdings are all tech-oriented companies as shown in the next chart (Roku, Coinbase, Tesla, Zoom, and UiPath) and they make up ~40% of the fund’s assets. Tesla and Zoom probably need no introduction. Roku is the largest holding in ARKK. Coinbase focuses on technologies that can enable cryptocurrency trading. UiPath focuses on robotic process automation.
With this background, my largest concern is that none of these top holdings have meaningful profit with the exception of Tesla as you can see from the next chart below. Zoom generates a token amount of profit ($141M) for a company of its size. The other three have been reporting losses so far. Such a general lack of profit makes the holdings more volatile (more on this in the next section) and more difficult to value. In my first chart, I had to rely on the P/S ratio only because P/E ratios are not meaningful for most of the holdings. Even the P/S ratios are still at a large premium compared to the overall market (which has an average P/S ratio of ~2.5x) after the corrections.
Will ARKK recover to previous highs?
As aforementioned, my top concern involves the general lack of profit for many of the fund’s top holdings. A common theme underpinning many of the fund’s picks is the so-called Wright’s law, which Cathie Wood certainly helped to popularize and her pick of Tesla is a great success story. Wright’s law is an observation (so not really a law either in the legal or physical science sense) that the cost of technology declines by a fixed percentage for every doubling of the cumulative quantity produced. You can see from the chart below that the traditional auto industry has been following this law closely in the past.
It’s certainly a sound idea (let alone a very tempting idea) to use the law to predict new industries, such as EV, robotics, DNA sequencing, et al. Again, the law seems to be valid on EV production based on my analysis of Tesla (see an example here). And ARKK provides other examples supporting the extrapolation of the law to other sectors such as robotics, one of the ARKK’s top exposure areas if you recall from the discussion of its holdings. The chart below shows the cost per unit as a function of cumulative units produced, just like the chart above. And here you see a general decline, again just like the case with traditional car manufacturing shown above. However, the main issue here is twofold to me. First, I do not think we have enough data points to start fitting a line yet. For example, the rate of cost reduction is very different using the few data points pre-2014 compared to those after. Second, Wright’s law – the way I understand it – depends on both technological and human factors.
Of course, computing power and AI may speed the technological advancement. But I do not see why human factors could be sped up at an equal rate. For example, a good reason behind Wright’s law is “learning by doing.” As more people repeat a task, they learn certain skills to do it more efficiently. Another good reason is that as more people use technology, they generate more ideas to improve it. Both factors rely on human experiences and past experiences have shown such experiences take time to accumulate. Past innovations, no matter how groundbreaking (even the internet itself), have ~10 years to mature and another 10 years to reach a large mass (the so-called 10/10 rule).
After this digression, let me get back to my concern surrounding the lack of profit for many of the fund’s holdings. Based on the arguments above, I’m uncertain about A) if the law applies to many of the holdings in the fund, and B) the timeframe for the law to work if it does. Due to both uncertainties, I will feel much more comfortable if a company has a profit to be sustainable. After all, Wright’s law, even in cases where it does work, provides a prediction once things reach a steady state. This means it predicts that production cost eventually declines by a certain percentage (say ~15% in the case of traditional auto production) per doubling of cumulative production. But the law says nothing about when a steady state can be reached.
Summary and final thoughts
To summarize, I see both positive and negative catalysts surrounding the ARKK fund. I see these catalysts in a tug of war, and I expect the fund to struggle sideways in the near future. I do not think the fund can find a clear direction and return to previous highs unless/until macroeconomics changes substantially (so that the market’s appetite for risks is back) or the fundamentals of its holdings change dramatically (e.g., begin to report substantial profits). To recap, the main positives I see are a more reasonable valuation compared to 1~2 years ago and the management team. The main negatives are a lack of profits for many of its top holdings, a large valuation premium above the overall market, and most fundamentally, the uncertainty of whether its holdings can become sustainable and enjoy the benefits of mass adoption – eventually.