Cathie Wood, founder of ARK Invest, is franticly attempting to convince investors that her “disruptive innovation” strategy will work again.
But ARKK’s portfolio is filled with cash-burning companies that continue to trade at nosebleed valuations.
Investors are simply buying the hype and hoping that other investors will play the greater fool and buy in at a higher price. We advise against being another investor’s exit strategy.
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simpson33/iStock via Getty Images With her flagship ETF, ARK Innovation Fund (NYSEARCA: ARKK ) down 55% from its 52-week high, Cathie Wood, founder of ARK Invest, is franticly attempting to convince investors that her “disruptive innovation” strategy will work again. We disagree. ARKK’s portfolio is filled with cash-burning companies that continue to trade at nosebleed valuations. These companies, along with the ARK Innovation Fund, are in the Danger Zone. Burning Cash Is Not a Competitive Advantage
Too many companies are built on strategies that assume access to cheap capital is a lasting competitive advantage. Who can blame them? Their stocks have soared on a rising tide of investor ebullience driven by ultra-easy monetary policy. Who can blame investors for their ebullience? For most of the last decade, they’ve seen frighteningly little downside risk in stocks. But times are changing, and as monetary policy tightens, the once high-flying cash-burning “innovation” stocks have much farther to fall.
Figure 1 shows that 28 of the 32 ARKK holdings under our coverage generate negative free cash flow and have negative FCF yields over the trailing-twelve months. ARKK currently holds an additional six stocks not under our coverage.
Figure 1: Free Cash Flow for ARKK’s Holdings Is Poor – as of 2/25/22 ARKK Holdings FCF Yield Ranked (New Constructs, LLC) Sources: New Constructs, LLC, company, and ETF filings Innovation Alone Is Not a Good Investment
Of course, ARKK doesn’t look specifically for cash-burning businesses. ARK Innovation ETF’s principal investment strategy is to invest in stocks that fit a “disruptive innovation” theme. ARK Invest believes “disruptive innovation” is the “introduction of a technologically-enabled new product or service that potentially changes the way the world works.”
Changing the world is certainly a bold goal and flashy selling point for raising money, and this approach has garnered ARK Invest a loyal following and $28 billion in AUM at its peak. However, innovation alone does not make a great company or investment thesis. Instead, one must find the companies that match innovation with a real business model – one that generates real FCF at a reasonable price – for investors to see gains.
Otherwise, investors are simply buying hype and hoping that other investors will play the greater fool and buy in at a higher price. We advise against being another investor’s exit strategy and buying stock in companies without a real business model or defensible moat. Fundamentals Might Not Be Sexy, But You Can Trust Them
Our focus on quantifiable fundamental benchmarks, instead of just using qualitative research and flashy selling points, has already led us to put five of ARKK’s holdings, 23% of the portfolio, in the Danger Zone. See Figure 2.
Without reliable fundamental data to accurately measure both profitability and valuation, ARKK routinely invests in companies with poor profitability at prices that imply unrealistic future profit growth.
Figure 2: ARKK Holdings That are Also Danger Zone Picks – as of 2/25/22 ARKK Holdings also Danger Zone Picks (New Constructs, LLC) Sources: New Constructs, LLC and ETF filings Our Fundamental Research on ARRK’s Holdings Reveals a Low-Quality Portfolio
Our Predictive ETF Rating for ARKK is Very Unattractive (equivalent to Morningstar’s 1 Star). Meanwhile, Morningstar gives the ETF a 3 Star rating. Our ETF research is different from legacy fund research because it’s forward looking and based on our risk/reward analysis of each individual fund holding. Most legacy fund research is backward looking because it’s based on past price performance.
ARKK’s Very Unattractive rating means that its holdings have both low profitability and expensive valuations. Our detailed holdings analysis, made possible by our Robo-Analyst technology, also reveals that ARKK has a much lower-quality portfolio compared to benchmarks, Invesco QQQ Trust ( QQQ ) and State Street SPDR S&P 500 ETF ( SPY ).
Per Figure 3, ARKK allocates 58% of its portfolio to Unattractive-or-worse rated stocks compared to just 9% for QQQ. At the same time, ARKK’s exposure to Attractive-or-better rated stocks is much lower, at 9%, versus QQQ at 29%.