ARKK: Disrupters Will Get Disrupted

Summary

ARK Innovation ETF has pulled back after delivering a spectacular 2020.
We look at the underlying components of this famous ETF.
We tell you about the two biggest forces that weigh on these components.
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Businessman Popping The Stock Market Bubble — Photo by DNY59/E+ via Getty Images

Perhaps no ETF has captured the average investor's attention in the last year as much as ARK Innovation ETF (NYSEARCA:ARKK). The fund is actively managed and aims to generate long-term growth of capital. This is done by investing the bulk of its assets (read at least two-thirds) in companies that are relevant to ARKK’s investment theme of disruptive innovation. ARKK's fact sheet showing returns as of December 2020 looks rather fantastic for an ETF.

Source: ARKK

The returns catapulted its manager, Cathie Wood, to stardom. ARKK has pulled back recently and investors are wondering if this dip should be bought.

We give you our thoughts on that.

What Is ARKK?

A cursory glance at the holdings of ARRK will reveal the household names that have dominated the bull market since March 2020.

Source: ARKK

The top 5 holdings have powered exceptional returns for ARKK.

Four of the five stocks have betas that would make any risk manager (outside of Credit Suisse) blush.

While no one can debate that these have delivered returns, ARKK's risk comes from the fact that none of these companies grew revenues remotely as fast as their share price.

Multiple expansion hence played a big role in this performance. Wall Street in general is an optimistic bunch, but even looking at their rosy price to sales figures shows that these firms now have stratospheric valuations.

Now, this figure is better than what we saw in the "Green Energy Bubble" where the top 5 components were trading at a 25X price to sales multiple, but numbers look daunting for forward returns. While it is an obvious statement that most stocks that trade at these multiples fail to produce longer-term returns, we need to address whether the bubble has been pricked or not.

Equity Issuance Is The Pin

While investors may chase returns and believe that this time is different, equities respond to supply and demand. Zero interest rates increase the allure of "growth" but ultimately the bubble is pricked by equity supply. What we are referring to is the number of IPOs and secondary offerings hitting the market. As we have previously shown, there is no cash on the sidelines. But on the other hand, every new stock issued has to be held by someone. If tomorrow a new company did an IPO and entered the equity markets, you would have to sell existing holdings if you needed to accommodate that. Now you might argue that you could sell some bonds you hold, but someone else has to buy that bond from you. The same applies to money market funds which hold shorter-term bonds and bills. Collectively, as new equity gets issued, other holdings need to get sold. That equity is coming in droves.

A record $162.4 billion has been raised by more than 600 issuers in 2021, the most ever at this point in the year, data compiled by Bloomberg show, with special-purpose acquisition companies accounting for half of the proceeds. In comparison, just $37 billion was raised in the first three months of 2020.

Source: Bloomberg

SPACs have raised more money in Q1-2021, than in all of 2020.

Why are SPACs so popular?

Our point is that if valuations remain anywhere in this ballpark, expect equity issuance to maintain a blistering pace. This amount will dwarf the sum of equity buybacks and stimulus checks entering the market and that equity issuance will eventually prick the bubble. Wall Street will of course look out for your best interests and make sure you "participate" in this.

Source: SentimenTrader

Bonds Could Add Some More Punch To The Downside

Growth chasing has long been justified by the TINA ("There Is No Alternative") acronym. But the 10 Year Treasury rate begs to differ.

The fundamental forces supporting even higher rates are well aligned and these rates could finally snap these valuations back to reality.

Can ARKK Navigate This?

Our response here is an overwhelming "no". The stocks underlying ARKK have been bloated by bubble beliefs and loose monetary policies. One easy way to look at this is to just compare ARKK's returns with the earlier mentioned "clean energy" bubble. First Trust NASDAQ Clean Edge Green Energy Index ETF (QCLN) has tracked ARKK rather well.

This is despite the fact that ARKK has very little direct exposure to similar sectors.

Source: ARKK

Our point here is that ARKK is just another participant in this madness and once the tables turn, don't expect much alpha from these names. Those said tables could have already turned. While ARRK was being put up on a pedestal, we would note that the ETF topped out just one trading day before this graced the internet.

Sentiment is not everything there is to investing, but you have to be cognizant of it.

ARKK remains an extreme beta play on growth and equity issuances and interest rates look to spoil the party. Underlying growth rates of stocks that ARKK holds are impressive but those that disregard valuations tend to pay heavily. Juniper Networks (JNPR) illustrates this in a rather epic manner, being down 80% from the March 2000 peak while its revenues have increased 27 fold.

Some of ARKK's holdings make sense if you start valuing most of them on optimistic 2030 earnings and assume no disrupter will enter the fight. But current valuations allow absolutely anyone to issue equity and enter the ring. Either the disrupter gets disrupted or valuations pull back enough that ARKK does not make positive returns. The ETF though is down far more than the broader indices, so we would restrain our pure bearish bias for a bounce. But we don't expect any positive returns over longer-term timeframes.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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This article was written by

Trapping Value

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Trapping Value is a team of analysts with over 40 years of combined experience generating options income while also focusing on capital preservation. They run the investing group Conservative Income Portfolio in partnership with Preferred Stock Trader. The investing group features two income-generating portfolios and a bond ladder.

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