ARK Genomic Revolution ETF: Value Realization Will Take Time
Summary
- ARKG’s Sharpe Ratio and outperformance suggest great stock-picking by the fund manager.
- However, the neutral rating is premised on a long-term time horizon for value realization in view of ARKG’s rich valuation.
- Furthermore, the general market is not unequivocally rising, and entering into higher-volatility ETFs at this stage with rich valuations may not be prudent.
- There also appears to be greater attention focused on “old economy” stocks as markets look forward to a post-pandemic recovery story.
Introduction
The BATS:ARKG ETF is a sub-sector of the healthcare industry, focusing on advanced biotechnology stocks such as gene editing and artificial intelligence-based companies. The company invests at least 80% of its assets in this sector globally, although most of its holdings are in the US. As expected of a high growth, high tech ETF, ARKG focuses on long-term capital appreciation as opposed to income. As such, the ETF can be seen as a growth-style investment. While genomics may appear rather high tech, it has a market for all kinds of uses, from simpler applications such as agriculture to advanced applications in oncology.
The neutral rating on ARKG ETF is premised on a mix of pros and cons, namely:
- Rich valuations, pricing in as much as 19 years of forward sales based on the P/S of its top ten holdings (44% of the fund size), which explains a forward P/S trading at a significant premium against peers.
- The ETF’s thematic biotech/genomics companies are highly sentiment-driven, and their success depends on being in the news and specific breakthroughs – this is explained by the ETF’s higher risk-return profile.
- The general stock market is consolidating, having declined from the euphoria of 2020. Furthermore, this is reinforced by a rotation to “old economy” stocks and concerns of profit-taking in the healthcare and biotech sector. Tailwinds are ebbing for beneficiaries of the pandemic.
- The advances in biotech and bioinformatics compress the time to commercialization, while long-term growth prospects are bright.
- The ETF fund manager has a demonstrated ability to pick stocks which drive positive alpha and an above-average Sharpe ratio.
An outline of advances in biotech/genomics and its market size
ARKG invests in companies that are bio-innovative and captures strong growth. Furthermore, the unique nature of this theme-based ETF allows diversification beyond more traditional modes of investing (e.g. growth and value investing). There are several reasons which capture the growth prospects of this sector (for example, the fund manager’s investment case and market size prospects as explained by Phillips and Douglas, 2018). This includes improving commercial economics driven by lower costs and being able to sequence more genomes in a shorter time frame, a high forecasted industry growth rate, and an increasing number of commercially viable genomic applications:
1. Improving commercial economics in gene editing.
Gene editing has much scope to advance, in terms of both technology and commercial economics. The growth catalyst would be breakthroughs in “long read sequencing” (LRS) technology in gene sequencing assisted by deep learning algorithms, as compared to short-read technology. The former will provide better completeness for the study of structural gene mutations and diseases linked to genes.
The predecessor would be “short read sequencing” (SRS) technology which has limits to solving greater genetic problems. The future breakthrough in this case would relate to its holdings in PACB and BNGO. Project economics in gene sequencing has improved over the last decade, which means bringing greater commercial value for these companies. Being able to sequence more genomes due to advances in bioinformatics would also compress the expected time to commercialization.
Technology improvements have allowed more genes to be sequenced at lower cost, which brings companies closer to effective commercialization.
Source: ARK funds
2. High industry growth rates in dollar terms.
Given the backdrop of viable commercialization, ARK Funds expects the LRS market to grow at a CAGR of 82% between 2020 and 2025 to $5 billion. The figure below illustrates that the market as a whole is larger and comprises complementary services and products such as instruments, bioinformatics and the broader areas of Next Generation Sequencing (NGS) services which LRS is a part of, and the market size of NGS services is estimated at $7.7 billion in 2020. Based on the growth from $2.2 billion in 2015 to $7.7 billion in 2020, the CAGR was 28.5% for the NGS market.
The ecosystem of sequencing products goes beyond LRS with the market size already at $7.7 billion.
Source: Phillips and Douglas (2018)
3. High industry growth rate in terms of number of gene therapies/breakthroughs.
Oncological applications are advancing with the genomics revolution. For example, routine cancer screening tests, therapeutics advancing from liquid to solid tumours, allogenic cell therapy, and in vivo gene editing. The expected growth rate here could be high, since 170 gene therapies could be approved in the next decade, as compared to 10 therapies as of Mar-2021. Translating this to CAGR terms, the number of gene therapies are expected to rise 32.8% each year and will also translate to high revenue growth terms for the industry as a whole.
In the past, genomics research used to be hampered by lengthy time periods to commercialization, and this will soon be a thing of the past. The advances in data science and bioinformatics have allowed a greater number of genomes to be sequenced more quickly, which enhances economies of scale – i.e. a greater number of discoveries at lower cost in a shorter time frame, which then leads to a higher probability for commercialization.
This creates a positive feedback loop, which raises investments into this sector, increases research intensity, supports more genomic and biotech discoveries, more innovative applications and greater commercial value. Based on the points above, we can see that the NGS market has grown at a CAGR of 28.5% per annum, while the number of new gene therapies could increase at a rate of 32.8% each year. Apart from advanced medical applications, genomics can be used for mass market agricultural applications such as raising the productivity of salmon farms (e.g. AquaBounty (AQB), which is an example of such a company that ARKG ETF has invested in).
The value proposition of ARKG’s holdings
Top ten holdings of ARKG as at 28-Apr-2021 comprise 44% of the total fund size. One way to gauge the price attractiveness of these holdings would be to compare valuations of these holdings against the industry’s aggregate sector valuations. In this example, I compare the top ten holdings in ARKG ETF to Seeking Alpha’s sector median and see that their TTM P/S, FWD P/S, TTM EV/S and FWD EV/S ratios are trading at hefty premiums.
The reason for the high valuation ratios is due to ARK Funds' choice of companies in emergent biotechnologies with high expected growth rates. Naturally, most of these companies are still making losses, hence no “E” to calculate “P/E”, but the future hope is for earnings to roll in upon mass commercialization. It is often difficult for such high-tech and high-growth companies to achieve positive earnings in the first couple of years when research costs are highest.
Top ten holdings in ARKG as at 28-Apr-2021.
Source: ARK Invest
The following table shows how the top ten stocks in ARKG are trading expensive relative to the sector’s median.
| Top 10 holdings in ARKG | TTM P/S | FWD P/S | TTM EV/S | FWD EV/S |
15.7 | 14.8 | 27.5 | 15.1 | |
14.1 | 13.6 | 15.7 | 13.6 | |
68.3 | 49.3 | 78.5 | 47.2 | |
6.5 | 4.3 | 5.8 | 4.0 | |
59.0 | 56.9 | 62.1 | 52.3 | |
9.1 | 8.1 | 8.1 | 7.3 | |
4.0 | 3.8 | 4.5 | 4.3 | |
19.4 | 16.0 | 20.6 | 15.2 | |
241.2 | 317.3 | 262.6 | 303.1 | |
4.3 | 4.4 | 4.4 | 4.5 | |
Simple Average | 44.2 | 48.8 | 49.0 | 46.6 |
Weighted Average | 17.6 | 19.0 | 19.9 | 18.2 |
Sector median | 8.1 | 7.4 | 8.4 | 7.1 |
Wgt avg premium to sector | 118.4% | 156.3% | 136.5% | 154.5% |
Source: Compilation of various pages across Seeking Alpha, author’s calculations.
Note: (1) data as at 27-Apr-2021; (2) P/E was not included due to negative earnings for most of these companies.
Active management style with a willingness to overweight top picks
As shown in the above table, there appears to be some evidence of active management, as the concentration in its top holdings are relatively high. ARKG has roughly a similar number of holdings (around 50) compared to the iShares Genomics Immunology and Healthcare ETF (IDNA). Both ARKG and IDNA portfolios are concentrated in top ten companies which comprise more than 40% of holdings. However, ARKG has outperformed IDNA as illustrated in the chart below.
This ought to be the case, since the expense ratio of ARKG is higher than IDNA, at 0.75% compared to 0.47%. The slightly higher expense ratio appears to be worthwhile as one-year performance is +123.35% compared to IDNA at +42.07%. ARKG ETF has an excellent five star rating by Morningstar. ARKG achieves higher returns by adopting higher risk versus peers, as shown in the below chart. However, this risk adoption is justified by a higher Sharpe ratio of 1.27 compared to 0.75 for peers (i.e. higher excess returns for each unit of risk).
Over the last year, ARKG has outperformed the S&P 500 and peers such as iShares Genomics Immunology and Healthcare ETF.
Source: Seeking Alpha
ARKG is a higher return but higher risk option versus peers, but the Sharpe ratio indicates this is sufficiently compensated for.
Source: Morningstar
Conclusions and Risks
While the growth story sounds exciting on ARKG, I am neutral, since its valuations are pretty high. Furthermore, while the market is recovering, there has been a rotation out of richly valued and innovative sectors into “old economy” stocks which are even more undervalued, having been hit by the pandemic. At this stage, since valuations are not particularly compelling and the optimism in 2021 cannot be matched with the euphoria of 2020, I would take a more measured stance towards innovative sectors with higher market volatility.
Generally, active management by the ETF manager has seen outperformance of ARKG versus peers, although this would likely mean a higher beta and potential underperformance if the market heads south. The market appears to be consolidation and I need to have confidence that the general market trend is rising before investing in a relatively more volatile ETF such as ARKG.
This article was written by
Analyst’s 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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