Forget ARKK: 3 Reasons Why I'm Buying High Yield Hand-Over-Fist Instead
Summary
- ARKK was the market darling of 2020 but now has several headwinds plaguing it.
- High Yield has been an outperformer in 2021 and we expect this trend to continue moving forward.
- We discuss three reasons why.
- Looking for a portfolio of ideas like this one? Members of High Yield Investor get exclusive access to our model portfolio. Learn More »
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Cathie Wood's ARK Invest flagship Innovation ETF (ARKK) has been on a strong run since inception, crushing the broader stock market (SPY) and even the Nasdaq (QQQ) over that span:
However, thus far in 2021, Cathie's funds have been badly lagging the broader market and high yield (DIV), in particular:
Moving forward, we expect ARKK to continue its 2021 underperformance due to its high 0.75% expense ratio (As Warren Buffett once said: "Performance comes, performance goes. Fees never falter."), large number of assets under management and the rapid volatility of inflows and outflows which result in less efficient transactions, and the astronomical valuations in some of its largest holdings like Tesla (TSLA) and Zoom (ZM):
or even worse, the large number of its holdings that are not even close to generating a profit, yet still trade at enormous valuations.
In contrast, High Yield (SPYD) - despite lagging tech significantly in 2020 - has made a comeback in 2021, one which we believe will continue moving forward for the following reasons.
#1. Significantly Discounted Valuations
While high yield and value have managed to close the gap some this year, the valuation spread between high yield and high growth remains extremely wide. While many high growth companies in ARKK's portfolio are not even profitable, its largest holding - TSLA - remains priced at over 100 times EBITDA. In contrast, some of the leading high yield stocks in our Equity Portfolio at High Yield Investor like Energy Transfer (ET) and Lumen Technologies (LUMN) remain valued at mere single-digit multiples of EBITDA:
Despite absolutely crushing ARKK this year:
Furthermore, both LUMN and ET have recently significantly bolstered their balance sheets. Last, but not least, LUMN recently announced significant asset sales alongside a large share buyback program and more focused and aggressive growth investments that should enable it to unlock significant value for shareholders. Meanwhile, ET is gushing free cash flow while also winding down its aggressive capital expenditure growth program that should enable it to reach its leverage targets soon and then pivot towards growing its distribution and/or buying back units hand-over-fist. These trends are increasingly common across the high yield and value space as evidenced by the fact that we have identified nearly 30 opportunities for our High Yield Investor Equity Portfolio that are deeply undervalued while still boasting solid balance sheets, stable cash flowing business models, and significant potential catalysts for unlocking shareholder value.
Despite all of these strengths that make them attractive and stable sources of yield, Mr. Market is pricing them at a massive discount to their historical distribution yield spread with interest rates:
As the chart above illustrates, over the past decade, interest rates have declined by a whopping 40%. Meanwhile, ET's EBITDA yield has nearly doubled over that same span even as its balance sheet and portfolio have strengthened considerably over that same period. The disconnect is truly historic, especially when compared to the outrageously bullish valuations seen in some of Cathie Wood's ARKK picks.
#2: Declining COVID-19 Impacts
Another big reason to bet on High Yield over disruptive tech right now is that ARKK's biggest catalyst - COVID-19 - continues to lose its grip on consumer and corporate behavior. The lockdown/stay-at-home economy provided an enormous tailwind for technology companies like ZM, Amazon (AMZN), Facebook (FB), DoorDash (DASH), and Teladoc (TDOC).
However, now with people increasingly returning to the office and consumers no longer staying home behind their computer screens in fear of the virus, these companies are losing some of the COVID-19 tailwind and traditional mature businesses - which are today's value and high yield stocks - are seeing demand return. Adding to that the pent-up demand and some of the year-over-year growth numbers being posted by the businesses of high yield stocks are quite strong.
While some health experts and government officials point to ongoing vaccine hesitancy in the U.S. as a risk to the economic recovery, a very large percentage of the U.S. population (~44 million confirmed cases, but likely many more cases have actually been had) has already had COVID-19 and a recent Israeli study offered very encouraging news.
According to Science Magazine:
never-infected people who were vaccinated in January and February were, in June, July, and the first half of August, six to 13 times more likely to get infected than unvaccinated people who were previously infected with the coronavirus... the risk of developing symptomatic COVID-19 was 27 times higher among the vaccinated, and the risk of hospitalization eight times higher. This analysis demonstrated that natural immunity affords longer lasting and stronger protection against infection, symptomatic disease and hospitalization due to the Delta variant of SARS-CoV-2, compared to the BNT162b2 two-dose vaccine-induced immunity. Notably, individuals who were previously infected with SARS-CoV-2 and given a single dose of the BNT162b2 vaccine gained additional protection against the Delta variant.
What this means is that, between the 67.2% of U.S. adults and 83.6% of U.S. senior citizens who are fully vaccinated and the many more unvaccinated who have had and recovered from COVID-19, public resistance to catching the virus - and in particular to experience severe symptoms - is already quite strong. As a result, we see little risk of major negative economic impacts hitting the economy from future severe COVID-19 outbreaks. This bodes well for the business outlook for value/high yield stocks.
#3: Surging Inflation And Supply Shortages
The third reason to bet on High Yield over ARKK today is that inflation and supply shortages appear here to stay for the foreseeable future. In addition to enormous supply chain disruptions and bottlenecks which are reducing supply even as record amounts of currency is hitting the economy thanks to ongoing quantitative easing, record low interest rates, and enormous government stimulus programs over the past year, energy supplies are now running short across the world.
On top of this, the CPI is already at multi-decade highs, hitting over 5% recently:
With nominal interest rates still at historical lows and inflation rates hitting multi-decade highs, it appears that real interest rates will be firmly in the red for the foreseeable future. This bodes very strongly for continued inflation. Additionally, policy makers have fewer tools to tackle inflation this time since government and corporate debt are incredibly high and the Federal deficit continues to hit new highs consistently. As a result, if interest rates were to rise meaningfully, it would likely cause a deep economic downturn that would only further exacerbate the Federal budget and threaten the U.S. with another credit downgrade.
With inflation surging, the discount rate used to compute the net present value of future cash flows will have to increase, thereby disproportionately reducing the intrinsic value of high growth companies that derive a large portion of their net present worth from long-dated cash flows. In contrast, high yield companies that are generating significant profits and returning them to shareholders today will be impacted much less severely. Furthermore, many high yield stocks have real asset focused business models which should benefit from inflation.
Investor Takeaway
ARKK and fund manager Cathie Wood have been on a phenomenal run capped by a historic 2020 performance. In fact, we are still finding some attractive opportunities in the high growth disruptive tech space like Coinbase (COIN) as we discuss in our recent piece I Don't Often Buy Cathie Wood Stocks, But When I Do, I Buy These 3.
However, the fund has grown too large with too much inflow-outflow volatility, the fees are too high, and the valuations of the underlying holdings are too rich to sustain its record-setting pace, much less beat the market moving forward.
Furthermore, the high yield/value space looks more attractive than ever and we are finding numerous stable cash flowing businesses trading at rock-bottom valuations and offering very attractive and sustainable dividend yields. With COVID-19 headwinds largely in the rearview mirror and inflation rearing its ugly head, the time looks better than ever to forget ARKK and go long high yield stocks like those we discuss in our recent piece The Best Investment Opportunity Might Not Be On Sale For Long.
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This article was written by
Samuel Smith is Vice President at Leonberg Capital and manages the High Yield Investor Seeking Alpha Investing Group.
Samuel is a Professional Engineer and Project Management Professional by training and holds a B.S. in Civil Engineering and Mathematics from the United States Military Academy at West Point and a Masters in Engineering from Texas A&M with a focus on Computational Engineering and Mathematics. He is a former Army officer, land development project engineer, and lead investment analyst at Sure Dividend.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of COIN, ET, TDOC, LUMN either through stock ownership, options, or other derivatives. 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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