- Ark Invest, and in particular the Ark Innovation ETF have had an incredible run over the past five years.
- However, much of these gains came from factors that are no longer applicable to the fund today.
- The fund's excessive size and concentration in positions are making it difficult for ARKK to navigate stormy seas.
- While ARKK may be due for a technical bounce in coming weeks, the long-term trajectory is in the downward direction.
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Ark Innovation ETF (NYSEARCA:ARKK) is the flagship fund from the Ark Invest group, run by prominent fund manager Cathie Wood.
Ark was starting to build its brand over the past few years with its bold research calls on Tesla (TSLA) and emerging industries such as space travel and 3D printing. However, it was in 2020 when Ark became a household name as its funds put up massive numbers during the tech stock rally following the onset of Covid-19.
The excitement around small speculative growth companies peaked in about February of this year, however. Since then, former stay-at-home champions such as Teladoc (TDOC), Peloton (PTON), and Zoom Video (ZM) have seen their stock prices get smashed. High valuations combined with slowing revenue growth is not a pretty mix.
As Ark is full of these sorts of disruptive technology names, it was taken a bruising as well. For the year, the ARK Innovation ETF is now down 21%, and it has fallen 39% from its 52-week high. That's not even the worst performer in the Ark stable of funds. The ARK Genomic Revolution ETF (ARKG) is now down 36% year-to-date and has fallen 49% from its 52-week highs.
Remember, we're talking about ETFs here, which own a basket of ostensibly diversified holdings. It's pretty remarkable when an ETF drops nearly 50% within a 12-month period. So what's gone wrong for Ark, and is there a path back to smoother seas?
Returns Are Harder To Replicate Now
An often overlooked concept with funds is that size changes everything. A fund manager that can make huge returns with a small pool of capital often has trouble delivering the same results on a larger fund base.
Arguably the biggest reason for that is due to liquidity. Prior to 2020, Ark Invest was able to buy just about any sort of small-cap company without really moving the price much or running into liquidity issues.
Now, though, her funds have grown so large that they have started having a dramatic impact on the price and trading action in their underlying holdings.
Here's a chart of ARK Innovation's assets under management over the past five years. This isn't all of Ark's assets, just the ones in the ARKK ETF:
From 2016 through the beginning of Covid-19, ARKK never had more than a couple billion dollars at play. That means that, if allocated across, say, 30 positions, each position could be $100 million or less.
In 2020, as tech stocks outperformed in the pandemic, investors raced to put money into Ark. By the peak, there was $25 billion in the ARKK ETF. This means that an average position size would be clocking in closer to $1 billion. In many cases, Ark has ended up owning 10% or more of the entire outstanding stock of a corporation because it has so much capital to deploy.
It's fine to own 10% or 15% of the equity of a speculative tech company on the way up. When things start dropping, however, it becomes a massive burden. The whole market knows what Ark owns -- holdings are published daily, after all. So when people are pulling funds out of Ark, it guarantees that those stocks will be offered for sale to meet redemptions. And since Ark has such gargantuan positions, it could take weeks of selling to get out given the limited volume in some of her holdings.
People like to point to her track record and say she's still beating the indexes in recent years despite the terrible performance as of late:
And that's an absolutely fair and true point. However, I'd argue that her returns simply can't be replicated with the current $20 billion that Ark now has in its flagship fund. It's one thing to dart in and out of small speculative growth companies as an emerging fund manager. When you are a behemoth in the space, however, it's far harder to operate efficiently.
In February, at the peak of Ark's success, it owned 10% or more of the float in 29 different publicly-traded companies. Ark had large positions in thin illiquid unprofitable firms such as Compugen (CGEN), Organovo (ONVO), and Skillz (SKLZ):
For Vuzix, Ark's suite of funds owns a combined $76 million of VUZI stock, which makes up 12% of the company's total $655 million market cap. As you can imagine, it'd be difficult to offload more than 10% of the company in a hurry if Ark felt the thesis had changed around the company or it needed the cash for other uses.
In the case of Beam, the situation is even more concerning. Ark owns $591 million of BEAM stock across its various ETFs. Beam has a market cap of $4.9 billion, putting Ark's ownership, once again, at 12%. In this case, however, Beam is far more important to Ark's fortunes. For one thing, $591 million isn't chump change.
For another, consider what would happen if Ark wanted to sell its stake in BEAM stock. Right now, Beam has an average of 600,000 shares a day in trading volume. At $70/share, that's $42 million a day in volume. If Ark managed to be 100% of the selling volume in a day (which is not plausible), it would take more than two weeks of steady selling for Ark to exit its position in Beam. Meanwhile, every day, folks would see that Ark was selling and front-run them, pushing the stock down even more. This is how you get a downward spiral as liquidity disappears.
Not surprisingly, Ark's most concentrated positions continue to slump. BEAM and VUZI shares are down 49% and 68%, respectively, from their 52-week highs.
Where Will ARKK Be In 5 Years?
This sort of investing in small companies with massive positions is a boom or bust strategy. If the sector is hot and the companies have good sentiment and macroeconomic tailwinds, this sort of fund can make a fortune. Ark's returns from 2016 to 2020 were breathtaking, and nothing can take that away from Wood regardless of how things end up.
However, this strategy is highly unlikely to survive multiple market cycles. The illiquidity of names simply exposes shareholders to excessive downside risk. With a company like Beam or Vuzix, it's hard to see how Ark could exit even if it wanted to without blasting the share price to smithereens.
And since most of her holdings have no profits, dividends, share buybacks or other such positives that would give support to a share price, these companies can see their stock prices plunge to shocking levels. A company whose valuation is driven primarily by a positive narrative can drop 50%, 75%, or even more when people stop believing the story.
Is ARKK Currently Overvalued?
It's a complex topic discussing valuation with a fund such as ARKK. The majority of Wood's holdings are not profitable on a P/E basis. A number of them don't even consistently generate positive EBITDA. There's virtually nothing in the way of a dividend yield to use a guidepost as well.
When Wood does have a profitable holding, the P/E ratio is often stratospheric. ARKK's top holding, Tesla, has a trailing P/E ratio north of 300. Another key holding, Roku (ROKU), still has a triple digit P/E even after the stock has lost more than half its value.
Valuation won't provide a floor for most of ARKK's positions at anywhere near current prices. So if you're considering trading Ark, you should probably be focused on sentiment and short-term trading factors. As detailed above, many of Ark's stocks have been getting pounded since they are illiquid stocks and people are betting against Wood directly. If that reverses, for example after tax loss selling season ends, these stocks could see sharp reversals. But it would be based on technical or sentiment-driven factors, not anything related to valuation.
Is ARKK A Good Investment Now?
In a word: No. It might be a decent candidate for a quick swing trade to the upside. Shares are certainly oversold in the short-run, and there's a ton of short interest in ARKK's positions. It's not hard to see factors that could lead to a 10-20% relief rally over the next month or two.
As an investment, however, Ark Innovation simply doesn't hold the sorts of companies that you can rely on over the long-haul.
Ark enjoyed tremendous success from a stock price performance perspective between 2016 and 2020. However, most of this was from improving sentiment and rising price/sales multiples for its holdings. The actual underlying businesses -- despite having a huge pandemic tailwind -- largely remain loss-making and are now seeing sharply decelerating growth as the economy reopens.
Meanwhile, ARKK has grown too big for its own good. It can no longer quickly trade in and out of hot stocks. Rather, it is stuck with bloated positions in a number of small loss-making firms, which could leave Ark in a most difficult position if the current tech sell-off intensifies.
This isn't just my casual opinion, either. I've put my money where my mouth is. Specifically, in October, I made a friendly wager with fellow Seeking Alpha author Exile of the Mainstream that ARKK stock will trade lower over the next one, three, and five years, respectively. $110 is our over/under point to determine the winner. If ARKK continues moving lower in coming months and years, Exile will own me three nice dinners in due time. And I'll be out those restaurant meals if ARKK ends up above $110 per share.
Why was I confident betting on ARKK being under $110 per share in future years? Simply put, I don't see the fund's model working with ARKK having $20 billion of assets under management. The fund is too big to operate smoothly in the sorts of stocks where ARKK made its original fortune. Meanwhile, the pandemic tailwinds are ending for firms like Teladoc and Zoom Video. If the Nasdaq 100 (QQQ) goes into a bear market in coming months, it's hard to see how ARKK would avoid taking massive losses.
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This article was written by
Ian Bezek is a former hedge fund analyst at Kerrisdale Capital. He has spent the decade living in Latin America, doing the boots-on-the ground research for investors interested in markets such as Mexico, Colombia, and Chile. He also specializes in high-quality compounders and growth stocks at reasonable prices in the US and other developed markets.Ian leads the investing group Learn more .
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
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