PLTR - ARKK: Not The Beta Play One May Hope For

2023-12-14 20:09:45 ET

Summary

• Half of the portfolio is in established and fairly valued stocks with limited upside potential.
• The other half is in developing companies with negative EPS, dependent on breakthrough growth and earnings far into the future.
• The combination may not produce Beta nor Alpha.
• An aggressive investor may be better served in some of the ETFs' small-cap ideas.

Summary

If an investor is looking for alpha the ARK Innovation ETF ( ARKK ) may come to mind. The ARK group´s leader, Cathy Wood, is all over the media explaining her investment vision and philosophy that creates awareness and “demand” for the stocks in the various ARK funds. I am an aggressive long-term investor and look for big themes and high growth/risk stocks. Thus, I took a close look at the ARKK ETF and unfortunately did not come away with a fabulous sense of opportunity. Half of the portfolio lacks growth or is fairly valued while the other half is in developing companies with negative margins and negative EPS that make them very long speculative bets.

Performance

Many investors have seen this chart with the skyrocketing value of the ETF in the pandemic years followed by a dramatic decline back to earth. This was due to holdings such as Tesla ( TSLA ), Zoom ( ZM ), and Shopify ( SHOP ) that benefited from stay-at-home, work-from-home, helicopter money, QE and zero rates. As the Fed woke up to inflation risk and hiked interest rates the fastest in 30 years, the ARKK fund´s focus lost key support as cash flow, earnings, and valuations mattered again.

Two Portfolios In One

ARKK is a concentrated and actively managed ETF with 33 stocks focused on “innovation " including Biotech, Fintech, AI, and Crypto. Below I list the holdings with a basic business line description. Other characteristics of this portfolio are that it includes large caps such as Tesla and Meta ( META ), much smaller companies, and many that do not yet report positive EBITDA much less EPS. It’s a visionary or speculative portfolio depending on one's point of view. To better visualize it, I divided the holdings into two sections, one I call Growth and the other Development companies. The primary selection metric is positive EPS.

On consensus price targets I calculated that ARKK has a 14% upside potential. This rather weak result is due to negative upside estimates on about 50% of the portfolio. The sell-side analysts seem to believe that these stocks are more than fairly valued. The over 100% upside stocks are mostly in the Biotech area, and I assume dependent on a new therapy or device sometime in the future.

Growth Companies

Using consensus estimates I calculated that the Growth side of the portfolio has 7% revenue growth with increasing margins that drive EBITDA up 13%. However, in my view, these are mostly well-known solid tech-focused companies with better-than-average moats that are now closer to fair value on established fundamentals. Outliers are Palantir ( PLTR ), Trade Desk ( TTD ), and Shopify with over 20% growth rates while Zoom looks to have under 5% growth.

Developing Companies

In the Developing side of the ARKK portfolio, I calculated very volatile revenue growth with 2024 estimated to be quite weak at 4% before increasing to 30% in 2025. Since many of these companies do not have a positive EBITDA margin nor EPS the fundamental side of the analyses stops here. Given that analysts have price targets with substantial upside one may assume that valuation metrics are more subjective and revolve around longer-term growth parameters. The same ones that were in use when the risk-free was zero.

Valuation

With half of the portfolio void of earnings and even EBITDA the valuation for ARKK is difficult. The Growth side of the holdings seems to be valued in line with the SP500 at 1.8x PEG (a PEG ratio of 1x is generally considered reasonable). I calculated EPS growth from consensus estimates of 12% for the YE24-25 period. With almost zero upside potential from 50% of the AUM, investors are dependent on the Developing side of the portfolio for significant performance which makes this a very speculative fund that has a greater probability of underperforming the NASDAQ.

Conclusion

I rate ARKK a sell. The current portfolio may underperform the NASDAQ since 50% is in the more established companies that seem to have good growth but high valuations with zero upside. While the other half of the current portfolio may have exceptional returns but are dependent on very high-risk “innovation”. In my view, it may be worthwhile for aggressive investors to invest in those developing companies rather than buy this ETF.

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