DNA - Tech Stocks Are Roaring - Why The ARKK ETF Has Been Left Out

2023-07-07 14:35:37 ET

Summary

• Amidst a furious rally in growth stocks, the ARK Innovation ETF has somehow been left out.
• Fund manager Cathie Wood has famously missed out on the bulk of Nvidia Corporation profits, but that is not the only issue here.
• I discuss why I like a lot of the fund's makeup here and discuss why the fund may have underperformed as of late.
• I reiterate my buy rating due to the overall undervaluation of the fund.

It can be surprising to remember that just 3 quarters ago, sentiment in the tech sector was very pessimistic. Tech stocks across the board have conducted a furious rally with many speculative names seeing the greatest gains. Yet one may be most surprised to see that the Ark Innovation ETF ( ARKK ) is somehow flat over the past year. An analysis of the holdings reveals the culprit: while the exchange-traded fund, or ETF, has exposure to a handful of recent winners, elevated exposure to extreme-risk names has more than offset that. In spite of the underperformance, I remain bullish on the current basket of positions, as there are ironically enough value-type names in the mix to warrant optimism.

ARKK Stock Price

After a historic beatdown among growth stocks, a recovery is well underway. Since November of last year, the Nasdaq Index ETF ( QQQ ) is up 33%, and names like Nvidia Corporation ( NVDA ) and Meta Platforms ( META ) are up in the triple-digits.

Yet ARKK has somehow delivered only modest returns since I highlighted the ETF in November. While some reason may have to do with the fund missing out on the bulk of the gains from NVDA, the issues may extend further than just one mistake.

ARKK ETF Top Holdings

ARKK's recent top 10 holdings can be seen below.

As someone who deeply covers the growth sectors myself, I found the holdings list to be quite surprising. As the "innovation" in the fund name suggests, there are several names which I view to be secular stories, including Tesla ( TSLA ), Unity Software ( U ), Shopify ( SHOP ), and DraftKings ( DKNG ). But a large number of the fund appears to have more of a value-tilt, like Zoom Video Communications ( ZM ), Roku ( ROKU ), and Teladoc Health ( TDOC ). While these names are still tech stocks, their top-line growth rates are very modest at best. I suspect that many of the holdings previously had very high growth rates prior and during the pandemic, but remain in the fund due to fund manager Cathie Wood's tendency to add to the losers. I note that I am not saying that this is a bad strategy, but merely highlighting the reasons why the fund today appears to be of such a different growth profile than it was just several years ago.

Looking beyond the top 10 holdings, we can see arguably the biggest drivers of the underperformance. ARKK has significant exposure to names like Ginkgo Bioworks ( DNA ), Beam Therapeutics ( BEAM ), and Intellia Therapeutics ( NTLA ), which are down over 50% over the past year. ARKK allocates over 1% of its funds to each of its top 20 holdings, making underperformance from just a handful of names enough to drag on overall gains.

There does seem to be a sort of "moonshot" strategy at play here, which may be the goal of some investors, but these names have been mostly left out of the recent rally. I personally am of the view that these moonshot names should have a lower allocation due to the elevated risk. The vast majority of names benefitting from this year's rally have been either those seeing high growth rates or having robust profit margins - two characteristics lacking at these moonshot names.

Is ARKK ETF A Buy, Sell, or Hold?

Experienced investors know that past underperformance may (but is not guaranteed) be a predictor of future outperformance. Is ARKK worth a waiver here?

I like a lot of the holdings here. Block ( SQ ) at 6x gross profits with 13% consensus forward revenue growth looks attractive. Zoom Video has become a cash cow and trades at 15x earnings with a large net cash position. Unity Software is poised to benefit from its VR partnership with Apple ( AAPL ) and trades at only 7x sales. Twilio ( TWLO ) has garnered takeover interest and still trades at just 6x gross profits. I am of the view that on the whole, the fund looks undervalued, but prospective investors should be aware that this fund may not be optimally positioned for generative AI or other obvious innovative trends. In particular, I am curious why Palantir Technologies ( PLTR ) is such a small holding and why other secular growth leaders like CrowdStrike ( CRWD ) are omitted. Even so, I caution against betting against this fund, as a lot of the negative press and reputation appears to have already taken its toll on the underlying holdings.

What are other key risks? I should note that ARKK has a sizable 0.75% expense ratio.

I also have some questions regarding the investment strategy. Cathie Wood is quoted as calling TSLA cheap for being at "6x revenues," with the obvious comparable being tech stocks, but I am unsure that this is an appropriate comparison given that TSLA has far lower gross margins than software names.

Further, some of the fund's publicly released research are not shy from outlandish price targets, including a $1,500 per share 2026 price target for ZM based on (in my opinion) overly aggressive growth assumptions. This means that even if I like the current fund layout, it is possible that the investment strategy leads to future investment transactions that prove to be suboptimal.

One mustn't ignore the risk of an economic recession and more difficult macro conditions. While ARKK has not participated meaningfully in this recent rally, I would not rule out the fund having significant exposure to any market declines given the fund's popularity (from both long and short investors). I reiterate my buy rating for ARKK but note that investors should closely monitor ongoing transactions as this is an actively managed fund.

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