A Risky, But Promising, Innovation ETF

Innovation can reshape industries and change competitive dynamics, creating opportunities for innovative companies and risks for established players that are slow to adapt. New innovative companies are staying private longer now than in the past, but there are still publicly traded stocks that benefit from innovation. These include firms built around disruptive products and technologies, like Tesla TSLA, and those that reinvent themselves, like Nvidia NVDA, which leveraged its leadership position in the graphics processing unit market to build chips to power self-driving cars.

While significant mispricing is less likely in the public markets than the private, innovative companies are difficult to value because they often have little or no profits and there is considerable uncertainty about their growth trajectories. So, the market tends to discount their potential to compensate for the risk. This can create opportunities for astute investors, like Catherine Wood, who runs ARK Innovation ETF ARKK. This transparent, actively managed fund targets stocks that will likely benefit from disruptive innovation and that are priced to offer attractive returns over the long term. This is a risky concentrated portfolio, but it will likely reward investors in the long run.

Strategy Overview This strategy focuses on five innovation themes: DNA technologies (genomics), energy storage, autonomous technology, next-generation Internet services, and fintech. These themes cut across traditional sectors, so ARK's investment team is organized around innovation themes rather than by industry.

The team starts by looking for innovative technologies with declining costs that will likely accelerate adoption. For example, as lithium-ion battery production has increased, the cost of these batteries has declined to the point where electric vehicles may soon be cheaper than similar gas-powered vehicles. At that point, adoption rates for electric vehicles will likely significantly accelerate.

ARK’s investment team estimates cost and demand elasticity curves for each technology, leveraging Wright’s Law. This law states that for every cumulative doubling of units produced, costs will fall by a constant percentage. Declining costs are often key to the team’s investment thesis. As such, the managers aren’t looking for firms to hold on to high margins. Rather, they want their holdings to ride the cost curve down and lead the segment, which should allow them to grow profitably.

The team pairs this top-down analysis with bottom-up analysis of the companies best positioned to benefit from the innovation. This includes an assessment of the firm’s leadership and culture, execution (including sufficient research and development spending), barriers to entry, product leadership, thesis risk, and valuation. To value each company, the team builds a five-year discounted cash flow model with bull-, bear-, and base-case scenarios, using the probability-weighted average fair value. Stocks must be priced to offer at least a 15% annual return over five years to make the cut.

The fund’s holdings don’t look cheap on traditional valuation metrics like price/earnings. Wood and her colleagues don’t rely on those metrics because they expect their companies to look quite different in five years than they do today. They believe the market doesn’t fully appreciate that explosive growth potential, and given a long enough time horizon, they are value investors. While that is debatable, they are definitely not momentum investors, often opportunistically picking up firms experiencing what they view as short-term issues. For example, the fund increased exposure to Tesla when concerns about the firm’s ability to secure financing and Elon Musk’s fitness to lead sent the stock down.

While many active stock managers have eschewed the exchange-traded fund wrapper for fear of others imitating their trades, ARK Invest embraces transparency, not only with its holdings but also with much of its top-down research, which it shares online. This open architecture allows members of the investment team to connect with, and get feedback from, experts in the industry to stress-test their assumptions.

Portfolio This is a compact, high-conviction portfolio that typically consists of 35-55 U.S.-listed stocks. While the team doesn't think about traditional sector allocation, its holdings tend to cluster in healthcare and tech.

This portfolio includes cornerstone stocks for each innovation theme and other firms that operate in the ecosystem around those stocks. For example, Illumina ILMN holds a dominant share of the DNA sequencing market and serves as a cornerstone for the genomics theme. Similarly, Tesla is a cornerstone for the energy storage theme. Production costs have come down for both firms, which ARK is betting will help fuel the growth of the surrounding ecosystem as well.

Wood and her team focus on firms' long-term potential, but changing valuations can drive turnover. For example, the team recently swapped Netflix NFLX for Roku ROKU, as the former was trading at a lower discount to its expected future cash flows. Roku was attractive to the team because it is firmly embedded in the core of the streaming TV ecosystem. It provides an operating system for streaming TV and commands a large share of that market.

Many of the fund’s holdings are not currently profitable, which adds to its risk. It’s not uncommon for innovative growth companies to lose money as they invest heavily to expand in hopes of a larger future payout. However, this makes them difficult to value and often highly volatile.

People Catherine Wood leads ARK's investment team and is the fund's sole named manager. She is the firm's CEO and CIO and has 40-plus years of industry experience. Before founding ARK in 2014, she was the CIO of global thematic strategies at AllianceBerstein, a hedge fund manager at Tupelo Capital, which she co-founded, and chief economist at Jennison Associates LLC. Wood has more than $1 million invested in this fund, which is a good sign.

Many of the analysts on the team have experience working in the industries they research, rather than at traditional asset managers. This is a valuable perspective that can help the team stay on top of emerging trends.

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