ARK Invest ETFs: Financial Footprints Of Disruptive Innovation

ARK Invest offers four actively managed ETFs that focus on disruptive innovation, which, on the home page for one of its ETFs, it defines as “the introduction of a technologically enabled new product or service that potentially changes the way the world works.” Who wouldn’t love to invest in companies that do that! But it’s easier said than done for those of us that aren’t science or engineering majors because the fundamentals on which investors rely typically offer little guidance, leaving us often to get burned by stories that sound great but really aren’t. Perhaps, however, reverse engineering these ETFs might help us get a sense of what, if anything, we can glean from the numbers.

ARK feature image

The ARK Quartet

ARK’s lineup of four actively-managed ETFs are, according to remarks made by Founder and CIO Catherine Wood at the 9/17/15 Forbes Advisor Playbook iConfernece, based on the proposition that “[d]isruptive innovation is often not priced correctly by traditional investment strategies because people may not understand how big the ultimate opportunities are going to be. They aren’t sizing the opportunity and they aren’t analyzing the disruption.” ARK seeks to profit from this through four ETFs.

Three of the ETFs are sector focused:

  • ARK Genomic Revolution Multi-Sector ETF (ARKG): Equity investments focused on companies that “are expected to substantially benefit from extending and enhancing the quality of human and other life by incorporating technological and scientific developments and advancements in genomics into their business.” Areas of interest for these companies may include CRISPR, Targeted Therapeutics, Bioinformatics, Molecular Diagnostics, Stem Cells, and Agricultural Biology. (Source)
  • ARK Industrial Innovation ETF (ARKQ): Equity investments focused on “the development of new products or services, technological improvements and advancements in scientific research related to, among other things, energy, automation and manufacturing, materials, and transportation.”  Areas of interest for these companies may include Autonomous Transportation, Robotics and Automation, 3D Printing, Energy Storage, and Space Exploration. (Source)
  • ARK Web x.0 ETF (ARKW): Equity investments focused on“shifting the bases of technology infrastructure to the cloud, enabling mobile, new and local services, such as companies that rely on or benefit from the increased use of shared technology, infrastructure and services, internet-based products and services, new payment methods, big data, the internet of things, and social distribution and media.” Areas of interest for these companies may include Cloud Computing & Cyber Security, E-Commerce, Big Data & Artificial Intelligence (AI), Mobile Technology and Internet of Things, Social Platforms and Blockchain & P2P. (Source)

The fourth seems to be a more generalized all-encompassing innovation-oriented ETF. 

  • ARK Innovation ETF (ARKK): Equity investments focused on companies “that rely on or benefit from the development of new products or services, technological improvements and advancements in scientific research relating to the areas of DNA technologies (‘Genomic Revolution’), industrial innovation in energy, automation and manufacturing (‘Industrial Innovation’), the increased use of shared technology, infrastructure and services (‘Next Generation Internet’), and technologies that make financial services more efficient (‘Fintech Innovation’).” (Source)

What to choose, what to choose . . . 

Although, as we all know, past performance does not assure anything in terms of the future, it’s at least an interesting starting point. Table 1 shows the three-year performance of the ETFs. All are benchmarked against the S&P 500 SPDR ETF (SPY). The table also shows the performance of an equally weighted portfolio of all four ETFs (with weights rebalanced once every three months).

Table 1

3 Year Tests Overall Genomics Industrial Web x.0 Portfolio Benchmark
ARKK ARKG ARKQ ARKW 4 ARK ETFs SPY
Annual % Return 38.18% 22.43% 28.88% 41.84% 33.11% 17.11%
Standard Dev. 22.92% 28.05% 19.11% 20.53% 20.53% 9.23%
Max Drawdown -29.87% -27.25% -26.15% -31.08% -28.20% -13.21%
Correlation 0.68 0.64 0.83 0.65 0.77 – –
Beta 1.69 1.96 1.73 1.46 1.71 – –
Annual Alpha % 11.88% -3.48% 1.99% 17.46% 6.59% – –
Average of 13-week Returns, each interval stating  one week later
All 7.14% 4.57% 6.26% 9.28% 7.14% 3.62%
Market Up 9.79% 6.97% 8.78% 12.04% 9.79% 5.07%
Market Down -6.80% -8.05% -7.02% -5.23% -6.80% -3.99%
Data from Portfolio123

Obviously, one would have done fine with any choice or combination of choices. (Speaking for myself, I own some ARKK.) That said, on a purely statistical basis, one might not have been overjoyed had all of one’s eggs been concentrated into the Genomic basket. However, emerging biotech is a tough filed for those without degrees in that area of study, and it has been very easy for investors who chose on their own to have gone wrong. Table 2 compares ARKG to a universe I created consisting of all Biotechs excluding those illiquid issues that trade on the “pink sheets” and also excluding more established firms included in the S&P 500. 

Table 2

3 Year Test Genomics Emerging Benchmark
ARKG Biotechs SPY
Annual % Return 22.43% 7.97% 17.11%
Standard Dev. 28.05% 27.64% 9.23%
Max Drawdown -27.25% -40.25% -13.21%
Correlation 0.64 0.63 – –
Beta 1.96 1.87 – –
Annual Alpha % -3.48% -13.54% – –
Average of 13-week Returns, each interval stating  one week later
All 4.57% 1.66% 3.62%
Market Up 6.97% 4.26% 5.07%
Market Down -8.05% -12.00% -3.99%
Data from Portfolio123

Neither ARK nor anyone else can change the fact that emerging biotech is an especially tough high-risk area. But for those who like this sort of thing, as many do, going all in on ARKs Genomic Revolution fund has been a pretty good way to go.

There is, however, an important caveat across the board and one to be taken seriously going forward. The good things that have happened to these ETFs seem to have been concentrated during up periods for the overall stock market. All have shown tendencies to underperform down market intervals.

When thinking about the future, as we must when we invest, we have to recognize the potential for more down periods than we’ve seen in the past. Interest rates are no longer plummeting as they have for the better part of nearly 40 years past. And the economy remains strong with corporate earnings carried along (and then some, due to the big tax cut). It’s unrealistic to think it’s always going to be this good. So the down-market rolling historic tests can’t be dismissed. 

On the other hand, yesterday’s innovators eventually become tomorrow’s stable blue chips if all goes well. I’m not saying every company in each of the ARK Innovation portfolios will wind up in the S&P 500 (although some are there already). But as time passes, successful companies transition from money-losers and cash burners to profit makers and cash generators. In this respect, Father Time could turn out to be a supportive friend to these ETFs. So down market performance may improve.

With all these possibilities out there, it can be worthwhile to consider the fundamental profiles of the companies in which ARK invests.

Fundamentals

Below is a series of tables that compares each if these ETFs to one another and to the S&P 500. All tables reflect market cap weighted averages of the respective constituents. It’s not perfect: There are a few securities in each fund for which I couldn’t get data and the S&P 500 isn’t strictly market cap weighted (they use a proprietary float-adjusted cap weighting). But as is the case in many, perhaps most or even all areas of stock market investing, reasonable approximation is a worthy outcome or as British logician Craveth Read said, in a phrase often wrongly attributed to John Maynard Keynes, “It is better to be vaguely right than exactly wrong.” Consider these Tables as being “vaguely right” and easily, in my opinion, enough so to allow us to think sensibly about these funds’ holdings.

Let’s start with valuation.

Table 3: Valuation

ARKG ARKK ARKQ ARKW SPY
Price/Sales 71.13 23.27 6.68 8.30 3.21
EV/Sales 57.13 19.23 6.29 8.02 3.81
P/FreeCashFlow 26.23 50.86 47.61 50.86 33.97
EV/FreeCashFlow -5.99 -0.60 24.73 35.84 32.84
EV/EBITDA -8.43 -215.66 -4.19 -278.98 13.81
Price/Book 9.83 12.30 8.87 17.02 4.22
Noise % MktCap * 133.88 113.99 91.87 90.75 56.12
From Portfolio123 using data from S&P Compustat.  *  Click here further information about the concept of P=V+N (Price = Value + Noise)

I eliminated reference to P/E ratios because there are too many meaningless data-points, due either to deficit EPS (which impacts historical P/E) or no analyst coverage-estimates (which impacts forward P/E). Based on such data as is available, it’s clear that if low ratios are a meaningful part of one’s investment case, than none of these ETFs can be considered. 

But one can’t simply say we’re substituting growth for value, because the growth numbers are all over the place.

Table 4: Growth Rates

ARKG ARKK ARKQ ARKW SPY
EPS Growth % PYQ -27.52 18.75 40.79 70.71 25.26
EPS Growth % TTM 6.70 10.14 23.63 25.04 22.24
EPS Growth % 5Y Avg 3.97 8.66 11.87 18.30 10.15
Sales Growth % PYQ 28.00 30.56 24.77 31.56 10.41
Sales Growth % TTM 265.59 145.24 28.64 33.38 9.40
Sales Growth % 5Y Avg 18.11 31.58 26.80 38.91 5.44
Proj LT Growth Rate % NM 23.54 26.16 33.32 11.28
Data from S&P Compustat via portfolio123.com and reflects Compustat standardization protocols, TTM = Trailing 12 Months, MRQ = Most Recent Quarter

I removed the Projected Long Term Growth rate for ARKG from the table because no analyst projections were present for most companies, meaning they counted as zero in a weighted average computation and produced a meaningless figure. ARKK’s numbers are pulled down by inclusion of genomics-type companies. ARKQ (Industrial) and ARKW (Web x.0) numbers are meaningful and when compared to the S&P 500, are more interesting — but perhaps not for the reason you may think.

The historical and projected growth rates for the ETFs are a lot higher than for the S&P 500. That’s to be expected given the nature of the businesses in which these funds invest. But compare the projected growth rates with the historical numbers (particularly Sales, which tends to be less prone to the accounting impact of odd events).

The 11.28% S&P projection is more than double the 5-year historical growth rate. The blue-chip projection is only slightly higher than the trailing 12 month and latest quarter figures. But do we really believe in this? Although the S&P Investment Committee does turn the index over periodically to substitute modern companies for old-time dogs, on the whole, this still is an index of established companies. So more likely than not, the strong recent figures reflect the recent exceptional economic strength, rather than a secular growth trend. Hence analysts are really expecting a lot for the long term, a heck of a lot, perhaps too much. On the other hand, when it comes to ARKQ and ARKW, analysts are, on the whole, not looking for more than what the companies have already shown themselves capable of delivering in terms of sales — and given the nature of the businesses, the ARK investees are much more likely to sustain and perhaps accelerate growth going forward than many of the S&P 500 constituents.

Now, moving on to margin and turnover, things get really interesting.

Table 5: Margin-Turnover

ARKG ARKK ARKQ ARKW SPY
Gross Margin % TTM -1070.27 -128.28 41.98 58.51 46.55
Gross Margin % 5Y Avg -277.84 5.68 29.79 57.07 44.03
Oper Margin % TTM -1177.69 -186.75 -6.56 6.39 20.40
Oper Margin % 5Y Avg -213.03 -68.84 -35.34 1.79 20.46
Inventory Turnover TTM 4.84 4.80 4.49 7.52 7.73
Inventory Turnover 5Y Avg 3.70 2.95 3.90 4.85 7.63
Asset Turnover TTM 0.37 0.56 0.72 0.73 0.55
Asset Turnover 5Y Avg 0.23 0.35 0.49 0.46 0.50
Data from S&P Compustat via portfolio123.com and reflects Compustat standardization protocols, TTM = Trailing 12 Months, MRQ = Most Recent Quarter

Its the margins that tell the stories of where these companies are. We like all margins to be positive all the time but when margins do go below zero, I can often live with them when it comes to pretax and net because these deal with oddities (e.g., write-offs) or the results of strategic but not inevitable choices (interest expense), so long as they don’t get out of hand. But operating and gross margins are another story. Those mean the company’s revenues aren’t even covering mundane essential costs of being in business. This state of affairs in common among start-ups an emerging companies (expenses typically materialize well before sales— life is harsh that way). When you see it, you absolutely must have an expectation that the company will grow into and then beyond its cost structure, and you must expect the company to be able to continually raise new debt and/or equity in order to cover losses and allow the company to remain open.

ARKQ (Industrial) companies appear to be in the latter stages of transition. Gross margins are well above breakeven and have been trending up toward the S&P 500 level. Operating margins, which usually include more fixed costs, aren’t yet where they need to be. But these have been moving very much in the right direction. ARKW (Web x.0) is interesting. Margins of the companies whose shares it owns are great. Look how far we’ve come from when the web was in early days: We have profits now!

ARKW and to a lesser degree ARKG serve as examples of what ARKG (Genomics) hopes to become, a portfolio of companies that successfully grew into and above operating costs. But at present, there’s a very long way to go. In fact, negative margins, deep as they are, are trending in the wrong direction, meaning that we’re still dealing with a lot of early stage R&D. ARKK (the catch-all fund), obviously reflects the genomics contribution to its portfolio.

Table 6 shows the balance-sheet characteristics of the portfolio companies.

Table 6: Financial Strength

ARKG ARKK ARKQ ARKW SPY
Quick Ratio 6.80 4.48 2.69 2.78 1.08
Current Ratio 6.97 4.71 3.06 2.94 1.35
Total Debt 2 Equity 0.72 0.94 0.89 0.95 0.91
LT Debt 2 Equity 0.65 0.84 0.68 0.82 0.80
Interest Coverage TTM -9.31 2.73 7.88 4.27 8.64
Interest Coverage 5Y Avg -28.93 -3.48 4.99 3.73 10.21
Data from S&P Compustat via portfolio123.com and reflects Compustat standardization protocols, TTM = Trailing 12 Months, MRQ = Most Recent Quarter

ARKG (Genomics),not surprisingly, can’t cover interest expense. It has a lot of liquidity, as reflected in the strong Quick and Current ratios. But put your hands back in your own pockets!Don’t expect dividends or share buybacks. Balance sheet cash is need to pay basic operating bills, to tide the companies over until the next time they raise more capital. ARKQ and ARKW are both OK finances-wise, with ARKQ a bit better.

Returns on Capital is where margin, turnover and finances come together. 

Table 7: Return on Capital

ARKG ARKK ARKQ ARKW SPY
Ret on Asset % TTM -26.48 -14.16 2.49 1.38 5.73
Ret on Assets % 5Y Avg -17.38 -10.77 -0.16 -2.39 5.55
Ret on Equity % TTM -37.47 -6.91 11.56 10.59 16.63
Ret on Equity % 5Y Avg -17.02 3.57 12.72 9.53 15.25
Data from S&P Compustat via portfolio123.com and reflects Compustat standardization protocols, TTM = Trailing 12 Months, MRQ = Most Recent Quarter

No need to rehash ARKG. You had to expect negative numbers based on what was seen thus far. ARKQ and ARKW both look OK (although not yet fully up to snuff) in Return on Equity. But this is a number that can be boosted by aggressive use of borrowing (and Table 6 showed us that borrowing, though not exorbitant, is present). Return on Assets gives the more unvarnished story and shows that companies in the portfolios of both funds still have a long way to go, but are trending the right way.

Finally, Table 8 shows elements of flow of funds.

Table 8: Use of Funds

ARKG ARKK ARKQ ARKW SPY
% Cash Surplus 2 Sales TTM 50.17 83.24 -1.31 13.15 4.67
% Cash Surplus 2 Sales 5Y 178.72 202.37 3.67 24.93 7.13
% R&D+Capex 2 Sales 5Y 552.25 203.63 48.33 24.41 9.97
% CapEx 2 Depreciation 5Y 204.02 163.41 133.92 133.06 110.49
Data from S&P Compustat via portfolio123.com and reflects Compustat standardization protocols, TTM = Trailing 12 Months, MRQ = Most Recent Quarter

Cash surplus is Cash from Operations minus Capital Spending minus Dividends (as few as there are among these companies) plus or minus debt/equity that comes in or is retired. The big surpluses for ARKG reflects new capital raised to stay in business, The third row of the table shows where significant money goes. In all cases, we’re dealing with R&D machines but with ARKG, as we would expect for an emphasis on genomics, R&D is supercharged, big time. When Capital Spending exceeds Depreciation, it suggests, as a general rule of thumb, that companies are not just spending to maintain physical assets, but also to grow the asset base. That’s happening across the ARK universe and especially at ARKG.

Circling Back to: What to choose, what to choose . . .

Had I studied harder and earned better grades in high school science, I’d be better positioned to dig further into the businesses. But I went on to Law and Business schools and spent the last few few decades analyzing companies. So I work with what I have.

If you need to pick just one winner, ARKW (the Web x.0 ETF) is probably it. Among sky-high valuations, this portfolio is the least pricey. Operationally, its portfolio companies have delivered the most, and over the past three years, this ETF has been the best performer in the group .I’d restrain my opinion if i thought maturity for the businesses was close at hand. But I don’t think that at all.

ARKQ looks to be the sleeper of the group. Industrials sound least sexy. But space exploration and autonomous transportation, two areas of interest for the fund, are in very early days and as pricey portfolios go, ARKQ’s seems to have the least bad valuations. And operationally, it has shown itself capable of identifying companies that are able to monetize their dreams.

I’ll bet you expect me to hate ARKG, the Genomics offering. Oh those negative and deteriorating margins, and the need to continue to raise external capital; yuk, phooey. Well, I don’t hate it, not at all. This numerical profile is inherent in the nature of the businesses in which the fund invests. I want to be a part of it, But how else can I be in unless I pick stocks on my own based on, I don’t know, pretty pictures of colorful molecules on the company web sites? Seriously? Refer back to Table 2. ARK Invest has already shown its ability to pick the better companies in this area, and I’m not egotistical enough to think I can do better. 

As to ARKK, the catch-all offering, as noted above, I already have a long position. My big decision going forward is whether to add to this position, or allocate some funds to the more focused offerings. 

Ultimately, I’m a fan of what ARK is doing and wouldn’t argue with being in on any one, or combination, of these ETFs (so long as you’re willing to live with potential underperformance of down markets, as the fund group saw in the past).

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