ARK Innovation ETF: Why I Buy The Most Hated ETF (NYSEARCA:ARKK)

ARK Innovation ETF (NYSEARCA:ARKK) has become one of the most notorious investments of the 21st century. That’s largely because investors see funds as synonymous with the rise (and burst) of the tech bubble.vocal fund manager Cathy At times, Wood seems to ignore valuations in favor of focusing on the long-term outlook. This investment strategy has worked well during the pandemic, but has been brutally punished over the past year. Due to the decline, ETFs are now very affordable.

ARKK ETF Price

Since ARKK is an ETF, it needs to diversify, but diversification could not prevent its crash.

The last time we covered ARKK was in December, and since then it has crashed another 60%. At the time, I rated it as a long term purchase. However, the malicious crashes of the past year make ARKK look like an attractive option even in the near future timeline.

ARKK ETF Outlook

For some, ARKK’s short-term prospects may depend on interest rates. Last week, the ETF surged after his CPI for October reached 7.7%, below his forecast of 7.9%.

Some may be skeptical that a 0.2% surprise justifies such a rise, and I have my doubts. However, in my view, interest rates are not necessarily the key factor. There is an idea that tech stocks have crashed because interest rates have risen. This is partly true because many tech stocks have previously traded at bubble valuations and tight monetary policy has proven to be very effective in dealing with bubbles. But valuations have arguably swung too far in the opposite direction. Consider that Alphabet (GOOG) (GOOGL) is currently trading at 20x earnings (before considering net cash and includes losses from Google Cloud and other betting), but Pepsi ( PEP) trades at 26x earnings. You’d be hard-pressed to find many investors who believe PEP has a stronger long-term outlook than GOOGL. All things being equal, GOOGL should trade at significantly higher multiples than PEP.

It’s an obvious fact that tech stocks crashed while interest rates were rising, but the correlation isn’t necessarily absolute as sentiment seems to be at play too. Tech stocks outperform other sectors. There is no inherent reason why it is highly correlated with interest rates. If anything, technology stocks are undeniably more resistant to inflation due to their higher gross margins and stronger growth. Growth rates for many tech stocks have slowed to “only” 15% to 20%, but are still growing significantly faster than other sectors. I expect mega-cap tech stocks like GOOGL to do well, and unprofitable tech stocks could also do well as a result. Rising interest rates could lead to growth pressure in the short term, but I think most current valuations already reflect that.

ARKK ETF Top Holdings

Kathy Wood famously said that her investment strategy during periods of extreme volatility is to focus on “high-conviction names.” Below are the top holdings of ARKK.

ARKK is not a technology-only fund, as Wood seeks innovative growth in various sectors. Technology definitely carries a strong weight, as evidenced by his 9.63% allocation for Zoom (ZM).

Are ARKK ETFs Buy, Sell or Hold?

Determining an ETF’s outlook can be difficult due to the variety of positions available, but an analysis of the underlying holdings can be used to try to determine this. Growth stocks are attractive due to their high annual growth rates, but the multiple expansion potential really makes ARKK attractive here.

ZM is now trading at 6x sales and continues to generate GAAP earnings. I think ZM can ultimately sustain a net profit of at least 35% over the long term. ZM expects to maintain above-average growth over the years as it continues to digitize meetings. Assuming a return to just 15% growth and a price-to-earnings multiple (“PEG ratio”) of 1.5x, the fair value is approximately 8x sales, implying a potential uplift of over 30%.

Roku (ROKU) trades at just six times the gross profit despite owning a smart TV ‘walled garden’ platform. The shift to video streaming will continue, and over time he expects growth to return to the 15%-20% range. Assuming a 40% net profit (based on gross profit) and a 1.5x PEG ratio, the fair value is approximately 9 times gross profit, implying a potential uplift of 50%.

Block (SQ) has been hit hard by the post-pandemic slowdown in fintech growth and exposure to the crashing cryptocurrency market. Still, the stock only trades at eight times his gross margin, and the company produces positive non-GAAP margins. We can see that SQ recovers to at least a 15% growth rate and maintains a 50% net profit based on gross profit over the long term. Applying a 1.5x PEG ratio, it could trade at a gross margin of 11.3x, corresponding to a potential uplift of over 40%. This same type of analysis yields the same results for many of the fund’s holdings. ARKK has risen nearly 25% in just a few days, but there are fundamental reasons to believe there is still room for this rise.

What are the risks? I don’t think valuation is the main risk at this point. Instead, it’s unclear how Kathy Wood will manage the portfolio from here, so it could definitely be actively managed. In particular, I’m not sure her decision to overweight stocks like ZM and Tesla (TSLA) makes the most sense here. She likely did so because these offered stability compared to the higher risk names in the portfolio. We don’t think it offers nearly as much of an advantage as the more beaten up names within. Kathy Wood runs the risk that she will position her portfolio in a way that will not benefit her even if the technology recovery does occur. Another risk arises from the lack of profitability in many of the fund’s holdings. Much of our valuation analysis assumes a long-term profitability profile, but there is no guarantee that it will happen. If growth doesn’t pick up for years, continued operating losses and shareholder dilution will leave you owning these risky stocks even at these valuations. You must be confident in your holdings. I wouldn’t personally build a growth portfolio in exactly the same way as Kathy Wood, but ARKK is undervalued enough to justify a purchase at these levels.