Heart of ARK-ness
Est. Reading Time: 7-9 Minutes
As of late, the investment waters have been a bit difficult to navigate. The tide certainly went out, and a few companies such as Carvana and FTX were found to be swimming naked, but whether the tide is now reversing, pausing or about to continue is the key question.
While the 2021 level of exuberance has yet to be reached, the sentiment in the first quarter of 2023 seems to rhyme and some familiar characters are reappearing giving a sense that the worst might be over.
But at New West Capital, we’re not so sure and it seems an apt time to remember no amount of perceived certainty can replace due diligence.
“For a time I would feel I belonged still to a world of straightforward facts; but the feeling would not last long. Something would turn up to scare it away.”
- Joseph Conrad, Heart of Darkness
Why Cathie Wood’s ARK is Still Not Seaworthy
In Q1 of 2021, following the stellar run of the ARK Funds on the heels of COVID demand surges, I produced an analysis for some colleagues that were planning to jump on the bandwagon. As they put it, you could try and fight the progress of disruptive technology, but only for so long.
The “inevitability” of the companies in which the ARK Funds invested, something the CEO Cathie Wood would often opine on, was a tempting siren song for many. So much so, that when I suggested the boat might be closer to the Titanic than Noah’s Ark, the report was promptly ignored.
This is not unique to ARK. The word inevitability has been shorthand for “due diligence not required” probably for as long as humans have had to make decisions about forgoing current for future consumption.
As it pertains to the ARK Funds, here is a snippet of that report from 2021:
As of last Friday (2/19/2021), the breakdown of Ark's funds are as follows:
The true value of these metrics will be slightly different as many of the ADR positions had insufficient accounting, but these gaps represented less than 2% of the overall holdings so interpolating these gaps given their weight still gets us to a useable overview of their holdings.
The overall trend is one of paying VERY high prices for assumed growth in the future. The risk of which was touched on prior. But the ETFs are actively managed, so let's say even if they are only half correct in their selections the funds will be fine right? If that were the case, we would abandon this here. But when taking a deeper dive into the individual holdings a new structural risk emerges.
Above is a snapshot of an analysis of their holdings relative to the available float. As a note, this was based on their updated holdings on 2/19/2021, so this will fluctuate slightly day to day, and it has moved from low 30% to high 40% at times in the last three months. The float data was pulled from multiple sources and where there was a discrepancy the highest number of shares was used for conservatism.
So, about a third of the holdings are concentrated in companies where if you were to exit the position in a downturn you would exacerbate the problem. It would seem the asymmetry of outcomes favors the downside.
The takeaway here is that even if we wanted to ignore the sky-high prices being paid for the so-called inevitability, there was a structural flaw in the ETF itself. Something that should’ve disqualified it regardless of the investment thesis. But structural issues are of no concern once we have convinced ourselves that the destination is preordained.
Recently, the flagship ETF for the ARK Fund (Ticker symbol: ARKK), has surged roughly 35%-40% in a month. Alongside of it several “meme” stocks have also exploded. So, has anything changed over on the ARK?
Below is the same analysis as of their reported positions on 2/13/2023.
It would seem the systematic risk has not changed much from two years ago. This also contains roughly fifty fewer positions across all ETFs despite the addition of the Space Exploration ETF absent in the first analysis. So, while the percent of holdings above 8% of the float is roughly the same, it is done with even fewer positions potentially increasing the systematic risk.
For those wondering, at 5% and 10% of float the percent of holdings above these thresholds are 50% and 20% respectively.
Despite the recent +35% rise in a month, it’s worth noting that its currently in line with its COVID lows of 2020. Don’t miss the forest while focusing on the trees.
(Almost) Always Bet Against Inevitability, or At Least Don’t Go Along With It.
It’s easy to pick on ARK after the precipitous drop, which is why I’ve waited to rerun the exposure analysis until after a newsworthy run. But ARK is far from alone on this topic of inevitable outcomes failing to live up to expectations.
A contemporary example might also be Tesla (Ticker symbol: TSLA). Before eliciting any of the aggressive retorts from the Tesla Fanboys, I’ll begin with a few truths.
The electric induction motor is a superior technology to the internal combustion engine. Full stop. With a mechanical engineering degree, I can speak to this in depth and cannot refute it. I have also designed and implemented +700 induction motor pump systems into industrial applications in the past. They’re better.
Incumbent car manufactures are VERY slow to change providing several years of growth for an early entrant before being seriously challenged.
Beyond the technology, the social and political pressures around fossil fuels will drive us to electric vehicle adoption. (This says nothing about the electrical generation)
These facts, at the macro level, create a very bullish case for the inevitability of the electric vehicle. There are, however, some bearish truths that seem to have been considered only recently.
The car manufacturing business is extremely capital intensive and is a durable consumer good (i.e. bad during inflationary periods).
Healthy operating margins, once established / discovered, invites lots of competition.