Do you have a gambling problem? Hopefully not. But what about the retail and professional investors who own shares in Cathie Wood’s ARK Innovation ETF (NYSEARCA:ARKK)?
Most traders base bets on emotions, rather than bet logically on quality businesses that appear to be undervalued. In fact, studies have found that stock market speculators share alarmingly similar traits to pathological gamblers.
So, who is the largest trafficker in overvalued risky securities? One of the largest “risk dealers” in the field of overvalued speculative growth stocks? You guessed it — ARK Investment Management.
If you’re considering investing in the ARKK exchange-traded fund or any other ARK-managed funds, here’s a breakdown of what you’re getting into.
Hint: It’s not as glamourous as you might think.
A Quick Look at Ark Investment Management
ARK has been a spectacular growth story in terms of garnering assets under management. AUM has grown to over $50 billion since its founding in 2014. It appears that its stock selection is simply made on the theory that “innovation causes disruption;” therefore, it simply buys stocks that are considered disruptive and innovative. ARK apparently does so without regard to price, value, risk, profitability or competition.
If it grows and innovates it must be good. Right?
The top 10 names in ARKK include a Murderer’s Row of high-performing stocks. You’ll see names like Spotify (NYSE:SPOT) and Teladoc Health (NYSE:TDOC). The cumulative losses on those companies would frustrate any small business owner trying to grow. And, to add salt to the wound, small businesses don’t get the luxury of billion-dollar valuations.
On the other hand, the top 10 collective valuation ratios are enough to give any real business analyst a heart attack.
Tesla Is ARKK’s Largest Holding
But nothing compares to the Tesla (NASDAQ:TSLA) story. And Tesla just so happens to be the No. 1 holding in ARKK today.
The electric vehicle firm, which sold nearly 500,000 cars in 2020, recently had a market capitalization of $713 billion. That’s almost three times larger than Toyota’s (NYSE:TM) $245 billion. Toyota, if you didn’t know, is a firm that sells over 11 million cars.
Let’s put aside the fact that Tesla’s market cap was greater than the entire auto industry for now. The current valuation for TSLA also ignores competition, particularly in China where Tesla has high hopes but has to compete against BYD (OTCMKTS:BYDDF), the market leader. Don’t forget to add Volkswagen (OTCMKTS:VWAGY), BMW (OTCMKTS:BMWYY) and many others to that list. And remember, at some point Tesla (and all EV manufacturers) will run up against the threat of the green myth, where potential buyers may increasingly scrutinize the supposed environmental benefits of these cars.
Beware the $3,000 Price Target for Tesla
Which brings us to Cathie Wood’s prediction in March 2021 that Tesla will hit $3,000 per share, or a $3 trillion market cap by 2025. ARK’s financial model for TSLA was immediately debunked by many analysts as a pie-in-the-sky number. Some solid critical analysis can be found here, here and here.
The market cap on that price target is greater than Apple (NASDAQ:AAPL) and Microsoft’s (NASDAQ:MSFT) combined market caps. But those two companies’ profits are twice as big as Tesla’s expected total revenues. How does a company achieve those goals in an enormously capital-intensive business without raising capital?
Despite its mythical status as a world savior, Tesla still needs massive infrastructure to build such large and heavy items, particularly the 10 million cars needed to justify a $3,000 price target. Tesla has already raised close to $30 billion in recent years to fund property, plant and equipment (PP&E). That’s still many billions shy of Toyota’s cumulative $216 billion (11 million cars) and Volkswagen’s $144 billion (10 million cars).
Pure financials also provide a sobering picture. Using a discounted cash flow calculation, a $3,000 price target implies annual EBITDA growth of approximately 75% over the next 10 years. That’s a feat even Tesla only achieved in three years since 2009 when they were much smaller. It obviously can’t repeat this due to the law of large numbers.
Legendary investor and hedge fund manager Doug Kass said it best when he stated on Twitter:
“How many times do you get to revise your already stupid price target up, on no new news about anything? ARK is a joke – just willy nilly make shit up, much like the sell-side. Not analysts, just a marketing machine. All the flak recently about short sellers, and people continue to get away with this garbage? Where is the financial media calling them out? NEW RULE – No price revisions. The more these stocks go down, the more these guys revise the target up.”
Tesla makes up 10.4% of ARKK, which makes this outrageous Tesla $3,000 price target look very similar to a pump and dump scheme. In fact, it’s very reminiscent of The Radio Pool incident in the 1920’s. This is one of the key reasons the SEC was created.
There is no reasonable sell-side analyst, portfolio manager or equity analyst that can create a realistic and honest reason for owning or recommending Tesla at these levels, much less promote a $3,000 price target. In my mind, it’s unforgivable for any investment professional to recommend any client or institution to buy Tesla at this time.
However, as frustrating as all of this may be, it appears the hyperbolically bullish tide may be slowly turning toward arithmetic and honesty. For example, Roth Capital analyst Craig Irwin stated on April 6 that the company is worth $150.
The Future of Ark Investment Management
When all the ARK ETFs and mutual funds fabulously collapse in the next bear market, someone should be held accountable. The damage Ark Investment Management and the types of stocks they hold and promote will do to peoples 401-k’s and private investment accounts will likely dwarf the damage done at the end of Dot.com bubble or the 2008 crash (which cost investors $8 trillion). The total value of the U.S. stock market currently is approximately $50 trillion and the average bear market drawdown is about 35%. However, excessively inflated and over-hyped growth stocks often decline more than twice that amount.
When experienced investment managers with $50 billion at their disposal invest like day traders sitting in their bedroom wearing pajamas, things generally don’t end well.
The day will come when ARK Investment Management will be mentioned in all the research studies for what went wrong in the U.S. capital markets in 2020 and 2021. I also think ARK will join the infamous names associated with investment scandals in history. It’ll also join the history books in the same chapter that discusses the South Sea Bubble, Tulipmania and the Dot.com bubble.
Words of Wisdom
One word of advice when it comes to the ARKK ETF. Everybody thinks they get out of the ARKK type stocks when things turn sour, especially with micro-second transactions and commission free trading. And yes, you can get out. But nobody asks the important question — at what price?
During the tech rout on May 11, 53 of 59 holdings in the fund declined, some substantially. As of today, the ARKK ETF is now down more than 18% year to date.
Not since the 2008 housing run-up have Americans seemed so hell-bent on gambling away their hard-earned money. It is important to look at your inner self and recognize any behavioral biases that may damage your investment portfolio.
As the saying goes, if you don’t know who you are as a person, the stock market is a very expensive place to find out.
If you feel you may have a gambling addiction, please visit the National Problem Gambling Helpline.
On the date of publication Tom Kerr did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Kerr, CFA, is an experienced investment manager and business writer who has worked in the investment and securities business since 1994.