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Authored by Bill Blain via MorningPorridge.com,

“If you want great things to happen think big. Focus on the future. Double-down on innovation.”

Cathie Wood of ARK is in the headlines for an ill-judged investment commentary. Could ARK be headed for the wall as its disruptive investment strategy of buying illiquid companies that sacrifice profits to be part of the “innovation age” crashes? Watch this space…

For my second Morning Porridge Christmas special I’m going to look at Cathie Wood’s infamous post from Friday last week: Innovation Stocks Are Not in A Bubble: We Believe They Are In Deep Value Territory. If you are looking for likely investment trainwrecks in 2022, then I’ve got ARK high on my list.

As a result of almost universal criticism of her recent note, Wood has made something of a climbdown… surreptitiously editing the post after initially telling investors to expect 40% annual returns for the next 5 years. Now it just suggests the “optimistic growth potential” – an investment metric I’m unfamiliar with – is high for the next 5 years, whatever that means.

When people get desperate they do desperate things. Wood’s post might be the stupidest investment letter ever written – it may prove a career defining “Ratner” moment, (named after a particularly arrogant UK jewellery CEO said his customers were stupid to buy his crap). Or it might have been a well intentioned, but ill-considered, piece of marketing puff designed to shore up the increasingly wobbly ARK thesis by demonstrating the founder’s confidence.

Whatever, it has backfired badly in terms of negative market comment. The note has made us think about what ARK really is.. Pull back the glossy covers and ARK is not so exciting after all.

The ARK Innovation ETF has not had a good 2021. It’s down 37% this year from its high point in Feb. In 2020 the disruptive innovation ARKK ETF was the market’s darling – soaring 150% on the back of its massive Tesla position and investments including some on the fringes of outright crypto speculation.

Wood’s market commentary published on Friday was quite extraordinary before she edited it. Like any good fairground barker selling finest snake-oil she started by puffing up her fund’s mission statement (transforming human lives during the next 5-10 years), her expertise and faith in disruption, her focus on conviction stocks and how they are taking advantage of volatility. Despite her losses this year, she bragged about how investor inflows have outweighed outflows because “investors understand our active management process and long-term investment time horizon”.

What?

The above statement, lifted verbatim from the note, is one of the most mendacious things I’ve ever read from a fund manager.

She knows fine-well investors – especially the funds she launched as ETFs to make it easy for ill-informed retail to invest – buy on the expectations of performance! They bought ARK in the expectation Wood would continue to generate the 37% annual returns she’s made since the ETF’s inception. Wood’s funds made dramatic gains for a small number of early investors since launch, and particularly 2020’s stratospheric 150% performance on the back of buying large stakes in small unprofitable firms (I’ll say more about her “portfolio concentration” strategy below), underpinned by the success of the large Tesla position. As funds get larger they typically struggle to maintain their heady start-up returns.

People bought the ARK ETFs because they don’t read the small print that says past performance is no guide to the future. Instead, they think Wood must be very, very clever and onto something, therefore she will continue to post above average returns.

Doh!

I wonder how many of her investors have heard of Neil Woodford? He was the UK’s investment expert in buying small illiquid unprofitable stocks. He bought because he knew they would rise to become world leaders because he was smart enough to see that when the rest of the investment community missed their brilliance and lustre. And how did that work out?

If Wood’s investors understood her “active management process” – they’d be running for the door because the world has changed. The cycle has moved on. Wood’s investment strategy has not.

What her “market commentary” made clear last week is that she is right, we are wrong, and she will continue to place her “portfolio concentration” bets accordingly.

When she doesn’t deliver returns, unhappy investors will walk. More to the point, as ARK deflates it will potentially pull the whole disruptive investment thesis down with it. What Wood does not acknowledge anywhere in the note is her disruptive growth strategy is under massive pressure from the market. Despite tumbles across disruptive tech, she sticks with her mantra – “portfolio concentration” on disruptive stocks will succeed because these firms are “sacrificing profitability to capitalise on an innovation age”.

(In her missive she actually takes a pop at investors who are investing in the immediate fundamentals of Covid and growth rather than sticking with her long-term vision of enormous wealth to be made from financing losses now.)

Woods makes some pretty obvious observations about some of the stocks she owns – correctly spotting that Zoom’s stock price has declined even though its revenues and EBITDA have risen. She calls it the rip and replace cycle in the $1.5 trillion “enterprise communications space” trigged by home working.

What she doesn’t so clearly iterate is Zoom faces massive competition for more diverse players in its unprofitable space, and despite home video conferences going from zero hours to 20 hours for most home workers each week, Zoom only doubled its revenues..!! Zoom and many other names on her account are hardly batting the leather of the ball. And that’s the point. A new company that has successfully innovated a whole new business sector but can’t monetise it is… not worth much. When I arrange a video call with clients I ask “shall we Zoom”, but we do the call on Teams.

The whole basis of Wood’s “portfolio concentration” (an expression she uses a lot) has been to invest in just about every single tech IPO of small companies that don’t post any meaningful profits, but she expects will dominate the world. That’s not analysis – that’s a speculative bet. Yes, we all agree that DNA sequencing, Robotics, Capacitance, AI and even.. maybe.. blockchain are potentially fascinating areas for investment – but many of the opportunities will remain speculative. For every 10 of the companies that emerge – only one might succeed.

The FT did a great piece on ARK a couple of weeks ago: Ark’s Cathie Wood: “Queen of the Bull market” faces her toughest test. It contains a great graphic showing that every single position on the ARKK ETF is down from its’ peak level in 2021 – most of them in bear market territory. Half have slumped more than 50% this year. Tesla comprises 9% of the fund and without its 28% upside this year (although it’s down 23% since November), the fund would be deep underwater.

In her note Wood blames quant and algorithm strategies for the value switch from her disruptive non-profit making tech into fundamentals. I remain somewhat confused when she says energy stocks will be disrupted by autonomous electrical transportation – what does she think is going to power her self-driving Tesla if it eventually happens in 20 years time?

I guess Wood is going all-in on disruption when she says the market; “myopically focusing on short term profits” is a mistake when blockchain, AI and the Metaverse will “destroy the roles of centralised date aggregators, ceding economic power to creators and consumers.” I think I understand what she means, but disagree it’s going to happen. That’s because predicting the future is notoriously difficult. Things don’t happen in the predicable, rationale, logical ways Wood’s investment narrative is based on. The world is an unpredictable place. For a start, there are bureaucrats and regulators armed to the teeth with spanners to fling in the works… just saying…

Tesla took 10 years to start making meaningful profits and establish itself as a real company. Without Elon Musk’s extraordinariness it never would have happened. Think about that a moment – the whole of ARK’s proposition is basically that the 44 firms its currently invested in are going to repeat the Tesla valuation story. No. They will not.

There are many points in Wood’s commentary that are very interesting – like asking if the real risk if deflation rather than inflation – but she only raised the point to back her own investment thesis on the basis deflation favours innovation… apparently.

And then we get into the “Jack’s Nappies” phase of the argument. A Jack’s Nappy is any opinion presented as irrefutable proof:

  • Wood says autonomous taxi networks could scale from zero revenue today to $9-10 trillion by 2030. Yep. I suppose they might. But they probably won’t because I can already call a cab today.

  • She believes her funds will deliver 30-40% per annum returns for the next 5 years on the back of the technologies her fund has identified as likely to change the world. One of these is blockchain… (I have found a use for it.. have you?)

  • She believes ARK’s research is the best in the financial world, and she understands the valuations on Bitcoin and Tesla – while the rest of us are dummies. I agree with one part of that.

Let me finish by telling you a story from my early days in the market.

Our bank trader was really, really negative on a certain Italian bank (who wasn’t?). He didn’t want to own any of its’ bonds, and if he did he would immediately turn the position by selling them on. He told his junior trader to stay away from them. That morning one of my clients asked me to give him a price for 5 million of the bank’s bonds. The junior trader told me: “look, I don’t like these bonds, I don’t like the name, and I think they are overpriced, but I will make your client 100.00/100.50 for them.”

Dutifully I relayed the cost and a bleak outlook on the bonds to the client, who sadly decided he’d hold. But after lunch, and after nothing has changed in the market, the client again asked me to bid. I went to head trader who smiled.. “That’s fantastic, I love these bonds, this bank is seriously undervalued, I really, really want these bonds… bid him 99.00, and I really want these bonds”. I excitedly got on the phone relieved at the trader’s positivity, while the delighted client thanked me for such a great bid and I owned them.

See what he did there?

The trader laughed, told me to grow up and immediately dumped them at 100.00 onto the street. He then explained just how much he hated the bonds. But he knew I was a silly young bond salesman, and if he made me excited, I’d excite my client. Sure enough it worked. The trader made $50k on the trade and everyone was happy.  

He was brilliant.

Cathie Wood? She has been pulling the same confidence bluff for years. But is she as good as my trader?

Our eyes have been opened.

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