ARKW: Waning Momentum In High-Growth Internet Stocks Highlights Risks (NYSEARCA:ARKW)


The ARK Next Generation Internet ETF (NYSEARCA:ARKW) invests in companies benefiting from trends in cloud computing along with mobile products and services. The fund is a good example of the recent growth in the ETF industry towards actively managed funds with a niche or theme-based strategy. Indeed, ARKW has been one of the best-performing ETFs over the past year benefiting from its concentrated portfolio and strong gains among key holdings that have been resilient despite the economic disruptions of the COVID-19 pandemic. That being said, some recent volatility through the recent Q2 earnings season among key holdings in the fund highlights ongoing risks as it relates to valuation in the context of the current macro environment. While we like ARKW for its ability to capture tactical exposure to high-growth momentum names, we take a more cautious view at the current level and recommend waiting for a deeper pullback before initiating a new position.

(Source: Finviz.com)

Background

The ARK Next Generation Internet ETF with currently $2 billion in assets under management changed its name in November of 2019 from “ARK Web x.0 ETF”. This was simply a marketing decision while maintaining the strategy and investment focus, but making it easier for investors to understand the concept. The “next-generation internet” theme has a broad meaning and can include stocks from various industries and sectors. According to ARK:

Companies within the ARK Next Generation Internet ETF* are focused on and expected to benefit from 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. These companies may develop, produce or enable:

– Cloud Computing & Cyber Security

– E-Commerce

– Big Data & Artificial Intelligence (AI)

– Mobile Technology and Internet of Things

– Social Platforms

– Blockchain & P2P

One of our criticisms of theme-based ETFs is that often the investment idea is too vague. A case can be made that every “technology” sector company is involved either directly or indirectly with one of the above categories. In this regard, it’s worth remembering that ARKW is actively managed and the fund has a wide discretion to select the holdings with buy and sell decisions not tied to any particular index.

(Source: ARK)

Taking a look at the constituents of the ARKW ETF, there are currently 48 equity holdings with a tilt towards mid-cap companies compared to a more diversified tech index like the NASDAQ 100 (QQQ). At the sector level, there is some grey area in terms of classification.

Tesla (TSLA), the largest holding in the fund with a 9% weighting, is technically a consumer discretionary auto manufacturer. Its inclusion in the fund is based more on its cutting-edge autonomous driving technology and efforts at mobile connected vehicles. A general theme of the fund is high-growth stocks with several representatives from application software companies. Holdings from Amazon.com (AMZN), DocuSign Inc. (DOCU), and Twitter, Inc. (TWTR) highlight the wide range of companies within the fund.

Performance

ARKW has had an impressive performance history up 400% since its inception date in September of 2014. Given the tech-heavy focus, a natural comparison in the NASDAQ 100 has returned a more moderate 174% gain over the period. ARKW is one of the best-performing equity ETFs over the last five years.

ChartData by YCharts

ARKW portfolio has regularly changed over the period so it’s incorrect to attribute the outperformance over the entire period based on current holdings. Nevertheless, we can observe some themes in its current momentum which help explain ARKW’s 79% return year to date in 2020.

Recognizing that Tesla represents 9% of the fund and around 10% over the past year, we can conclude that the stock’s 246% gain year to date has contributed nearly 25% to ARKW’s return this year. Within the top 10 holdings, Square (SQ) up 135% and Zillow Group (Z) up 79% this year are also big winners and have contributed to the fund’s large gains.

ChartData by YCharts

The story this year since the emergence of the COVID-19 pandemic has been a dynamic where tech companies maintained a relatively resilient operating environment benefiting from trends like consumers staying in and working from home. In essence, the developments this year represented the perfect environment for “internet” based companies that ARKW has exposure to. Tesla for its part was able to deliver better-than-expected Q1 and Q2 results supporting a more positive, long-term growth outlook with an expectation the company can continue to capture the automobile market share boosting the momentum in shares.

Analysis and Forward-Looking Commentary

Considering the strong gains this year, one of the trends we’re observing is renewed volatility this past week among some of the highflyers. ARKW fell by as much as 4% on Friday, August 7th, amid a broader selloff in tech.

(Source: Seeking Alpha)

One of the catalysts that pressured the fund was the Q2 earnings report from data analytics software-as-a-service company Alteryx (AYX) which beat expectations but included weak guidance by management. Compared to the prior market consensus for full-year revenues of $505 million, the company is now guiding for a range between $460 million and $465m. The lower growth outlook was enough to drive a 30% selloff in the stock price. The impact had repercussions across sentiment in the broader software applications industry, as many of the key high-growth stocks as constituents of the ARKW ETF traded lower. The question it raises is if growth estimates across the entire industry are too aggressive going out many years.

(Source: Finviz.com)

The chart below highlights some significant laggards this past week among the top 25 holdings of the ARKW ETF. With Alteryx now down 34% from its recent highs, other poor performers include Teladoc Health (TDOC) down 23% and 2U, Inc. (TWOU) down 16% from its highs over the past five days. While the weakness was widespread, company-specific factors also pressured the stocks this week.

ChartData by YCharts

Even as the ARKW ETF has had a banner year, it’s a good time to question how much of the positive operating environment and growth opportunities for these stocks are already priced in. The current weakness among key holdings of the fund highlights the ongoing risk of investing in momentum and high-growth tech names which are susceptible to wide swings and excess volatility.

Alteryx serves as a warning for what can happen when growth underperforms to stocks already trading with potentially stretched valuation. The chart below tracks the price to sales multiple for selected constituents of the ARKW ETF. These stocks, in particular, are all trading with a P/S multiple above 10x which represents an otherwise objectively aggressive growth premium.

ChartData by YCharts

The setup here is that despite strong stock market performance in 2020, significant uncertainty remains regarding the strength of the economic recovery. It’s possible that if the macro outlook and global growth underperform expectations going forward, sales and earnings estimates need to be reset lower across the market. Technology stocks are not immune to a structural cyclical downturn and we see the risks tilted to the downside from the current level.

Takeaway

What we like about the ARKW ETF is that it offers investors an easy way to gain exposure to high-growth tech stocks. The active management of the fund should be able to screen out companies with potential underlying fundamental weaknesses adding to the quality of the holdings. The performance of the fund speaks for itself and is a testament not only to favorable market conditions but also effective stock selection.

Our message today is that the risk profile of ARKW with shares near $100 is different compared to when the fund was trading under $50 back in March and April. Regardless of how bullish investors may be on any particular stock in the fund, we believe it’s likely any gains going forward will be smaller compared to the returns in the first half of the year. At this stage in the cycle and potentially extreme bullishness among internet stocks, ARKW may be due for a correction and we’d like to see shares pullback before taking a more bullish view. We recommend investors reduce risk and take a more defensive approach to the market.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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