HACK: Interesting And Well-Built, But Rangebound For Now (NYSEARCA:HACK)

By Rob Isbitts

Cyberattacks are expected to grow an estimated $10.5 trillion in damages annually by 2025. This creates a massive opportunity for the companies HACK ETF invests in. That said, the excitement around innovation in this industry has created stretched valuation levels in these stocks. Current stock market volatility may speed up the transition of these companies from a new growth industry into more of a long-term value story. International diversification of this ETF adds a positive element, given the potential topping of the US Dollar. In this, our initial report on HACK, we assign a Hold rating.

Strategy

ETFMG Prime Cyber Security ETF (NYSEARCA:HACK) aims to track the Prime Cyber Defense Index. That index tracks the performance of the securities of companies around the globe that provide cyber defense or services as a significant component of their overall business, and provide hardware or software for cyber defense.

ETF Grades

• Offense/Defense: Offense

• Segment: New Growth

• Sub-Segment: Cybersecurity

Technical Ratings

• Short-Term (next 3 months): C

• Long-Term (next 12 months): C

Rating scale: A = Excellent, B = Good, C = Fair, D = Weak, F = Poor

For a detailed description of MII’s proprietary technical rating system, see disclosures at bottom of this report.

Holding Analysis

HACK currently holds 62 companies. Companies in the US and Canada dominate this portfolio, with 88% of assets. Half of the other 12% of this ETF is invested in United Kingdom-based companies.

The 10 largest stock positions are all roughly 4-5% of assets, and account for nearly half the total portfolio (46%). That means that investors in HACK get a good idea of what they own. Those 10 stocks have 5 times more influence over the direction of HACK’s price than the other 50 or so positions. Taking it a step further, 25 stocks make up 90% of HACK. As is the case with many of the ETFs we like to follow, this essentially means that the other 37 stocks don’t really matter too much. This is a 25-stock portfolio, with some appendages that complete the tracking of the index, but that’s about all.

The turnover rate is 51%, which means that the index has historically replaced about half of its portfolio in an average year.

Strengths

From a structural standpoint, we like the ability to see through to what an ETF owns, and think of it more like a stock with inherent diversification, as the risk is spread across many individual businesses. As with many industries and sectors, the industry leaders’ stock prices tend to move together, but the “blowup risk” of a major loss from a single stock is greatly diminished. HACK rates well on that concentration scale, as it is really more of a 25-stock portfolio that happens to own 60 or so, in line with the benchmark index is aims to track.

HACK has plenty of industry-related investment positives as well. Growing concerns and damages from cyberattacks puts this ETF squarely in a spot where investors will almost have to consider it, or its peers. The ever-increasing demand for and awareness of cybersecurity makes the role of the companies HACK holds a critical part of the future of global commerce.

Weaknesses

The increasing importance of the role of cybersecurity companies does not always translate to intermediate-term stock prices of the companies that HACK owns. This ETF already has a 43% drawdown on its record, so it is unlikely to escape a broader bear market climate for very long. Furthermore, the stock market tends to group such “new growth” industries (our term to collectively analyze industries that did not exist a generation ago). So, a “risk-off” period in the stock market often puts HACK and its peers in the hot seat with investors.

Opportunities

Cyberattacks are expected to grow an estimated $10.5 trillion in damages annually by 2025. That presents a massive opportunity for the companies in HACK to service the undeniable necessity for cybersecurity for international companies and governments.

As an example of how cyberattacks can wreak havoc on businesses, communities, and people, and thus have investment relevance, the Colonial Pipeline ransomware attack in May of 2021 caused a huge increase in gas prices. That event ultimately forced the company to immediately pay a $4.4 million ransom the next day (in Bitcoin, not US dollars).

More recently, in September 2022, Uber (UBER) and video game company Rockstar were infested with malware and had login information sold on the dark web. These attacks are further evidence that cybersecurity will become a critical battleground for geopolitical competition in the coming years. Governments may want to partner with these companies to access their expertise in the area. In addition, consumers are more concerned about online privacy, and will pay to secure the digital environment they work in. This all plays into the hands of the cybersecurity industry, and in turn, HACK.

Threats

Many new companies are being created in this industry, utilizing new technology. And, iconic, established tech players have entered the cybersecurity business. While technological innovation creates consumer and investor excitement, we are concerned that this is already reflected in HACK’s price. This ETF’s trailing Price to Book, Price to Sales and Price to Cash Flow to levels are currently 30-35% higher than the S&P 500.

2022 was a rough year for high-beta, high-expectation, high valuation stocks. If that continues to be a feature of the current investment cycle, HACK could suffer from a revision in valuation, which could lead to additional price declines. HACK’s price has been rangebound like much of the stock market itself. Except for a brief surge higher last August, this ETF has traded in a range of $41-48 for most of the past 9 months. That’s a wide range indeed, but a range, nonetheless. That limits upside potential until that range breaks decisively to the upside.

Conclusions

ETF Quality Opinion

HACK easily makes our list of ETFs we intend to track, for the many and diverse reasons above. Society is clearly becoming more dependent on technology, so a fund that targets this niche area is one we wish to know about and track going forward.

ETF Investment Opinion

HACK receives a Hold rating from us in this, our first report on it. If the volatility in cybersecurity stocks subsides, if the price finally breaks to new high ground with staying power, or if HACK crashes (pardon the cybersecurity pun there), that could prompt us to more seriously consider a positive rating for this very likeable ETF.

Modern Income Investor’s proprietary technical rating system was created by the firm’s founder, Rob Isbitts, a chartist for more than 40 years. The ratings emphasize risk-management, and the belief that while any investment can appreciate in price at any time, each investment carries a different level of potential for major loss. The balance of reward and risk is calculated each night for thousands of securities, using a formula that analyzes price trend, strength of that trend and key price levels. It analyzes data over multiple time frames to produce a short-term rating (looking 3 months out) and a long-term rating (looking 12 months out).