Innovation Stocks Are Not in A Bubble: We Believe They Are in Deep Value Territory
Throughout my career, during times when disruptive innovation strategies have fallen out of favor, my primary concern has revolved around our clients. Perhaps influenced by negative headlines in the media and by the inherent volatility of our strategy, some clients have sold near the bottoms of market cycles, turning what otherwise would have been temporary losses into permanent losses.
For that reason, ARK places significant focus on our five-year investment time horizon, communicating constantly with our clients via blogs, newsletters, media interviews, webinars, and other videos like our monthly “In the Know” series. Our primary message is that innovation solves problems and is expected to transform human lives at an accelerated rate during the next five to ten years. We also reiterate that we take advantage of volatility during corrections and concentrate our portfolios toward our highest conviction stocks. The result of engaging with our clients has been asset retention better than many observers might have anticipated. Year-to-date, our inflows have outweighed our outflows significantly, suggesting that on balance, investors understand our active management investment process and long-term investment time horizon.
Historically and according to our research, this concentration of our portfolios during corrections has led to significant absolute performance and relative outperformance as the market rebounds. According to our current estimates, only one other time in ARK’s history, at the end of 2018, has our research suggested such an optimistic growth potential over the next five-years.
After correcting for nearly 11 months, innovation stocks seem to have entered deep value territory, their valuations a fraction of peak levels. Many skeptics attributed our outsized returns last year to “stay at home” stocks and expected their fundamentals to deteriorate this year. For example, since its peak on October 19, 2020, Zoom’s stock price has dropped roughly 68% to a level not seen since June 1, 2020, as shown below. Yet, since its fiscal quarter ended July 2020, Zoom’s revenue and EBITDA have increased 58% and 53%, respectively. Last quarter, on a year-over-year basis, against a 367% gain during the depths of the coronavirus crisis, Zoom’s revenue increased 35% and its EBITDA, 52%. In our view, the coronavirus crisis initiated a “rip and replace” cycle in the $1.5 trillion enterprise communications space, the first major product replacement cycle since the emergence of the internet roughly 30 years ago. We do not believe this shift was “temporary.” Stimulated by “stay at home,” this transformation has shifted to “stay connected” in a hybrid work world and “stay competitive.”
|Zoom (ZM)||DocuSign (DOCU)||Teladoc (TDOC)|
|Peak to Trough Percentage Price Decline||-68%||-56%||-70%|
|Previous Month at That Stock Price||6/2020||6/2020||1/2020|
|Annualized Revenue During that Quarter (billions)||$2.7||$1.4||$0.7|
|Annualized Revenue During Q3’21 (billions)||$4.2||$2.2||$2.1|
|Latest Quarterly Revenue Growth Rate YOY||35.2%||42.4%||80.6%|
|Annualized EBITDA During That Quarter (millions)||$807.6||$-100.4||$-24.4|
|Annualized EBITDA in Q3’21 (millions)||$1238.6||$67.2||$-17.3|
|Weight in Nasdaq (QQQ)||0.29%||0.19%||0.00%|
|Weight in S&P 500||0.00%||0.00%||0.00%|
In this blog, we would like to share with you ARK’s thought process during this important time in the equity market. We welcome your questions, comments, and constructive feedback.
In the meantime, and as always, we wish you wonderful times with your family and friends at this blessed time of the year.
HAS INFLATION DERAILED DISRUPTIVE INNOVATION?
Since mid-February 2021, many broad-based market indexes have scaled to record highs and, in the process, rotated away from growth stocks toward “value” and defensive stocks, including the FAANGs. Chief among the reasons for this rotation are fears that inflation is not a short-term problem related to supply chain bottlenecks, but the result of excessive monetary and fiscal policy responses to the coronavirus and its variants. Associated with strong economic cycles, inflation tends to benefit “value stocks,” particularly energy, financial services, industrials, and materials. At the same time, by raising discount rates and lowering the present value of future cash flows, higher interest rates tend to hurt long duration assets like aggressive growth stocks. Typically, the companies underlying those stocks are sacrificing short term profitability and investing aggressively to capitalize on substantial growth opportunities. In November 2021, Federal Reserve Chairman Jerome Powell suggested that inflation might not be “transitory” after all, turbocharging the rotation toward value stocks and giving investors more reason for tax loss selling in the innovation space as the year winds down.
ARE QUANT STRATEGIES AND ALGORITHMS EXACERBATING INFLATION FEARS?
As was the case during the depths of the coronavirus last year, quant and algorithm-based strategies seemed to dominate stock market activity during the first three months of the rotation earlier this year and then again recently. By some estimates, algorithmic trading accounts for roughly 70% of all trading in the US, and even higher percentages during periods of heightened volatility. Last year, as the equity market responded to the ugly reality of the coronavirus during March and April, quant and algorithmically driven strategies seemed to seize simplistically on two variables – level of cash on company balance sheets and rate of cash burn – and, in just a few weeks, they crushed many stocks by 50-75%. Momentum followers and market commentators embraced this “obvious” trade, but they were wrong. Many of those stocks were in the genomic space, their underlying technologies critical to tackling the coronavirus: genomic sequencing, synthetic biology, mRNA technology, machine learning, and molecular diagnostic testing, among others. Against conventional wisdom, buying those stocks was the right move.
At times this year, as inflation and interest rates flared, quants and algorithms again seemed to dominate trading activity. This time, they seemed to seize on one variable: high valuations based on the short-term earnings of stocks that benefited during the coronavirus. Instead, they favored low multiple sectors like energy and financial services, two groups that we believe will be disrupted dramatically and respectively by autonomous electric transportation and digital wallets/decentralized finance (DeFi). Once again, market commentators – investors, strategists, high frequency traders, and others – followed the influencers, warning against mistakes made during the tech and telecom bubble.
In our view, these Pavlovian responses will prove just as wrong as those in the early days of the coronavirus crisis. They are backward-looking and do not recognize that companies investing aggressively today are sacrificing short term profitability for an important reason: to capitalize on an innovation age the likes of which the world has never witnessed. This new age is thanks to the five major innovation platforms evolving today: DNA sequencing, robotics, energy storage, artificial intelligence, and blockchain technology. Unlike companies paralyzed by short-term oriented shareholders demanding their profits and dividends “now,” truly innovative companies are on the offense.
Investment paralysis, or benchmark sensitivity, seems rooted in the muscle memory developed during the tech and telecom bust and then again during the global financial crisis in 2008-09. Yet, if our research is correct, companies myopically focused on short term profitability have not invested enough to capitalize on the explosive growth opportunities associated with the five innovation platforms that have been germinating since their seeds were planted in the 20 years that ended in the tech and telecom bubble. Instead, many are likely to suffer from “creative destruction.” Even the FAANGS could be in harm’s way as the convergence of blockchain technology and artificial intelligence in the so-called “metaverse” attempts to destroy the roles of centralized data aggregators, ceding economic power to creators and consumers.
OTHER MARKETS ARE NOT CORROBORATING FEARS OF INFLATION
Perhaps oddly, we have been encouraged this year by talk of a “bubble” in the public equity markets as valuations associated with disruptive innovation have collapsed. Why?…because other markets are not corroborating the fear that inflation is here to stay. Broad-based public market indexes, for example, are near record highs, their valuations at levels not seen since the tech and telecom bubble. In the early eighties, as inflation ravaged the US economy, the trailing twelve-month price-earnings (PE) ratio of the S&P 500 collapsed to a low of 6.8x, roughly a quarter of the level in place today. Which market has it wrong: stocks associated with disruptive innovation or broad-based public equity indexes? Likewise, private equity market valuations are near record highs thanks to successive up-rounds. The latest example, Nubank, started this year with a funding round at a $25 billion valuation and went public this month 60% higher at more than $40 billion. Meanwhile, shares of Mercadolibre, a well-managed, competitive e-commerce and fintech stock growing at nearly the same rate, have been cut in half. Finally, the bond market seems to be warning the Fed not to tighten. Since February, the yield curve as measured by the difference between the yields on the 10-year Treasury bond and the 2-year Treasury note has flattened from 159 basis points to 80 basis points, pointing to the rising probability of recession, lower inflation, or both during the next year.
In our view, the wall of worry built on the back of high multiple stocks bodes well for equities in the innovation space. The strongest bull markets do climb a wall of worry, a fact that those making comparisons to the tech and telecom bubble seem to forget. No wall of worry existed or tested the equity market in 1999. This time around, the wall of worry has scaled to enormous heights.
COULD THE RISK BE DEFLATION?
I started my career while in college in the late seventies when inflation was soaring. At the time, most economists believed that inflation was transitory, except for Drs. Doom and Death – Henry Kaufman of Salomon Brothers and Al Wojnilower of First Boston – and Milton Friedman. Having witnessed that bifurcation, I am sensitized to the possibility that I could be wrong on inflation. That said, my conviction is growing that the bigger surprise to the markets will be price deflation – both cyclical and secular – and that, after collapsing this year, higher multiple stocks could turn around dramatically during the next year.
The secular case for “good” deflation is powerful. According to our research, which is centered around Wright’s Law, five innovation platforms will introduce deflationary forces that will build over time and impact every sector, industry, and company globally. According to Wright’s Law, our research shows that costs associated with every cumulative doubling in the number of whole human genomes sequenced with long read technologies will drop 28% and those associated with short-reads, 40%. Meanwhile, every cumulative doubling in the number of industrial robots and batteries produced will drive costs down 50% and 28%, respectively. Moreover, artificial intelligence training costs are declining at a rate of 60% per year. Provocatively, these platforms are converging, creating the potential for more dramatic cost declines as S-curves feed and reinforce one another. According to our current research, for example, the convergence between and among robotics, energy storage, and artificial intelligence will create autonomous taxis and significant growth potential: by 2030, autonomous taxi networks could scale from no revenue today to $9-10 trillion globally, which, when combined with the productivity uplift from time freed up from behind the wheel, could total more than $20 trillion. For perspective, US GDP today is roughly $21 trillion. In other words, “good” deflation could result in outsized growth rates for those companies positioned on the right side of change.
Subject to much more debate is the cyclical case for deflation. Supply chain bottlenecks that have lasted much longer than most of us expected have turbocharged the debate, especially now that the University of Michigan Consumer Sentiment Index has dropped to a level below that in the depths of the coronavirus crisis. As stimulus payments bloated the saving rate to 33% in the spring of 2020, consumer spending on goods – which accounts for roughly one third of total consumption in the US – soared, overwhelming businesses that had shut down. Prior to the coronavirus, businesses already were in a “risk-off” mode not only because of trade tensions between the US and China, but also because of an inversion of the yield curve in the late summer of 2019. As businesses were shutting down in early 2020, some consumers turned around and used government stimulus payments to “hoard” goods, boosting the level of “inventories” in their homes and garages. Exacerbating some supply chain issues, consumers started holiday shopping early this year out of fear that shelves would be empty, pushing the CPI inflation rate to 6.8% in November 2021. At the same time, the US consumer saving rate dropped below 8%, the range in place before the coronavirus crisis, leaving less room for future consumption and hoarding.
As a result, consumption growth is likely to slow significantly during the next three to six months, just as supply chain bottlenecks are clearing, potentially saddling businesses with excess inventories. If we are correct, during the next three to six months, the market is likely to focus more on the risk of recession in the US, the serious slowdown in the Chinese and emerging market economies, and potentially a surprising drop in inflation. Some commodity prices already are flashing red: iron prices have dropped 36%, perhaps in response to the real estate turmoil in China, while the Baltic Freight Dry Index has declined 39%, DRAM prices 27%, and US lumber prices 35%. Even the oil price, a notable outlier until recently, has declined by 15%. Typically, during a slowdown, the adoption of new technologies accelerates as concerned businesses and consumers are more willing to change behavior. Many of the technology leaders to which they turn now seem to be in deep value territory.
INNOVATION STOCKS ARE NOT IN A BUBBLE: WE BELIEVE THEY ARE IN DEEP VALUE TERRITORY
During the late nineties, equity investors ignored value stocks in favor of growth stocks, particularly those in the tech, telecom, and biotech spaces. The internet and its network effects seemed miraculous, enough so that investors chased the dream: volatility on the upside was a beautiful thing. Unfortunately, too much capital chased too few opportunities – the technologies were prohibitively expensive and not ready for prime time. The cost to sequence the first whole human genome at that time, for example, was $2.7+ billion. Tech and telecom companies like Cisco, Oracle, Hewlett-Packard, Intel, and WorldCom were not the companies that later would create the cloud, software-as-a-service, or artificial intelligence chips. Yet, their stocks hit exorbitant valuations. Again, investors were chasing the dream – often with eyeballs as the only valuation metric. Value managers believed that valuing companies by the number of potential eyeballs they might serve globally in 10 years would not end well, and they were right. The day of reckoning took longer than expected, but on March 10, 2000, the bubble burst and value stocks took off.
Ravaged by the tech and telecom bust in 2000-03 and then again by the financial meltdown in 2008-09, investors – especially institutional investors – are much more risk averse today. Volatility has become a bad word because every spike in the Volatility Index (VIX) since 2000 has been associated with a bear market. Instead of surfacing and researching exciting investment opportunities in the burgeoning innovation space, investors seem to be hugging their benchmarks and looking to the past for future success. Benchmarks guide investors to companies that already have enjoyed considerable success.
BROAD-BASED EQUITY BENCHMARKS COULD BE IN HARM’S WAY BECAUSE OF DISRUPTIVE INNOVATION
Because the global economy is undergoing the largest technological transformation in history, most benchmarks could be in harm’s way. Unlike many innovation-related stocks, equity benchmarks are selling at record high prices and near record high valuations, 26x for the S&P 500 and 127x for the Nasdaq on a trailing twelve-month basis. Yet, the five major innovation platforms which involve 14 technologies are likely to transform the existing world order that the benchmarks represent. As a result, we believe “tried and true” investment strategies will disappoint during the next five to ten years as DNA sequencing, robotics, energy storage, artificial intelligence, and blockchain technology scale and converge.
With a five-year investment time horizon, our forecasts for these platforms suggest that our strategies today could deliver a 30-40% compound annual rate of return during the next five years. In other words, if our research is correct – and I believe that our research on innovation is the best in the financial world – then our strategies will triple to quintuple in value over the next five years. Yet, as this year winds to a close, investors seem to be more interested in “playing it safe” and moving closer to benchmarks that, in our view, are unlikely to generate even average returns during the next ten years. Much like the early years of ARK’s research on and investing in electric vehicles (TSLA) and bitcoin, disruptive innovation seems to be in deep value territory. Based on the last eight years of our research, the opportunities will scale from $10-12 trillion today, or roughly 10% of the global public equity market cap, to $200+ trillion during the next ten years.
We will not let benchmarks and tracking errors hold our strategies hostage to the existing world order. The coronavirus crisis permanently changed the way the world works, catapulting consumers and businesses into the digital age much faster and deeper than otherwise would have been the case. Dismissing innovation strategies as “stay at home” glosses over a crucial point: innovation solves problems in a way that consumers and businesses adopt with relief, enthusiasm, and delight. Critical to investment success will be moving to the right side of change, avoiding industries and companies caught in the crosshairs of “creative destruction” and embracing those on the leading edge of “disruptive innovation.”