Why This Review?
Foreword (2 May 2022)
I started this “review” right after its publication, late January and started working more seriously in early February. Then the war in Ukraine started and the market went haywire. After a couple of weeks in which I was totally absorbed (and distressed) by the events following the Russian invasion, I gradually resumed my work on this report. It turned out to be much more demanding than I thought and I ended up writing over 40 pages. I decided to break this review into smaller parts and post them as I finish proofreading. The review has been useful for me as it forced me to re-organise my thoughts and led me to redefine my investment strategy, not by following ARK’s proposed concept, but by adopting an approach based on what is missing in the ARK’s report. It sounds negative, but is not. While my review is critical, I attempted to be constructive by highlighting both positive and negative aspects of the report.
Meanwhile, the market changed so much in a couple of months. I believe we are living history, witnessing changes that we will take time to fully understand. There is so much to absorb, so much to do. I wish I had more time to polish my review, but I work with what I can. I am certain I made many mistakes and that is because of the large scope of this review (analysis, really), time and personal limitations. Anyway, that’s how it is.
Introduction (February 2022)
ARK’s declared focus is “disruptive innovation and developing technologies to displace older technologies or create new markets”. Because of my background in research on disruptive innovation and being an investor at the same time, I decided to take a closer look at ARK’s Big Best Ideas 2022 report.
There is a myriad of investment philosophies. None of them is “pure”, in the sense that no investment strategy is one dimensional, focused solely on one view. There is always a combination of rules and principles that define an investment strategy that change over time in response to evolving markets and advances in theoretical frameworks. Investment themes have fuzzy boundaries, overlapping to some extent. A pragmatic approach is to define investment strategies as a coherent model containing a collection of rules with only a few dominant characteristics that are clear and easy to identify.
One characteristic that could be used to inform an equity investment strategy is the adoption stage. Not often used, not at least explicitly, it is useful by creating a label that indicates where the companies find themselves on the innovation curve. If they are in the later stages of adoption, the investment strategy will seek to produce gains by investing in mature businesses that generate positive cash flows consistently, have predictable profits and pay dividends. Businesses that are in the early stages on the innovation curve may not generate positive cash flows, but they are attractive because the prospect of being profitable in the later stages of adoption of innovation support substantial growth and appreciation.
It is important to distinguish between innovation as gradual improvement of established products and disruptive innovation which creates new products from scratch and lead to the formation of new markets and industries.
The investment strategy focused on disrupting innovators is risky, but very rewarding if investors and innovators get it right.
I invest in individual companies that I find using my innovation focused research, valuation parameters and technical methodology, scanning a multitude of sources and ideas, but not ETFs. I have been aware of ARK for some time, mostly because Cathie Wood’s presence in the media, but it wasn’t until early this year that I decided to look into ARK’s ETFs and I found them intriguing. Some companies are easy to be classified as disruptors while others aren’t (for instance Deer & Company is much more a status quo loving incumbent rather than a disruptor). Why is this company there, I asked myself. The publication of ARK’s report was an opportunity for me to investigate in more detail.
In this review I attempt to respond the following questions:
- What is ARK’s fundamental philosophy used to formulate the investment ideas?
- Are the report’s recommended ideas investable (use them to define clear actionable rules for investment decisions)?
- What are the investment risks using ARK’s proposed model?
- What are the positives (that I can take with me and help refine my own investment strategy) and the negatives (ideas that I wouldn’t follow or recommend others to follow),
- Produce an overall assessment of the report.
My analysis is organised around the report structure although I am trying to group some of the related topics – with one exception, the DNA Sequencing, to which I give a very small amount of space (I will explain why). I will write an overall summary with a list of key observations and a final conclusion.
ARK: Risks of disruptive innovation
The Best Ideas of 2022 report lists the following risks related to investment in disruptive innovation: rapid pace of change, regulatory hurdles, exposure across sectors and market cap, political or legal pressure, uncertainty and unknowns and competitive landscape.
Are these risks specific to disruptive innovation?
The answer is simple: none. In fact some of them are not risks at all. For instance “rapid pace of change” is not a risk for disruptive innovation because it is supposed to actually produce that risk to the detriment of traditional businesses.
“Regulatory hurdles” is a universal cause of concern, especially in health care. This is a cliché risk item mentioned in any formal document published by a public company.
“Exposure across sectors and market cap”: how is that a risk for disruptive innovation, as opposed to any other?
The most notable missing point here is the risk of failure of adoption. This is the key risk for disruptive innovators. Following this is the lack of capital (maybe this is what the market cap risk is alluding to), but this is really is a problem for any business. However, for a disruptive business the adoption success if paramount for ensuring adequate capital. Generally speaking, if strong adoption is proven, especially in a large TAM (Total Addressable Market), the money joins the party even in difficult market conditions.
To illustrate what a difference the adoption rate makes let’s compare Rivian to Tesla as an example. Rivian has one key adopter, Amazon. When Amazon announced the decision to buy EVs from Stellantis the event had an immediate impact on Rivian’s share price because its risk profile changed substantially. Tesla on the other hand has millions of adopters who have formed tight social networks of devoted fans supporting the company. It is worth remembering how important those networks were when Tesla had distribution issues and customers volunteered to help deliver Teslas to new customers. That had a remarkable risk mitigation effect for Tesla.
ARK: Fundamental Investment Philosophy
ARK’s research team colours the best investment ideas for 2022 as an embodiment of the sweeping changes that begin occurring this year with profound impact on our society. The opening statement implies that we live in a moment in history that is undergoing a transformation unlike many others in the past, that a momentous divergence from the path of linear and slow improvement is upon us in an accelerated fashion, a divergence that is expected to generate massive equity market returns. Booming times ahead of us!
The report doesn’t explain how the research team decided which are the most transformative areas of business activity that, if investors understand them well, “will capture exponential growth opportunities, which deserve a strategic allocation in their portfolios”.
There are two conceptual themes in this report: technological platforms and technological convergence. The first concept is based on the idea of technologies enabling other technologies in an ecosystem-like environment are platforms that become dominant economic engines with high growth rate into the foreseeable future. There are five platforms comprising of fourteen technologies that interact in a synergistic way.
The idea of convergence is not clear, presumably referring to the synergy between these technologies to the effect of strengthening the five platforms.
Five Innovation Platforms
One notable energy that permeates throughout the report is an unbound optimism that fills the space between a long series of forecasting pictographs. ARK says: “We believe that historians will look back on this era as one of unprecedented technological foment—and they will say: everything changed“.
The optimism expressed mostly as a belief in a bright outlook calls for a conservative read as most of them invoke significant growth rates over long periods that are in dire need for convincing. That may work for one or two technologies, but fourteen converging technologies experiencing large growth rates simultaneously over a decade is not just goldilocks, that is dream time. In hindsight we may pick a number of technologies and use them to demonstrate that is possible to experience such growth, but in foresight it is very, very hard, especially that many and all at the same time.
ARK believes that five innovation platforms are causing a historical change: AI, Robotics, Energy Storage, DNA Sequencing and Blockchain Technology:
The fourteen technologies will grow from a market cap of $14t in 2020 to $210t in 2030:
Are these innovation platforms? Maybe we should ask first, what is an innovation platform?
I like the definition used by UK Gov Services which seems to be in line with the majority of the definitions found on the web: “An innovation platform is a space for learning and change. It is a group of individuals (who often represent organizations) with different backgrounds and interests: farmers, traders, food processors, researchers, government officials etc. The members come together to diagnose problems, identify opportunities and find ways to achieve their goals. They may design and implement activities as a platform, or coordinate activities by individual members“. (accessed 21 Feb. 22).
This throws a shade of doubt over the appropriateness of referring to these five entities as platforms. Let’s take Artificial Intelligence as an example. This is a very broad concept which describes man-made artifacts capable of making a variety of decisions based on their interpretation of the surrounding environment in an adaptable way, including the creation of new rules, mimicking the way humans learn, memorise, develop and respond to stimuli. This is not an innovation platform, but an innovation concept, a theoretical theme. A platform implies the existence of a common structure involving individuals and organisations motivated by solving solutions for problems that affect the environment in which they operate. Artificial Intelligence is none of that. This is an evolving field that is present in many industries for a variety of unrelated purposes. This is not even an homogenous field. There are so many approaches to AI it is hard to see how this could be referred to as a platform.
The 14 transformative technologies identified by ARK touch multiple platforms. Are Reusable Rockets part of the AI, Battery Technology, or Robotics platform? It is hard to see how that could be inferred for any actionable benefit. Solutions are developed through the confluence of multiple technological approaches, but no one would be tempted to see them as platforms.
There is nothing in this report to support the idea that we are amidst an unprecedented technological change. We may be in it, but ARK’s Best Ideas 2022 document doesn’t explain why, other than perhaps using the forecast of significant increase in enterprise value across these technologies over the next decade as a point of demonstration.
The Five Technological Platforms Will Increase 15 Times between 2020 and 2030 in Market Capitalisation
This is a phenomenal growth. The assumptions appear logical, playfully simple, banal, almost matter-of-factly (although there is a warning in small print, “forecasts are inherently limited and cannot be relied upon”), but sprinkled with interesting observations that deserve a closer look.
There is not much investable insight in this suite of assumptions because they are expressed in a general form and often lacking real novelty. For instance, when referring to mobile connected devices the report notes that “legacy computation manufacturers and operating system providers could be in peril, along with media, entertainment, and content production companies with business models optimized for legacy distribution platforms”.
This is stating the obvious, we know this, we read about it in the media every day. It happened a decade ago with the advent of the iPhone and Android mobile phones. Or, another example, when referring to Cloud Computing: “legacy software and hardware provides are likely to be vulnerable”.
The broad optimistic nature of this report is marked by the frequent use of “could” or “should” qualifier: “consumer habits could be modified”, “voice interfaces should take share of e-commerce”, “concentrated computational infrastructure could allow every device to harness the power of supercomputers”.
These assertions are not impossible, but they are general, vague, lacking insight and supporting arguments and thus difficult to use for building specific investment hypothesises.
Probably the vaguest technology platform in this report is the Battery Technology. Linking this technology to “micro-mobility, and aerial systems, including flying taxis” is akin to linking oil refineries to aviation as an innovation platform. The advance in battery technology is driven by demand, but the innovation in new industries happens because of their own circumstances. One could argue there is an inverse relationship: new industries stimulate innovation in battery technology to make them cheaper, lighter, and with higher density of energy.
One of the most enthusiastic of the five platforms is Robotics. The style in which the report makes the claim that it could generate over $10t in equity capitalisation by 2030 may be seen as exaggerated optimism usually found in colourful real estate marketing pamphlets promoting new development plans: “collaborative robots powered by artificial intelligence could flourish in increasingly dynamic environments, transforming the economy”, “given the economics of rocket reuse, both low earth orbit constellations and hypersonic point-to-point travel could become feasible, transforming military asset delivery, shrinking the world’s supply chains, and enabling economical broadband connectivity anywhere on Earth ”
I will not get too much into DNA Sequencing because my limited knowledge and because this is a domain in which is inherently hard to pick winners. However, I have to say that I couldn’t find any solid inspiration, something that I could use as an investment idea. That increased computing power and application of computers in DNA Sequencing leads to improved performance is well known, but this fact is not sufficient to inform an investment strategy; you need more details, you need to identify a theme, a proven applied scientific trend. Moreover, the language has a vague eloquence. For instance the report anticipates that genome sequencing “ should be deployed widely, spurring volume increases by three orders of magnitude. Pan-cancer blood tests are likely to scale and commercialize, therapeutic treatments should become more precise and efficacious, and highly effective measures against inherited complex disorders should become prophylactic. Importantly, gene sequencing advances could extend into agriculture and materials science”. This is worthy of an official policy statement promoting a government healthcare initiative.
The idea that DNA Sequencing as a platform on which Gene Editing technologies can flourish is difficult to justify. CRISPR as a platform in the field of gene editing would be far more appropriate. The terminology is also mixed up. At the beginning the proposed platform is called DNA Sequencing, while later the report uses the term Genomic Technologies.