This article was originally written by Katherine Lynch in Morningstar's US office
ARK Innovation ETF (ARKK) has become one of the best-known growth-stock mutual funds around thanks to its outsize gains and losses, along with the bold forecasts of its manager Cathie Wood when it comes to potential growth.
Through its investments in fast-growing companies in areas like artificial intelligence and DNA sequencing, this strategy brought the exchange-traded fund (ETF) huge success in 2020, when it gained 156.6%.
But ARKK’s biggest holdings have taken a beating. Roku (ROKU) and Zoom (ZM) are down more than 30% this year to date. That’s led to losses of more than 50% over the past year and 30% this year to date.
This has led Wood to describe her fund in a recent CNBC interview as a "deep value fund." “We do believe innovation is in the bargain basement territory,” she said. “Our technology stocks are way undervalued relative to their potential...Give us five years, we’re running a deep value portfolio.”
Meanwhile, according to Morningstar’s equity analysts, many of her holdings are now deeply undervalued. So is ARKK now a value fund? Or is it still a growth fund with poor-performing investments?
Based on Morningstar’s metrics for where funds land in the Morningstar Style Box, it’s still very much a growth fund.
What Makes a Growth Fund?
Here’s how the process works. The Morningstar Style Box plots the weighted average of a fund’s holdings based on each stock’s “style score.” These stock scores are relative with companies landing in value, core, and growth Morningstar Categories. (Stocks are also separately ranked by stock market value for small, mid-cap, and large capitalisations.)
The style score is based on a metrics such as growth rates for earnings, sales, book value, and cash flow. In addition, it factors in dividend yields and relative valuations such as the price/projected earnings ratio, price/book, price/sales and price/cash flow.
Growth stocks have higher readings on earnings and sales ratios, for example, and low dividend yields. Companies that end up at the lower end of the spectrum on these metrics land in the value category, and in the middle, core. That data is then aggregated up to the portfolio level and determines where the fund lands in the Style Box. (Funds in the middle are labeled “blend” rather than “core.”)
ARKK's Strong Growth Profile
ARKK's collection of companies ranks as one of the most growth-oriented portfolios among U.S. funds. Out of 2,642 U.S. equity funds, it ranks 22nd in growth orientation. Some of the fund’s most growth-oriented holdings, on the far right of the Style Box, include Tesla (TSLA) and Shopify (SHOP).
"At the fund level, it would take a large shift for ARKK to enter value territory,” says Morningstar’s director of manager research, Russel Kinnel.
“Since we also classify funds as blend and stocks as core, there's a progression from growth to value as stocks and funds get cheaper based on the factors used in our Style Box.”
Still, ARKK's portfolio position has shifted slightly. It’s currently at the most value-oriented position it’s been in three years, but the strong growth components of most of its holdings still place it on the right of the Style Box, and ARKK still ranks as one of the most growth-oriented offerings in the fund universe.
ARKK's Undervalued Stocks
It’s a different picture when looking at ARKK’s stocks from the perspective of Morningstar’s star ratings for stocks, which are largely based on a stock’s price compared with the fair value estimates set by Morningstar’s equity analysts. These ratings are unrelated to where a stock lands in the Style Box. A “value” stock can be overvalued or undervalued.
Currently, all of ARKK’s holdings – with the exceptions of Tesla, Exact Sciences, and Block (SQ) – are trading below Morningstar’s fair value estimate. The top seven holdings all trade between 3- and 5-star levels.
Teladoc (TDOC) is the most undervalued holding by Morningstar’s metrics, trading at a 64% discount to its fair value estimate.
The fact that prices on ARKK's holdings have fallen sharply hasn't been enough to push the individual companies in its portfolio into value territory based on the Style Box for stocks.
Only one holding, Crispr Therapeutics (CRSP), has a price that has fallen so far that Morningstar now classifies it as a value stock. Although ARKK’s holdings have seen their price multiples contract significantly over the past year, they remain higher than most domestic stocks and thus mostly remain categorised in the high growth column of the Morningstar Style Box, says strategist Robby Greengold.
With Teladoc, for example, even though it is trading at only 36% of what Morningstar equity analysts assess its fair value to be, the company’s strong growth profile outweighs the impact its low price has on valuation metrics. It remains in the growth stock group.
Bargain Prices, but Not a Value Fund
Wood also takes the view that her stocks are significantly undervalued, sometimes attaching valuations well above those of many analysts. Perhaps most notably, Wood has put a $3,000 price target for Tesla (the company is currently trading at $810) and defended her valuations at Morningstar’s Investment Conference.
Wood suggests “the fund is now at a bargain price by depicting ARKK's holdings as deep-value stocks,” says Morningstar analyst Robby Greengold. He recently pushed back on Wood’s assertion that investors have punished “innovation stocks,” pointing out that that investment style doesn't explain the magnitude of ARK Innovation's losses.
