introduction

It’s been a wild ride since the launch of the ARK Innovation ETF (NYSEARCA:ARKK). Led by Cathie Wood, the ARK Innovation ETF comprises 28 growth stocks in the disruptive innovation industry that are crowding out older technologies or create new markets. The ETF covers several sectors such as:

• Artificial intelligence
• energy storage robotics
• DNA sequencing
• Blockchain Technology

Its returns have been tremendous from its inception in 2014 to its peak in 2021. Now it has completely lost its return, a period of almost 10 years with no return. This was mainly due to high inflation and risky growth stocks in ARK’s holdings. These growth stocks thrive in low-interest-rate environments because cash can be borrowed at almost no cost.

Now that the Fed has had to raise interest rates to curb high inflation, these growth stocks have fallen in value.

Growth stocks are companies that have fast-growing revenue and are typically small. They are not yet profitable or have a positive free cash flow. A rise in interest rates can pose a problem for these companies because their interest expense will increase significantly (because they typically have a lot of debt). Additionally, investors are slowing down their investment activity in these companies during a high-yield environment. Therefore, growth stocks are considered risky.

The ARK Innovation ETF has several growth stocks in its portfolio, but only 3 of them are of interest to me. Companies with characteristics that interest me grow revenue, earnings, and free cash flow. They must also trade at a favorable valuation.

In my article, I address 3 companies that exhibit these favorable characteristics.

#1 Tesla

The first is Tesla (TSLA), many know Tesla for its advanced electric vehicles with strong performance and cool features like autopilot, karaoke, bioweapon defense mode, touch screen, streaming and video games, web browser, easter eggs, air suspension, sentry mode, supercharger and a cool mini- Tesla key.

Tesla is allocated 7% in the ARK Innovation ETF. This puts Tesla in an important position to push the ETF’s price higher.

The stock price is under pressure right now, which is a nice buying opportunity as I wrote in my Tesla article earlier this month. In this article I wrote about Tesla’s competitive advantages:

1. Tesla has the best energy storage systems on the market.
2. Fast growing company in an expanding market.
3. The stock’s valuation is in the favorable range.

In 2022, Tesla saw sales increase 51% year over year. Tesla operates in an expanding market as the EV market is expected to grow at a CAGR of 17%.

Electric vehicle manufacturing is more streamlined than internal combustion engine vehicles. As a result, Tesla is able to generate one of the highest free cash flow margins in the entire mass-market automotive sector.

At the moment Tesla seems to be a bit expensive. But with a 2025 P/E ratio and fast-growing earnings, I think the stock’s valuation is attractive. On a positive note, Moody’s upgraded its credit rating to a Baa3 rating. Quoting from a news article on Seeking Alpha:

Tesla will remain one of the leading manufacturers of battery electric vehicles with an expanding global footprint and very high profitability.

#2 Shopify

The second promising stock is Shopify (SHOP). Shopify ranks #7 in the ARK Innovation ETF with an allocation of 4.8%. Shopify also ranks high in the ETF, which contributes greatly to returns. Shopify offers an e-commerce platform that is used by many online stores today. The company is popular as it has a 28% market share. Shopify is also easy to use, making it an ideal choice for starting a business.

In October 2022, I wrote an article about Shopify, describing how I was overly cautious about buying the stock over concerns that Fed policy would affect consumer behavior. I described how the stock was cheaply valued, with a price-to-sales ratio at its lowest level in years. As a result, I have given the stock a hold rating. It was a wrong pick, as the stock has since appreciated by 65%.

There are several things I like about Shopify. The first is their customer retention and the ease of use of the platform compared to Woocommerce, Magento and other ecommerce platforms. Second, I like that the e-commerce market is expected to grow strongly at a CAGR of 14%.

However, some analysts have a mixed outlook for Shopify, as 17 analysts have revised their earnings estimates up and 15 down. They expect revenue to grow 18% this year and earnings per share to break even. My expectation in October 2022 was that consumer confidence would fall during the Fed’s rate hikes, but Shopify continues to grow strongly.

Valuation remains at cheap levels, as illustrated in the chart below. Therefore, it is worth buying the stock for the long term.

#3 Roblox

The third and final interesting pick is Roblox (RBLX). Roblox is a popular gaming platform where users can create their own games and also play games made by other users. Users can customize their own avatar that can communicate and chat with other users in a virtual world. Roblox and its games are free to use, and users can make in-game purchases using Roblox’s virtual currency called Robux.

Roblox is extremely popular and grew strongly during the Corona crisis, when many users had to sit at home due to Corona measures. Roblox has several competitive advantages over other game developers.

The first competitive advantage is that Roblox is not a game developer but a platform for users to create and play games. Many games rise and fall in popularity, and since Roblox users develop their own games, the Roblox platform is less sensitive to the varying popularity of the games. As a result, Roblox’s earnings will be more stable than, say, Tencent’s (OTCPK:TCEHY).

The second benefit is their social media feature. This feature allows users to chat and interact with each other, making users more likely to stay on the platform. The third benefit is that Roblox is accessible to many consoles such as desktop, mobile, and many gaming consoles.

The final competitive advantage is that it offers multiple concerts on the platform featuring many well-known artists such as Mariah Carey, Elton John, Lauv, George Ezra, Charli XCX, Tate McRae, Lizzo, Boris Brejcha, 24kGoldn, David Guetta, Twenty-one pilots and many more. These artists are popular with the youth.

Roblox’s competitive advantages are a great way to keep users loyal to their platform. That stickiness is evident in their sales growth as well. While its revenue grew just 16% in 2022, many analysts expect it to grow 55% this year. The increased popularity and competitive advantages will benefit Roblox for further growth.

So what about the stock valuation? To get an insight into the stock’s valuation, let’s look at its enterprise value to sales ratio, as it incorporates cash and debt into the valuation equation. The EV to sales ratio is currently 10.9, close to its all-time low. The next question is what is a favorable EV to sales ratio. To answer this question, I’ll look at other companies in the gaming industry that have gross margins roughly on par with Roblox.

I found Electronic Arts (EA) to be a good comparison because it has gross margins that are almost the same as Roblox. The ratio of EV to sales is only 4.3. However, EA is not growing as fast as Roblox. Roblox’s earnings are expected to grow 50% this year, while EA’s earnings are expected to remain flat. At this price level, Roblox’s projected EV to revenue ratio is around 7, making it an interesting stock. Because of its competitive advantages and cheap forward valuation, Roblox is worth buying.

Diploma

While I’m not interested in growth stocks due to their risky characteristics and volatile behavior, I still find 3 stocks in the ARK Innovation ETF interesting. These 3 companies are household names in the sectors in which they operate and the recent price correction presents an interesting opportunity to buy the shares cheaply. They also have competitive advantages over others, grow quickly in an expanding market, and trade at cheap valuations. They’re also (or were) cash flow positive, making the stocks less risky (in my opinion). So I think they are good bargains.

I’m also interested in your thoughts, please leave your thoughts in the comments section below.