6 min read

The problem with investing in Disruptive Innovation (ARK Invest)

Disruptive technologies have great potential to change the world. Investing in them, however, isn't straightforward.
The problem with investing in Disruptive Innovation (ARK Invest)

Watch the video on Youtube, or read the script below.

Intro

If you clicked on the video, there's a good chance that you already know what ARK is. ARK and its visionary founder, Cathie Wood, aim to invest in disruptive innovation. Their home page, ark-invest.com, mentions disruptive 16 times and innovation 60 times! The industry has taken note! Ark grew by 649% in 2020, measured by the net inflows of capital into their firm. Investors obviously love their offering, though this could be due to their recent performance.

My take on ARK is a bit different. I love their theme. As a technologist, I love their focus on artificial intelligence, robotics, genomics, and fintech. I believe we're moving into that future and that the future will be better than the past. But as an investor, I'm wary of investing in innovation when capital is bountiful and recent performance has been incredible. To be clear, I'm not one to shy away from risk. I believe you need to embrace risk if you want to get rewarded. But, I think there's a better way to invest in innovation.

Uncertainty

The way innovation spreads is interesting. First, no one cares, then a few people care, followed by late adopters. However, when it comes to money, most people only care to invest when they see others investing. Take Tesla, for example. Why does everyone suddenly want to buy Tesla shares at $800 a share in 2021 when they dismissed the stock at $63 a share just three years ago? Elon Musk has been saying what he plans to do since then, so why now?

Uncertainty is one of the main reasons why disruptive companies command higher multiples. For example, Apple cannot command the same multiples as Tesla because the space Apple is innovating in is widely known and adopted. Iphones, Macbooks, Services? These technologies are essential, but they won't change how the economy works because they already have. On the other hand, if self-driving gets adopted, society must rethink everything from transportation to real estate.

Why buy a shack in a city like San Francisco for a million dollars when you can live in a ten-bedroom on a farm and commute safely and effortlessly to work while sleeping? Why own a depreciating asset like a non-self-driving car when your car can make you money on its own? My point is that genuinely disruptive technology moves society to the next level. Electricity was disruptive, so were the railway, the computer, and the internet. The blockchain is disruptive. These technologies help us leverage what we can achieve as a species. Thanks to electricity, we got the computer. And then, we got the internet. And because of all three, I'm able to transfer information from my brain to yours without ever meeting you.

I know Apple is also working on self-driving cars, but they are stuck in the current economy. Investors expect them to spend most of their resources on technologies that have already been adopted. On the other hand, Tesla can spend all their money working on projects that may seem out of reach. Apple's changes could very well be innovative. But at most, it'll be a step function that continues to work within our current paradigm. Tesla's, however, could change everything forever.

People investing in disruptive technologies are betting on three things, each with its own set of risks:

  • first, that the company can actually create the technology
  • that the technology will be widely adopted by the public
  • and third, that its adoption will disrupt the current economy by helping us be more productivity

There are so many unknowns, which explains why these stocks are so volatile compared to the rest of the market.

Hype (We can't help but buy high)

If you dismissed Tesla in 2019, but are praising it in 2020 or 2021, I'd like to know why. I have a few guesses, but comment yours down below.

Studies have shown that we are pleased with what we have until our neighbors show up with something better. It's one of the reasons market cycles occur. We typically over-invest when market conditions are excellent and under-invest during the best opportunities. Investors are usually hesitant to invest in disruptive technologies until other investors start making money. It leads to many investors wanting to get in on the fun around the same time regardless of price.

This pattern has repeated itself throughout history.

[Railway Mania, 1840] Railways changed the world, but not before investors got greedy by throwing money at railway projects regardless of price.

[Dot Com Bubble, 2001] And, more recently, the internet changed the world. But not before investors got too greedy by throwing money at "companies" that were innovating by coming up with catchy domain names to buy.

Buying regardless of price only works as long as there's still a lot of uncertainty surrounding the technology. Tesla shares could trade at $500 or $10000 tomorrow, and we still wouldn't know exactly how to value the company because its technology hasn't been widely adopted yet. EV penetration is still very low, and Self Driving is virtually nonexistent as far as most consumers are concerned.

Bulls vs. Bears. Tesla In Simple Terms
Regardless of where you stand, you should understand what a Tesla stock is (especially if you’re new) and how it fits into your portfolio.

In a blog post I sent out in early January, I discussed how uncertainty is a good thing for Tesla's stock. If investors can't put the company in a box, its shares can indeed go to infinity. But if everyone knows what Tesla is and what Tesla can do, then the market can draw an accurate box around it.

Cathie Wood knows this [Clip 8:55]. Early on, she realized that analysts have been trying to fit Tesla into some of the old boxes that fit into our current paradigm. The adoption of EVs, self-driving, and all the other disruptive technology that Tesla is working on will remove some of the uncertainty Tesla Investors have to deal with. How the stock will react is still unknown, but less uncertainty is mostly a good sign in the public markets. But the box will let us know if it is overvalued or undervalued. At that point, the only important figure is the price that you, the investor, paid for your shares. Oddly enough, a bet on large-scale adoption could very well be a bet that shares will fall.

Disruptive Technologies vs Disruptive Returns

Investors can often make more money betting on old, ignored boring companies while the new exciting companies get bid up in price. Researchers showed that holding the companies in the original S&P 500, the original 500 stocks, and their descendants that made up the index in 1957 would have outperformed the updated index with lower risk.

They found that declining sectors like energy outperformed expanding ones like information technology for several reasons. They pointed to the internet bubble and the temporary overvaluation when the index announces that it will add a company. It happened very recently with Tesla, whose shares skyrocketed after the S&P 500 announcement. ETFs and indexers that track the S&P 500 must buy the stock regardless of price when this announcement is made.

It's difficult to judge ARK's performance with interest rates being so low. Most of the companies in ARK's portfolios are growth companies that directly benefit from the lower discount rate created by the interest rate environment. I'm interested in how ARK will perform when interest rates start rising...if they ever will.

I think investors should be buying investments with high expected future returns. Most of the companies in ARK's portfolio have had substantial unexpected returns. This means that their expected returns going forward are relatively low. The price you pay for a stock is often more important than the underlying company's potential. An investor that buys a mediocre business at reasonable prices can get higher returns compared to someone that chases the hottest stock at high prices. I just don't think I'm getting a good deal with ARK.