The recent surge in Cathie Wood's Ark Innovation ETF (ARKK 0.95%) likely brings relief to its investors. The exchange-traded fund (ETF) benefited from a massive surge during the pandemic. Unfortunately, the 2022 bear market reversed all of those gains, and the increases in the fund have mostly been modest since that time.
Moreover, despite the increase of over 70% from its April lows, the fund is more than 55% off its all-time high in early 2021. Hence, the current price may leave investors wondering whether the Ark Innovation ETF has become overheated or if it is just beginning its journey back to record highs.
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Understanding Ark Innovation's gains
The key to Ark Innovation's gains is its stock, particularly its top 10 holdings. All reported significant gains over the 3.5-month period, so much so that the worst performer in this group, Tesla, gained 48% during that time.
Additionally, three of those holdings, Robinhood Markets, Roblox, and the fund's top holding, Coinbase Global, more than doubled in value over that time.
Still, the largest contributor to the gains was likely Circle Internet Group, which did not begin trading until June 5. Ark Invest made a pre-IPO investment in the stock, placing just over 3 million of its shares in the Ark Innovation ETF. From an IPO price of $31 per share, it surged to nearly $300 per share before pulling back.
Although Ark Invest has begun to sell some of its shares, it now holds about 1.9 million shares in the Ark Innovation ETF. Despite the reduced position size, it remains the fund's fifth-largest holding.
Where those gains leave the Ark Innovation ETF
Indeed, the dependence on Circle Internet Group could set the Ark Innovation ETF for a fall. Since peaking on June 23, Circle Internet has already lost nearly one-fourth of its value.
Furthermore, Circle's valuation metrics appear lofty. The company's price-to-sales (P/S) ratio now stands at 41, a level where even the most risk-tolerant growth investors may shy away. Also, even though free cash flow is at a level where it will grow substantially, its increases are unlikely to justify the current price-to-free cash flow ratio of approximately 675.
Also, Palantir's P/E ratio of over 600 may raise concerns. Still, at 4.4% of the fund, the ETF is less exposed than with Tesla. Tesla, Ark Innovation's second-largest holding at nearly 10%, has long maintained a premium valuation, and the P/E ratio of around 180 is up from 60 last fall.
If Tesla's robotaxi launch does not succeed, it could drop and pressure the Ark Innovation ETF. However, a successful autonomous driving platform could spark massive gains in the stock, according to Ark Invest's research in that company, making Tesla a wildcard among Ark Innovation's holdings.
Additionally, viewing the P/S ratio of the ETF's top holdings may offer some relief. Of the top 10 holdings, only three have sales multiples above 20, which means valuations may not prompt investors to sell. Also, considering that its third-largest holding, Roku, sells at less than 3 times sales, the gains on most of its holdings are well positioned to continue.
Is the Ark Innovation ETF overheated?
Considering the holdings of the Ark Innovation ETF, the fund's rising stock price is probably not overheated.
Admittedly, the valuation metrics of Circle Internet and Palantir point to overvaluation. This could put parts of the fund at risk if these companies show any signs of negative news. Also, Tesla is arguably the major unknown in this fund, as the success or failure of this position likely hinges on its robotaxi.
Nonetheless, seven of the 10 top holdings sell at a P/S ratio of less than 20, a level that is not unusual for the growth tech stocks that Cathie Wood and her team typically target. Assuming these stocks continue on a growth path, it could keep the Ark Innovation ETF's stock price steady, or possibly enable it to continue its rally.
