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The bottom may be further than you think

John Rekenthaler  |  25 May 2022Text size  Decrease  Increase  |  
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Ask people when Charlemagne became emperor, while wondering aloud if the event occurred before A.D. 1200, and the reactions will be as follows. Those without a clue will respond with dates near 1200, while those who realize that Charlemagne was coronated before that time, but who do not remember when, will shave their estimates. Roughly, their median reply will be 1000.

Conduct the same exercise while mentioning A.D. 400 as the possible moment, and the responses will change. The uninformed will once more defer to the cue, thereby cutting their estimates by eight centuries. Meanwhile, those who vaguely know the answer will again alter the original suggestion, but this time by raising their estimates. Their median reply will be the year of the Lord 600, give or take.

Charlemagne's actual coronation took place in A.D. 800 (Not that I need remind you of that.) The educated parties overshoot the mark in the first exercise and undershoot it in the second. They err because they reason through anchoring and adjusting--concepts popularised by behavioural economists such as Richard Thaler. That is, they begin with a benchmark, then make an adjustment. But such modifications are usually insufficient. The anchor proves too heavy.

For example

The reaction by both investors and observers to ARK Innovation's (ARKK) performance has provided a textbook case of anchoring and adjusting. Most have used the fund's high-water mark as their reference point. That is typically how people view investments—how far has it declined from its peak value? From that perspective, a large loss implies an upcoming rally. But such thinking comes from anchoring and adjusting, and may therefore be flawed.

On Feb. 12, 2021, ARK Innovation reached its high-water mark. The previous year had been breathtaking, with the fund notching a 156% total return. It looked to be on its way to repeating the feat in 2021, appreciating by another 26% during the year's first six weeks. However, ARK Innovation suddenly headed south, dropping 25% in three weeks.

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So far, so expected. Such things happen with risky securities; and manager Cathie Wood

never maintained that ARK Innovation was anything but volatile. Nor did the fund's prospectus. Its discussion of "Principal Risks" occupies seven pages. One would blanch if a 2025 target-date fund were to abruptly shed one fourth of its assets. Not so for ARK Innovation.

A value fund?

After treading water, albeit vigorously, for the next eight months, the fund nosedived again. By 20 December 2021, it had fallen an additional 19%. The decline prompted Wood to proclaim that the fund's stocks had become so cheap that they were in "deep-value territory." After all, ARK Innovation was down almost 40% from its February peak. Its holdings had thus become bargains.

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That would indeed have been the result if the stock market had anchored and adjusted. But equity prices do not necessarily act that way. They may for blue-chip firms. A company that earns steady profits is unlikely to lose more than half its stock market value, even when threatened by severe recession and/or steep inflation. However, businesses that sell mainly on promises, as with those in ARK Innovation's portfolio, trade differently. It is difficult to see their floors.

Rinse, repeat

Following Wood's pronouncement, ARK Innovation promptly dropped again, by another 25%.

(Click to enlarge)

If ARK Innovation had previously been oversold, then surely that slide signaled a fire sale. On Jan. 26, 2022, the day after the above chart ends, The Motley Fool reported that Wood had been "bargain-hunting" by "doubling down in her conviction." A few days earlier, an article from InvestorPlace contended that ARK Innovation would rebound. It argued by anchoring and adjusting: Stocks "don't go down forever—and Cathie Wood's stocks have fallen too far, too fast."

That may be, but by mid-March, ARK Innovation had shed an additional 25%. (In case you have lost track, that makes for three 25% declines, plus a 19% decrease.)

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Another loss, another opportunity. On March 14—the very day that the above chart concludes—Reuters reported that, when questioned by an angry client who had "millions invested with her fund," she responded that the fund had become more attractive because of its lower valuation. When the conversation ended, the customer not only remained in the fund, but he committed additional monies.

Perhaps his faith will be rewarded. Since the date of that client's purchase, though, ARK Innovation has dropped another 19%.

(Click to enlarge)

The worst case

Clearly, anchoring and adjusting has not adequately explained ARK Innovation's performance. To better understand the fund, investors must cease looking at the trees and instead view the forest. Forget what ARK Innovation was once worth, then adjusting one's assessment accordingly. That information is immaterial. What matters is how far such a fund might fall, if worse truly comes to worst.

That, of course, cannot be stated with certainty, both because history does not repeat precisely, and because ARK Innovation is so unusual. Few funds are as hazardous. However, during the new millennium, one fund was even more daring: Jacob Internet. It, too, invested in unproven fare—but those businesses were smaller than those held by ARK Innovation, even less profitable, and confined to a single industry. Wherever ARK Innovation's floor resides, it likely rests above that of Jacob Internet.

That is the good news for ARK Innovation's shareholders. The bad news is how Jacob Internet behaved after it was similarly pummeled. From March through November 2000, Jacob Internet lost 72.6%—the amount of ARK Innovation’s current cumulative decline. According to the precept of anchoring and adjusting, Jacob Internet had become a bargain. If you liked the fund at $1.00, surely you will love it at $0.27.

If anybody did, their adoration was misplaced. This is how Jacob Internet performed over the ensuing 10 months, following its initial 72.6% decline:

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In conclusion

As stated, I do not believe that ARK Innovation is as risky as Jacob Internet was. Thus, I would be surprised if it were to suffer an additional 80%-plus loss, as Jacob Internet did after it was already deeply depressed. But I certainly would not be astonished by a further 40% decline.

This, mind you, is not a prediction: For all I know, ARK Innovation's recovery starts today. It is instead an attempt at setting a realistic possibility for the limits of the fund's performance. Because so far, the efforts have not been successful.

 

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

is vice president of research for Morningstar.

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