Part 3: How does a portfolio manager invest in disruptive innovation?

Active thematic investing, based on innovation themes rather than a benchmark, seeks to capitalise on powerful opportunities for growth associated with secular shifts and long-term trends. We sat down with ARK Investment Management’s founder, CEO and CIO Catherine Wood to understand how a disruptive innovation fund manager invests in this space and where they find opportunities.

Top-down research to define the investment universe

ARK has a rigorous investment process, which includes top-down and bottom-up investment analysis as well as a proprietary scoring system.

Its investment process initially examines from the top-down how the world is changing and where it is headed. By anticipating and quantifying multi-year value-chain transformations, typically caused by technologically enabled disruptive innovation, ARK believes it can capitalise on these opportunities and provide significant outperformance to its investors.

“Innovation enables industry growth, facilitates convergence across different sectors of the economy, and drives long-term investment opportunities. Over time, innovation should displace industry incumbents, increase efficiencies, and gain majority market share,” explains Catherine.

For this reason, ARK focuses on innovations centered around five key innovation platforms: robotics/automation, energy storage, genomic sequencing, and next generation internet technologies, including deep learning, mobile connected devices, and blockchain technology, all of which are converging to change the way the world works.

An open research strategy to capture best ideas

To understand quickly changing innovation themes, ARK employs an open research strategy to gather information, both helping to define and refine its internal research process. Inputs include theme developers who are thought leaders in their fields, social media interactions, and crowd-sourced insights as people respond to ARK’s public research.

““We use this information in an iterative fashion. I work with our analysts and our Director of Research, Brett Winton, to size and re-size the opportunities. We then use the insights and analysis to anticipate and quantify multi-year value-chain transformations and market opportunities. We model the cost-curves and calculate elasticity of demand to identify entry points for tech-enabled disruption.

“We use Wright’s Law to identify and model disruptive innovation opportunities. We figure out the learning curve associated with a new technology. That learning curve is expressed in declining costs. Once we figure out the declining costs, we ask ourselves, ‘For every percentage point in price decline, how much will a demand increase?’ We need to get an idea of price elasticity of demand. Is the market ready now?” said Catherine.

Through this process, specific companies percolate to the top as best positioned to benefit from the identified investment premise, at which point we begin our bottom-up process.

Bottom-up analysis to refine the investment opportunity

ARK’s bottom-up analysis begins with a distilled group of potential investments, not a benchmark. ARK scores potential investments based on the following six key metrics, inputting the values into a proprietary scoring system to quantify the companies in the context of the opportunity:

  1. Company, people and culture
  2. Execution of objectives
  3. Moat or barriers to entry
  4. Product and service leadership
  5. Thesis risk
  6. Valuation: 5-year return (requires a 15% compound annual return hurdle rate)

The sixth metric (i.e., a 5-year return) requires building out a revenue model for each company in the portfolio over the next five years. These models incorporate the company’s unit volume growth, cost declines, market adoption and penetration, share count growth, and future multiples, arriving ultimately at a per share price five years from the current date that should be roughly double the current price.

Finally, as the CIO and Portfolio Manager, Catherine has the final accountability for the selection of investments and approval for all investment decisions.

“What you’ll find in our portfolios are companies that are investing aggressively to capitalise on massive opportunities. Visionary companies that want to be leaders on these innovation platforms,” said Catherine.

Read Part 1 in this series

For more information on the Nikko AM and ARK Invest Partnership: Nikko Asset Management and Ark Invest partner for disruptive innovation investment solutions

Parts of this document were prepared by ARK Investment Management LLC. This material is issued in Australia by Nikko AM Limited ABN 99 003 376 252, AFSL 237563 (Nikko AM Australia). Nikko AM Australia is part of the Nikko AM Group. The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. To the extent that any statement in this material constitutes general advice under Australian law, the advice is provided by Nikko AM Australia. ARK Investment Management LLC and Nikko Asset Management Co., Ltd. do not hold an AFS Licence.