Watch Out Below if You See This ‘Overvalued’ Ratio Combo

It’s easy to trumpet the virtues of value when high-flying tech stocks crash…

Cathie Wood’s ARK Invest family of exchange-traded funds (“ETFs”) is the perfect example. These former market-beating ETFs peaked about a year ago… Now, they’re laggards.

As my colleague Pete Carmasino noted on February 4, the flagship Ark Innovation Fund (ARKK) is down more than 50% from its February 2021 peak. The other ARK Invest ETFs have followed similar paths.

In cases like this one, it might seem easy to point the finger… We all know better than to load up on overvalued tech stocks, right?

But as with most things in life, a gray area exists… More specifically, I’m talking about the definition of “overvalued.”

After all, Wood’s flagship ETF had soared more than 675% from the start of 2015 through its peak. And the stocks she bought sure as heck didn’t fit the value-investing mold.

The stocks she held in ARKK looked expensive – and for quite some time at that.

Today, we’ll cover an indicator of doom for high-flying stocks. When this signal happens, watch out below. And it’s exactly what happened – and is still happening – with ARKK…

In short, this indicator is a combination of poor scores on a pair of valuation metrics.

The first one from the pair is the ratio of a company’s enterprise value (“EV”) to its sales. EV is a measure of the current market value of all shares of stock plus debt minus cash.

It’s especially useful for gauging companies that are losing money or have minimal profits. That’s the kind of setup we typically see throughout growth-oriented ETFs like ARKK.

ARKK peaked on February 12, 2021. That day, the median EV-to-sales ratio for domestic stocks in ARK Invest’s ETFs with accessible data was a whopping 29.1.

In other words, the EV of all the stocks in ARK Invest’s universe was nearly 30 times their sales. That’s darn high!

For perspective, the median EV-to-sales ratio in the benchmark S&P 500 Index equaled 4.1 at the time. And even the tech-heavy Invesco QQQ Trust (QQQ), which tracks the Nasdaq 100 Index, only clocked in at 7.9.

But we can’t stop there. High valuation isn’t necessarily “bearish” on its own…

For example, online-retail juggernaut Amazon (AMZN) has been described as overvalued since its start. But that hasn’t hurt its stock… It has returned nearly 160,000% since May 1997.

Any valuation ratio is OK as long as expected growth remains strong enough to support investors’ beliefs about the company. But that poses a problem…

We’re dealing with future growth. That puts us in a world of predictions, not facts.

To get around that, I look at a real-world measure that answers a simple question, “Is this company making steps toward profitability?”

For that, we look at the company’s operating margin. Improvement in this metric is a vital clue for disruptive growth stocks. It indicates progress toward the day when the company will have grown enough to benefit from “economies of scale.”

ARK Invest’s ETF holdings fail to impress in that regard…

As of February 12, 2021, the median five-year operating margin was negative 18%. For the 12 months leading up to that point, it was negative 16%. And the current median is still negative 16%.

So as you can see, ARK Invest’s ETFs fail both of the “overvalued” ratio tests…

The EVs of the companies in these ETFs are well over their current sales. And instead of becoming more profitable as they grow, these companies are losing more and more money.

That’s a big reason why our Power Gauge system still ranks ARKK as “very bearish” today.

Good investing,

Marc Gerstein

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