The Captain's ARK


Back in 1934 when Benjamin Graham's and David Dodd's Security Analysis was first published stocks were considered speculation and Security Analysis depended heavily on the study of bonds which is a much simpler subject matter. Bonds have fewer imponderables than stocks, mostly the question if the firm is solid enough to pay the interest and return the capital as promised. If the answer is yes, then the investment can be calculated with paper and pencil, slide-rule, or calculator. Stocks are much more complicated. In time newer methods have evolved to calculate the value or, more accurately, to estimate the potential of stocks and Cathie Wood is probably at the apex of this development.

In going from bonds to stocks the quite simple calculation of "Yield to Maturity" was replaced by value investing which is an effort to determine the future by looking at the past as recorded in the company's financial statements. It worked well enough with traditional industry that developed at a more stately pace and more often than not was grounded in large capital investments. Progress rendered these methods obsolete. The greatest disruptor was Being Digital the title of a book by Nicholas Negroponte, founder of MIT's Media Lab. The digital disruption was centered in Silicon Valley and it should not come as a surprise that it was a Silicon Valley marketing guru who published one of the first books outlining a new way of determining the value of stocks. The Gorilla Game by Geoffrey Moore, copyright 1995, was based on his earlier marketing books like Crossing The Chasm. Just from the titles one can see the leap from "deep dives" into valuation calculations into the analysis of how complex systems work. The Gorilla Game was limited to a very small but highly influential market segment. One other very influential work was The Innovator's Dilemma by Clayton Christiansen that highlighted how old technologies get disrupted. This collection of ideas negated a long held conviction, that "Build a better mousetrap, and the world will beat a path to your door." This is true for commodities but not for high tech products and services that exhibit a very different dynamic. Complexity: The Emerging Science at the Edge of Order and Chaos by M. Mitchell Waldrop is a great primer for the layman.

What Cathie Wood has done is to use all these ideas to create a new way of valuing certain segments of the stock market and the results has been phenomenal. But Cathie Wood is up against an immutable law of nature that applies to complex systems from avalanches and earthquakes to the distribution of wealth, the power law distribution. According to Wikipedia examples can be found in:

General science:

There is nothing Cathie Wood can do about the power law distribution but Warren Buffett has given us a hint about how we can beat Cathie Wood at her own game.

“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”

Beating Cathie Wood at her own game

Because Cathie Wood has so much money to manage, ARK Invest has billions under management, she has to distribute this capital over an increasing number of stocks. The power law distribution dictates that the returns of these various stocks will follow a power law distribution. Each of ARK's five thematic ETFs has between 30 and 55 positions. With the overlap, between them they might have 80 to 100 positions. But if you only have a million or ten to invest you can buy just six or twelve of Cathie's positions, those with the highest growth rates, instead of the long tail of under performers.

Instead of looking at the market every day, you could spend a week each quarter to realign your Cathie Wood portfolio. But what the heck are you going to do with so much free time in this age of stupid lockdowns? There is always a fly in the ointment.

Denny Schlesinger