This season of “The Switch” is focused on making a case for disruptive innovation. In this episode, hosts Cathie Wood, CEO of ARK Invest, and ETF Trends’ CEO Tom Lydon and CIO Dave Nadig discuss how to assess the impact of disruptive technologies.

Many asset managers build their funds around market cap metrics or sector allocations, but ARK Invest instead structures its funds around innovation. Their analysts specialize in technologies that often track across industries and sectors; by understanding the core technology, they are better able to recognize the disruption potential.

Wood gives the example of autonomous vehicles; in their research to decide what goes into making them, analysts discovered that GPUs would play a critical part. This allowed ARK to recognize that NVIDIA, which they already held for gaming, would have a crucial role in autonomous technology and robotics.

“It was many multiples of the market we thought it was going after, which was the PC gaming chip space,” Wood says. “So once we have the top-down, how big is this autonomous mobility market going to be — and we now have seven years of modeling around this — as we bring a company into focus in this new world, we also do a bottom-up analysis.”

In the case of NVIDIA, ARK recognized that autonomous vehicles would be not only part of the market share for their technology but also the artificial intelligence for which GPUs drive the core component of training exercises.

How ARK Measures Companies

Once ARK has done their top-down and bottom-up analyses, they also use a six metrics scoring system that Wood believes is extremely important when dealing with innovation. Any company that scores below a six is removed from its funds.

Included in the aspects that ARK is scoring on are a company’s management and culture, what barriers to entry might exist, product and market leadership, execution in how a company is investing in its research and development, valuation that looks at market share and gross margins and then applies a mature growth stock multiplier, and thesis risk, which includes things like regulatory risk.

Explaining how ARK predicts future growth within valuations, Wood says, “We put FAANG-like multiples, so a fairly mature growth stock multiple, on it in five years. We don’t believe that most of our companies will be that mature in five years, so we feel we’re being conservative.”

This approach is one that Wood says means that ARK is now a value-oriented company.

Nadig points out that ARK has been very bullish on bitcoin and blockchain technology, despite the space being an “unknown” regarding regulations. Wood explains that at a conference she attended in 2015 that had lawyers, an FBI agent, and regulators present, the message they all gave was that regulators, whether federal or state level, didn’t want to interfere with innovation in a way that would prevent the country from dominating.

Hedging Against Disruption

Shifting to discuss how ARK decides to invest in a company given the size ranges and the fact that sometimes said company might be a branch or project within a business that is being invested in, Wood says, “we’re very focused on pure plays.”

Most companies that already existed and had a set structure before an innovation-driven disruption happens find it challenging to make the changes and continue operating at previous levels successfully. Wood gives the example of the automotive industry and the transition from both internal combustion engines to electric and from human-driven to autonomous. Innovators such as Tesla are given a multiple internally by ARK that is completely different from the multiple traditional automakers are given; “they don’t even resemble one another,” Wood says.

“Sometimes you need big companies to make new, big markets,” says Wood, discussing the fact that size considerations don’t matter in their pure-play investment strategy.

Finally, Wood describes how ARK can navigate investments to avoid value traps, something she says she is seeing more investors falling into lately as they get caught up in short innovations. Because of the amount of research and the understanding ARK has of technologies and the disruptions they pose, ARK doesn’t invest in anything that stands in that path of being disrupted.

“You need a hedge against the disruption, against the creative destruction that’s going to occur in the traditional benchmark space. We can be that hedge for you,” Wood says.

For more episodes, check out The Switch video playlist.

For more news, information, and strategy, visit the Disruptive Technology Channel.