Robotics Innovation - Not "Trendy" ETFs - Is What's Driving Higher Market Valuations

Written by: Jeremie Capron Bill Alpert, Barron’s Senior Editor, stirred the pot a bit last week when he published Robo-Boosted Drone Maker AeroVironment May Be Headed for a Fall . In his article, he states that “the only apparent explanation” for military drone maker AeroVironment’s skyrocketing stock price is the fact that “trendy ETFs like ROBO Global Robotics & Automation (ROBO)” have made AeroVironment (AVAV) a top holding. It’s an interesting presumption, but it’s a skewed concept that does AeroVironment—and ROBO Global for that matter—a considerable disservice.What Alpert (or perhaps hedge fund manager Ben Axler who is quoted as the source for the theory) must not have realized is that this explanation holds no water. AeroVironment is a bellwether member of the ROBO Global Robotics & Automation Index , which means it represents less than 2% of the index and of the ROBO ETF. At that small percentage, even the large inflows into the flagship Robotics & Automation ETF could not be the main reason for the stock’s impressive advance this year. We estimate that the ROBO ETF accumulated just over 600,000 shares of AVAV in the first nine months of 2017, which represents an average of 3,200 shares per day, compared to the daily average 227,000 shares that traded on the market over that period. It would it be quite improbable—if not wholly impossible—for a buyer that is less than 2% of the flow in a stock to move its price materially. In fact, most institutional traders would agree that it would take more than 10 times that level of trading to have a significant market impact.Yet according to Alpert and Axler, this isn’t the first time ROBO Global’s buying practices have influenced the valuation of a stock in this way. The article states that it’s “a story Axler believes he’s seen before” when shares of iRobot were “catapulted by the buying of the same ETF.”While I have the utmost respect for Bill Alpert and Ben Axler, I do wish they had taken a closer look at the methodology behind the ROBO Global Index before coming to their conclusions. Had they done so, they would have seen that, in contrast to certain other ETFs that concentrate their holdings on just a few dozen of the largest market-cap weighted robotics and automation companies, the ROBO Global Robotics & Automation Index includes over 80 companies around the world. Members of the Index are either “bellweather” companies (established leading players whose core business is directly related to robotics, automation and artificial intelligence, or “RAAI”) and “non-bellweather” companies (companies who have a defined portion of their business and revenue in RAAI and have the potential to grow through innovation and marketplace adoption).Once companies are selected by our team of industry experts based on their revenue exposure to RAAI technologies and market leadership, we use a modified equal-weighted approach designed to provide diversified exposure to the growth and return potential of RAAI. Notably, the Index rebalances quarterly, thereby naturally selling high and buying low on a regular basis. This reduces company-specific risk by limiting the weighting of every one of its holdings. Including the largest, the most popular, or even the most promising companies in the space. And yes, including both AeroVironment and iRobot. In addition, the methodology caps maximum ownership across funds that track the ROBO index at a combined 5% of free floating shares for every index member. Related: Investing in Robotics? Follow These 5 Simple Rules

So if the purchasing power of a “trendy” ETF like ROBO Global isn’t what’s driving up the stock price of AeroVironment, it begs the question: what is?

One of the primary reasons for AeroVironment’s recent rise has been excitement around the company’s Switchblade product, a “back-packable” precision strike solution that provides miniature flying intelligence, surveillance, and reconnaissance, as well as its other Tactical Missile Systems (TMS). TMS looks increasingly like a big hit. The business delivered $75M in revenue in FY17, up from $46M in FY16. These solutions currently account for about one-third of total revenues for unmanned aircraft systems, and nearly half of that is customer-funded R&D, which suggests very strong customer interest. According to management, TMS addresses a market as large as $1 billion, based on the company’s analysis of DoD spending. Thus, TMS sales have potential to grow multiple times from here and drive significant earnings growth for the company. This momentum has helped Aerovironment deliver financial results that exceeded analyst expectations in each of the past three quarters, in stark contrast to the series of disappointments in the prior year.Adding to that existing momentum was AeroVironment’s October announcement of a new contract award from the United States Navy for “continuation and expansion of its Blackwing™small Unmanned Aerial Vehicles (UAV) program.” While the company’s stock is not riding quite as high as it was in late September, it continues to rally, and that push in valuation is due to the basic fact that the company is continuing to demonstrate its ability to innovate and to win contracts and new revenues as a result.Of course, not all ETFs share ROBO Global’s methodology. (Bloomberg’s October 25 article Like the Terminator, This Robot Fund Just Keeps On Buyingcalls out some of the unintended consequences of riskier, more concentrated approaches) So Alpert and Axler may be correct in one respect: it is possible for a robotics fund to create stock overvaluations. It can happen. It’s just not likely to happen when the fund in question has a methodology in place designed to prevent this very thing.