Cathie Wood's ARK Innovation ETF (ARKK -0.18%) is known for its aggressive bets on the cutting-edge companies of tomorrow. Between its holdings in lesser-known businesses with big potential, like Ginkgo Bioworks(DNA -0.32%), and its investments in more familiar names like Tesla(TSLA -1.10%), there's a lot to appreciate about Wood's approach to buying stocks.

While her flagship ETF is underperforming the market over the last three years, her investing style is worth learning about because it's a great contrast to other famous investors like Warren Buffett. In particular, there are three principles Wood uses to select stocks that you'll benefit from understanding, so let's dive in.

The pillar of Cathie Wood's approach to investing with her company ARK Invest is to find businesses that are creating disruptive innovations. Disruptive innovations, in her conception, can take several forms, including technologies that significantly slash costs, technologies that change more than one industry or geographical region, and breakthroughs that enable other follow-on innovations in a handful of different product segments.

In practice, that means she invests these days in a lot of companies that are competing in artificial intelligence, robotics, autonomous vehicles, DNA sequencing, energy storage, 3D printing, and blockchain technology.Focusing on potentially disruptive innovators explicitly means not paying much attention to entrenched competitors. It means investing in players that are pioneering new business models or pioneering new fields entirely.

Take Ginkgo Bioworks, for instance. Its idea is to use robotics and other forms of automation to streamline the process of designing and manufacturing custom-built microorganisms for use in the biotechnology, agriculture, and food industries, among others. Management claims that with its expertise in automation, it'll be able to benefit from economies of scale that drive down costs compared to other ways of accomplishing the same bioengineering and biomanufacturing tasks.

For the moment, Ginko Bioworks is unprofitable but rapidly growing. But if it succeeds, it'll be a favorite collaborator in multiple industries, and its stock will soar over the course of years. And that's why it's a Cathie Wood favorite.

Cathie Wood likes to invest in businesses that have the potential to become huge over the next three to five years or so as a result of their mastery of their markets, and enabled by disruptive innovations. In short, she doesn't much care for businesses that can make consistent and incremental progress on their earnings year after year as they're more likely to be less innovative competitors.

And exactly how big are the returns Wood is looking for? There's no single answer, but here's an example. In late August of this year, before Tesla's latest stock split, its price was near $891. A month before, in late July, Wood had set an ambitious price target: Tesla shares would be worth $4,600 by 2026. That means within three and a half years, she anticipated that shares would grow by around 416%.

Therefore, if you want to follow Cathie Wood's approach, look for businesses that could boom if their disruptive innovations are realized to their fullest potential.

It's officially part of ARK Invest's screening process to evaluate stock valuations. But evidence indicates that pricey valuations are seldom a deal breaker for Cathie Wood, and that other factors, like a company's potential to grow, are far more important when it comes to what makes the cut.

For example, in the first quarter of 2022, she bought shares of Tesla on numerous occasions. At the time, Tesla's trailing 12-month price-to-earnings (P/E) ratio was between 343 and 219. For reference, the market's average P/E since 1990 is a little over 23, so Tesla's valuation was (and still is) on the very high side in comparison. That doesn't deter Wood, though -- with the run-up she anticipates, it makes complete sense to keep buying shares of an "overpriced" stock.

So, if you want to invest like Cathie Wood, don't get fixated on valuations today. Tomorrow's valuations are far more important to whether your investment is profitable.

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Want to Invest Like Cathie Wood? Use These 3 Principles. - The Motley Fool