A record number of companies debuted on the public markets in 2020, and the pace is continuing in 2021. Digital payments and financial technology are an especially interesting theme, as e-commerce is more important than ever because of the pandemic. But sifting through all these new opportunities can be overwhelming.
How can an investor separate the best companies from those just taking advantage of the hype? Start with these three points.
Look for diversified platforms and "optionality"
It's normal for a smaller company to focus on one particular market or one niche service. It takes time to build out a diversified platform. But eventually, a fintech with optionality -- the ability to find valuable new uses for what it does well -- will have more ways to succeed than a specialist. A full-blown fintech platform is a safer bet than a niche one.
It's true that there's usually a greater payoff down the road if a small financial service can successfully expand. But don't assume that by the time a company can produce a well-rounded platform, it's become too big for meaningful growth. Take Social Finance, or SoFi, which is going public through Chamath Palihapitiya's special purpose acquisition company Social Capital Hedosophia Holdings V (IPOE). SoFi's equity value is expected to be just $8.65 billion after its SPAC merger. In a global financial system that encompasses trillions of dollars a year, that's still a small company with plenty of room to make waves.
In fact, you can get market-crushing returns from a fintech bigger than that. One need only look at the incredible run of stocks like Square (which started 2020 with a roughly $27 billion market cap) and PayPal Holdings (whose market cap was about $127 billion).
Not all niches are created equal
A company making headway in a small corner of the financial industry can become a powerful player in the broader world of finance later on. Take Affirm Holdings (AFRM 2.68%), which just completed its initial public offering (IPO) in January. Lending on credit to consumers isn't new, but the company has been growing at a rapid pace with its easy-to-use and transparent buy-now-pay-later offering. Revenue has nearly doubled year over year as it picks up new merchant partnerships and consumers look for flexible options to pay for larger purchases.
But not all niches are equal. The global consumer credit market is massive and ripe for disruption. Compare that to other fintech niches, like a digital payments company focused on one particular industry vertical, like gaming or retail. A total addressable market (TAM -- the spending a company can capture with its product or service) of a couple billion dollars sounds big, but in the grand scheme of things, it isn't.
Granted, said TAM could be growing very quickly (as with the buy-now-pay-later movement). But investors should take long-term projections with a grain of salt. Global finance is massive, and there's no shortage of competitors that could crash a party and bring a tiny fintech's momentum (and its growing "TAM") to an abrupt halt. Instead, look for fintech that is successfully disrupting an already established and very large market.
What's the secret sauce?
I like to look for companies with a secret ingredient that differentiates them from the pack. It might be an ecosystem of services that keeps users locked in and coming back again later to complete another transaction (like PayPal's Venmo or Square's Cash App digital wallets and investing tools). Or it could be the ability to make better use of data to improve the customer experience (like using software enhanced by artificial intelligence).
But lots of fintechs say they're one up on the competition. How can an investor be sure? I look for double-digit growth rates and a clean balance sheet (little to no debt and plenty of cash). Such a financing structure would indicate a company has been able to attract plenty of investors and customers with its growing service, and has avoided the need to take on debt to make acquisitions and make other investments along the way.
This is important post-IPO, as it means cash raised from a public offering (either a traditional IPO or via merger with a SPAC) can be used later to maintain growth -- rather than pay off debt. And as many fintechs aren't profitable (yet), a large net cash balance will be key as they stay aggressive in trying to attract new users and merchants to their ecosystems.
Be careful out there
The market is flush with new fintechs, and plenty more are on the way. Many of them aren't worth your hard-earned savings, even if day-one hype makes you feel like you're missing out. When parsing the available options, focus on those that have the optionality to grow into a platform of services; large addressable markets that they're disrupting; and a track record of growth without taking on excessive debt.