If you invest in fintech stocks, as I do, then you likely have been feeling the sting over the past few weeks as the market has sold off the sector aggressively. Up until recently, big players like Upstart (UPST -0.44%), Affirm (AFRM -0.16%), and SoFi (SOFI -0.56%) had run up to huge valuations. But now, even after price action from third-quarter earnings results, the market has for now turned its back on these heavyweights.
Let's look at what has been driving the move over the past few weeks and whether or not this is likely to persist.
A tough macro environment
If you've been sitting at your computer and seeing these stocks sell off for seemingly no reason, the good news is that not much might have changed in your investment thesis. The bad news is that the macroeconomic environment seems to be a bigger driver right now.
Image source: Getty Images.
Inflation has been creeping higher for a while now. Earlier this month, the U.S. Labor Department announced that the Consumer Price Index, a measure of price changes in daily consumer products, had jumped 6.2% in October from the same time in 2020, reaching its highest point in more than 30 years. The report served as confirmation to a lot of investors who believe inflation might not be as transitory as the Federal Reserve has been saying.
It also led a lot of investors to believe that the Fed may indeed start to hike the federal funds rate next year. Earlier this year, many thought a rate hike might not occur until 2024. On top of all of this, the Fed has also begun tapering its bond-buying program, which has effectively been pumping hundreds of billions of dollars into the economy since the pandemic began.
All of this has had several effects on these high-flying growth stocks that recently reached monstrous valuations ranging from nearly 15 times revenue for SoFi up to 35 times sales for Affirm. Of the three, only Upstart is profitable, and its price-to-earnings ratio is above 200 after having been well into quadruple digits just a few months ago.
For one, the tapering and signs of stronger inflation all support the fact that rate hikes are very possible in 2022. Rate hikes are bad for tech and growth stocks because higher interest rates make materials and debt more expensive and reduce the future value of cash flows. Higher rates also make safer assets like U.S. Treasury bills more profitable and therefore more attractive. It's not easy to predict exactly how tapering will impact rates, but in recent months both short- and long-term rates have moved up as the expected beginning of tapering has approached.
The other thing more specific to Upstart, Affirm, and SoFi is that these companies are in the business of lending, which is greatly impacted by interest rates. While rising rates increase the yield on the loans these companies originate (hence making them more profitable for the end investor), it also increases the cost of the funding needed to make those loans.
And higher rates affect borrowers because they increase the cost of their debt, which tends to lead to higher default rates. That's concerning for a company like Affirm in the buy now, pay later space because recent reports have suggested that these borrowers are falling behind on their debt payments as it is.
Many fintech lenders like Upstart are using artificial-intelligence loan underwriting models that are new, and the companies only briefly experienced higher interest rates before they went public. Investors could be wondering how these underwriting models are going to hold up in a higher-rate environment. And if inflation gets really high, it can stymie borrower demand, which these fintech companies need to make money.
Think about valuations
There is a ton of uncertainty about the macroeconomic environment, so it's hard not to have some concerns. But the U.S. economy is still expected to generate strong growth, albeit growth forecasts have been cut a decent amount from what they were earlier this year.
One thing these fintech lenders have going for them is that the effects from stimulus payments on consumers' balance sheets are starting to fade, so I would think that lending could definitely pick up in future quarters. With such a complex macro environment, the big thing for me is that Affirm, Upstart, and even SoFi to a lesser extent ran up to huge valuations too quickly, so I think a pullback is healthy here. My advice would be that if you still like your investment thesis in any fintech, very little has changed on the fundamentals.
But valuation is key, and higher inflation and interest rates erode huge valuations, so it's better to try to purchase these stocks at more realistic entry points with more realistic growth expectations.
