You don't need to be an expert to know that technology stocks of just about every stripe have taken it on the chin over the past year. The sector has been down more than 20% for most of the year. However, technology is a broad umbrella that may include hardware, software, communications equipment, information technology, and telecommunications companies, so it is not a monolith. Some areas are performing better than others.
One subset of technology is the growing area of financial technology, or fintech. Companies that are considered fintechs use technology to improve or automate financial services in some way. Of course, all financial companies rely on technology, but the term fintech typically applies to those where the technology is the primary driver of the business -- although the definition has become pretty loose.
Throughout the bull market of the 2010s, fintechs were the darlings of both sectors -- financial and technology -- running up huge gains. It has been a different story over the past year as many have had huge losses. Is now the time to buy fintech stocks? As always, it depends on the stock, but here are a few things to consider.
Evaluating fintechs
Many fintechs saw their stock prices skyrocket coming out of the pandemic as more and more investors piled in to enjoy the ride. Some attracted interest by generating big revenue increases each quarter, while others just rode the momentum. This led to some ridiculously high valuations for companies, many of which were still not profitable.
Block (SQ -1.12%), for example, gained 247% in 2020. In August of 2021 it was trading at over $275 per share -- now it is down to about $54. It was running so hot that it had a price-to-earnings (P/E) ratio of 489 at the end of 2021.
It is not unusual for smaller-cap growth stocks to have high valuations, but when they spike above past levels, a red flag should go up for investors. This is particularly true for companies that have not yet turned growing revenue into actual earnings. For companies with net losses, you couldn't look at P/Es, but there are other metrics, such as price-to-sales and discounted cash flow, that you could use to determine valuation.
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It is not unusual for a small company to be unprofitable when it is in growth mode, as it is investing heavily in its own growth. But eventually, you want to see those net losses narrow and turn into net income. If they don't, it's likely because the company's revenue growth is slowing, or its expenses are too high -- or both.
Do they have competitive advantages?
The other concern investors should be mindful of when evaluating fintechs is their competitive advantages. Many hit the market running because their technology often fills an unmet need or improves upon the status quo. But soon, new competitors emerge and the larger players may develop their own in-house capabilities to handle that task, or acquire a firm that does.
The aforementioned Block does indeed have some unique competitive advantages, as it serves both buyers, through its Cash App mobile payment portal, and merchants, through its suite of products in its Square division. It also has a bank charter, that allows it to take deposits and facilitate its own loans -- saving money by eliminating having to use a third party bank.
SoFi Technologies (SOFI -0.29%) has a similar advantage, and like Block is one of the few fintechs that have a bank charter. In addition to providing banking services, SoFi also has an advantage with its technology platform, which it sells to companies that want to build out their own banking capabilities. This provides a second revenue stream that has been growing rapidly.
So, as an investor, it is important to do a deep dive into the company and the markets in which it operates. Does its niche have a lot of companies vying for market share? Is its proprietary technology superior to its competitors? Is that superiority durable? Does it have multiple revenue streams in case one slows? Who runs the company and is the management team effective? What is its cash and liquidity position and is its debt manageable? Is it too reliant on a few large clients or does it have a broad, growing customer base? These are just some of the items to consider.
One fintech that might be too reliant on one customer is Marqeta (MQ -3.96%), which provides a platform and the infrastructure to facilitate payments. Roughly two-thirds of Marqetaʻs revenue comes from its partnership with Block. Then there's Affirm Holdings,(AFRM 1.51%) a buy now, pay later leader. But it is in a newer industry that has tons of competition and has not yet turned a profit.
Proceed with caution
So, back to the question: Is this a good time to buy fintech stocks? It without a doubt is, because the valuations of many fintechs have come crashing down and are now sitting at very reasonable levels. Block and SoFi are two that might warrant consideration, because of their advantages.
But investors have to be cautious, particularly in this economy, because rising interest rates are going to make it more expensive for fintechs to make capital investments and fund their growth.
Also, if there is a recession, fintechs that offer banking services or payments, or that work with banks and financial institutions, will be challenged by a slowdown in borrowing, lending, and spending.
The ones that are best able to generate consistent revenue during the downturn, and manage expenses, may likely be the best candidates to emerge once the economy recovers from the current slowdown. The key to finding them, as always, is to do your research.
