One of the market's biggest losers in 2022 is Upstart Holdings (UPST -1.50%). Its stock price is down nearly 85% year-to-date and it appears nvestors have abandoned the stock, assuming its business model is broken.

But as we'll see, there's good reason to believe the business model is still working. And if it's working, Upstart stock could be a market-beating investment from here.

Why investors gave up on Upstart

From its initial public offering (IPO) price of $20 per share to its peak in mid-2021, Upstart stock was up 19.5 times in value in less than one year as a public company. Now almost exactly one year later, it's down roughly 94% from that peak. Clearly, something happened for investors to give up on Upstart stock.

To understand what happened, we should first look at Upstart's business model. The company connects lenders with borrowers, attempting to help both parties. Borrowers want lower interest rates. Lenders want to be paid back. Upstart uses artificial intelligence (AI) software to instantly measure credit risk based on more than 1,500 factors, which theoretically leads to fewer defaults for lenders and better interest rates for borrowers.

Upstart makes these loans happen. But it doesn't aim to hold the loans; the company's bank partners don't always hold them either. The business model relies heavily on institutional investors. And loan funding from this party recently dried up. With less institutional money to fund the loans, Upstart couldn't process as many as it would have liked, leading to a drop in revenue.

The timing of this problem coincides with the Federal Reserve raising interest rates, as the chart below illustrates.

Effective Federal Funds Rate Chart

Effective Federal Funds Rate data by YCharts.

In the first half of 2022, Upstart actually filled the aforementioned funding gap with its own balance sheet, a move investors disliked because of the fundamental difference between servicing loans and processing loans with software. As of the end of the second quarter, the company held $624 million in loans on the balance sheet.

Investors don't know if this situation for Upstart is long lasting or temporary. Some believe institutional investors are shunning Upstart's loans because default rates are increasing and rising interest rates give these investors comparable returns elsewhere with less risk. If that's true, then Upstart could be forced to continue using its own resources in coming quarters to fund loans, which wouldn't be good for shareholder returns.

Why Upstart stock may be a buy (for some)

There are two reasons the market may be blowing this entire situation out of proportion. First, the recent increase in default rates might not be a big deal. Consider that default rates dropped early in the pandemic when there was an abundance of economic stimulus money. Now that there's not, default rates are rising for Upstart. Therefore, some investors question the performance capabilities of Upstart's AI in all economic conditions.

However, the entire industry is experiencing the same reality. For example, LendingClub recently noted that its delinquency rates were "normalizing" -- in other words, going up compared to the extraordinarily low delinquencies during 2020 and 2021. Moreover, American Express and Discover Financial Services both recently noted an increase in net charge-offs. Therefore, this is clearly an industry problem, meaning it's unfair to criticize the effectiveness of Upstart's AI based solely on its recent default rates.

Second, the market assumes institutional investors are turning from Upstart's loans, but that's not necessarily the case. During times of uncertainty, people will pause investing activity while awaiting greater clarity. Consider that bonds are experiencing a bear market. The bond drawdown is a historical anomaly and suggests hesitancy from institutional investors to be active in this space also.


^MOUSBMYO data by YCharts.

It's possible institutional investors are simply pausing their investments in loans originated through Upstart, waiting to see when inflation and interest rates will peak to better make informed investment decisions for the long haul. This is what Upstart's management believes. Therefore, it's entirely possible we're again looking at a macroeconomic issue, not an Upstart issue.

Assuming both of these things are true, then in a worst-case scenario Upstart's business model is merely prone to cyclicality -- it's not a broken business model. That's a big difference. Investing in cyclical stocks isn't for everyone. But for those willing to ride out this risk, Upstart stock could offer enormous value right now.

Upstart stock currently trades at less than two times sales, its cheapest valuation ever. And it can potentially grow sales exponentially in years to come. Consider that it keeps gaining new bank and credit union partners. It's diversifying into loan categories like auto and mortgage, which are much larger than its core personal-loan market. And institutional investors could return to funding loans in time.

All of these things could reignite Upstart's growth and unlock market-beating returns for those who buy today.