The S&P 500 and the Nasdaq Composite slipped into bear markets this year on recession fears, with stock price drops cutting deep into many portfolios. Disheartened investors should take heart in the fact that broad downturns are temporary, and some of these fallen stocks will rebound when the next bull market thunders to life.
Two of these fallen stocks, Block (SQ 5.04%) and Upstart (UPST 3.90%), are shaping the future of technology in the finance and lending industries, respectively. Block aims to simplify financial services for businesses and consumers with integrated product ecosystems, and Upstart is working to modernize lending with big data and artificial intelligence. Those bold ambitions could help send both stocks soaring when the market rebounds.
Here's what investors should know about these two growth stocks before the next bull market.
1. Block: Disrupting the financial services industry
Block simplifies commerce for sellers with its Square ecosystem. Square brings together all of the hardware, software, and banking services needed to manage a business across online and offline locations. It first gained traction with micro-merchants and small businesses, but mid-market sellers (i.e. those with over $500,000 in annual sales) accounted for 40% of gross payment volume in the third quarter, up from 31% two years ago. That trend bodes well for Block, as mid-market sellers generate more gross profit by adopting more products and churning less frequently.
Additionally, Block simplifies consumer finance with its Cash App ecosystem. The Cash App unifies the ability to borrow, spend, and invest money in a single digital wallet, and Block is currently building commerce capabilities into the platform. In time, Cash App users will be able to browse and buy products from Afterpay or Cash App Pay sellers within the digital wallet, which could set in motion a powerful flywheel effect. Commerce capabilities should drive consumer adoption of the Cash App, and that should incentivize more businesses to accept Afterpay and Cash App Pay.
Block delivered strong financial results in the third quarter, an impressive accomplishment under challenging economic conditions. Gross profit climbed 38% to $1.6 billion and non-GAAP net income soared 68% to $0.42 per diluted share. As a caveat, that momentum may fade in the near term, especially during a recession, but Block remains well-positioned to create value for patient shareholders in the long run.
In 2022, Block valued its addressable market at $190 billion, up from $160 billion in 2020, and its efforts to grow upmarket with Square and blend commerce into the Cash App should be powerful tailwinds, especially when the macroeconomic headwinds diminish. That's why this growth stock is worth buying.
2. Upstart: Modernizing the lending industry
The FICO score from Fair Isaac has been around since 1989, and it's still the gold standard in assessing the credit risk of potential borrowers. But traditional FICO-based systems consider a limited number of variables, meaning they often fail to correctly quantify risk, and that creates problems for lenders. Some trustworthy borrowers are rejected, while some untrustworthy borrowers are approved -- and both are headwinds to profitability for the lenders who use the platform.
Upstart wants to make the system more efficient. Its lending platform considers more than 1,600 data points per borrower, and it leans on artificial intelligence (AI) to correlate those data points with fraud and default, which ultimately leads to better risk assessment. In fact, Upstart can reduce default rates by 75% while keeping approval rates constant, according to one study, and its AI models have consistently separated high-risk borrowers from low-risk borrowers five times more effectively than FICO-based models since 2018.
Unfortunately, the current difficult economic climate has been a nightmare for Upstart. Banks tightened lending policies to hedge against rising default rates amid the inflationary environment, and demand for credit dwindled in response to rising interest rates. Those industry-wide challenges translated into catastrophic financial results for Upstart in the third quarter. Revenue fell 31% to $157 million and the company reported a net loss of $56 million, down from a profit of $29 million in the prior year.
As a caveat, Upstart has never been through a low period in the credit cycle, which makes the stock especially risky right now. But the company demonstrated that its AI models are superior to FICO-based models during a high period in the credit cycle, and if its AI models continue to outperform in the coming quarters, banks could be champing at the bit to use its next-generation lending platform by the time inflation cools and interest rates fall.
On that note, Upstart sits in front of a huge addressable market. Its AI platform currently supports personal loans, auto loans, and small business loans, which collectively present a $1.5 trillion opportunity. For the sake of comparison, Upstart powered just $1.9 billion in loans in the third quarter, or about $7.6 billion on an annualized basis, meaning the company captured less than 1% of its addressable market.
With that in mind, shares currently trade at 1.5 times sales, the cheapest valuation since Upstart went public in 2020. That creates a good opportunity for risk-tolerant investors to take a small position in this growth stock.
