Fintech company Upstart (UPST 2.76%) uses artificial intelligence (AI) to assess borrowers' creditworthiness to help financial institutions make better loan approval decisions. The company has been making steady progress, but the ride has been all but steady for its investors.
Upstart did an initial public offering (IPO) at $20 a share in December 2020. By October 2021, it had reached $390, and a year later, it was back to around its IPO price. Fast-forward to the end of July, and the stock was around $72 and has surged about 425% this year.
AI hype has fueled a lot of Upstart's 2023 rally, causing some investors to be skeptical of its valuation and short the stock. However, does this negate Upstart's viability as a long-term investment option? Let's see.
What exactly is a short squeeze?
When investors short a stock, they're counting on it to decline in price. They borrow shares from a brokerage and sell them immediately. They intend to repurchase the shares at a lower price later and return them to the brokerage and pocket the difference as profit.
For instance, imagine a stock is $50, and someone believes it'll drop to $35. The plan would be to borrow the shares now at $50 and sell them, then repurchase them once they hit $35 and profit $15 per share. If the plan works out this way and the stock price actually drops, perfect. If the stock price doesn't drop, then they have a problem on their hands.
Your brokerage company is only concerned about getting their shares back; they don't care how much it costs you to return them. Furthering our example, if the stock's price rises above $50, the investor begins to lose money because they'll have to repurchase shares for more than they sold.
When investors rush to buy back shares before losing any more money (or being forced to do so by their brokerage company), the stock price gets pushed up even further, creating what's known as a short squeeze. Remember the GameStop saga from 2020? That was a short squeeze.
Is investor skepticism warranted?
Upstart's float (shares available for the public to trade) is 69.99 million. Of those, 25.86 million have a short interest. Upstart's short interest, at 36.9% of its float, is one of the highest in the stock market, joining companies like Carvana (41.6%), C3.ai (36.1%), and Wayfair (31.8%).
Despite the pessimism surrounding Upstart's stock, the company has the tools needed to become a good long-term investment. There's sure to be volatility along the way, with some short sellers making money and others regretting they ever went down that path, but so-called long investors with time on their side should feel encouraged about the problem(s) Upstart is taking on.
It's hard to argue against its efficiency
AI has been all the hype lately in tech, but to Upstart's credit, AI is its foundation. It's what the platform has been built on from day one. More importantly, it's hard to argue against the results its AI-powered platform produces.
Upstart says borrowers it approved had 53% fewer defaults than non-Upstart-approved borrowers from major U.S. banks at the same approval rate. This means Upstart could approve 173% more loans and have the same default rate as the non-Upstart approval method.
Image source: Upstart's Q1 2023 Earnings Deck.
AI, in general, relies on tons of data to be trained, and the more, the merrier. Since AI has been ingrained into Upstart's DNA since its founding over a decade ago, it has a leg up on other financial institutions or fintech companies that may just be joining the AI party.
Upstart says its models have been trained on more than 100 billion data cells, adding an average of 90,000 loan repayment data points each day. As Upstart's platform grows and gathers more data, it should become more efficient at approving borrowers. In the first quarter alone, the company upgraded its model 23 times.
The long-term potential rests on the housing market
Upstart only approves borrowers for auto, personal, and small business loans at the moment. Here are the total addressable markets (TAM) for those:
- Auto: $775 billion.
- Personal: $171 billion.
- Small business: $644 billion.
Together, that's just under a $1.6 trillion TAM. Not too shabby, but it pales in comparison to the TAM Upstart will have once it enters the mortgage space. Mortgages alone have a TAM of $2.7 trillion.
Upstart will need to strengthen partnerships with top banks that dominate the mortgage market to have a chance at even remotely touching that TAM, but efficiency is a good selling point. The better its platform services auto, personal, and small businesses, the less friction it's likely to have when it enters the mortgage market.
At some point, the old FICO scoring system had to face a formidable competitor. Upstart could be that.
