If you were invested in any stock with a hint of artificial intelligence (AI) technology, you've had incredible returns in 2023. But more recently, you've likely started to feel the pain of a sell-off. Take Upstart (UPST 2.76%), for example. At its peak, the stock was up an astounding 445% in 2023 alone. However, thanks to the recent market pullback, it has plummeted 55% from its highs in August alone, although it's still up 150% for the year.
But that begs the question: Was this a case of a hot stock cooling off? Or is this a great buying opportunity for getting in on a stock you missed? Read on to find out.
Bringing better-priced loans to more consumers
Upstart is a leader in the credit approval space. Instead of using a traditional FICO score that only assesses a few factors, Upstart deploys AI to better assess if a consumer may default on their debt. These additional factors include education, bank account balances, and work history, and do a better job of telling lenders how likely the borrower is to default.
As a result, lenders can provide more competitive rates to borrowers who may not have the best credit score. In fact, Upstart found that its model has 53% fewer defaults at the same approval rate as traditional models. This approach saves lenders from costly losses, which makes Upstart an intriguing product to deploy.
Currently, Upstart only offers personal and auto loans. Still, it lists mortgages and small businesses in its total addressable market slide, which could indicate it might expand into those areas eventually.
While the story of Upstart's investment thesis is strong, its actual execution is lacking, but for a good reason.
AI is not what investors should be watching for Upstart
The run-up in Upstart's stock was triggered by investors piling into AI-related stocks, expecting massive interest to fuel further growth. However, that expectation isn't matched up with Upstart's reality. While it may provide a game-changing product, it's held hostage by one external factor: Interest rates.
As the Federal Reserve raised interest rates to quell inflation, it became more expensive to borrow money. In return, the demand for loans dropped substantially, showcased by Upstart's second-quarter loan volume of 109,000 processed loans totaling $1.2 billion, a 64% drop from the same quarter the year prior. That decline doesn't represent Upstart's product quality; it has to deal with macroeconomic factors.
As a result of the demand evaporation, Upstart's revenue declined 40% year over year and lost $33 million from operations.
UPST Revenue (TTM) data by YCharts.
But is all hope lost for Upstart?
Eventually, the Federal Reserve plans to reduce interest rates to more borrower-friendly levels. However, unless something drastic happens, investors will never see the dirt-cheap interest rates found in 2020 and 2021 again. This could have a meaningful effect on Upstart's potential loan volume, but consumers will always need some form of personal or auto loan eventually.
So investors shouldn't depend on AI to push Upstart's business to the next level. Instead, they should monitor the Federal Reserve to determine where Upstart will go next. Thanks to the recent pullback, Upstart's stock is now trading for about 5 times sales, which isn't all that expensive for what some would consider a promising growth stock. So if you're willing to hold Upstart's stock through the current interest rate environment and into a declining phase (which may take years), then Upstart may not be a bad purchase at these levels.
But, you must have a cool head on your shoulders, as Upstart is a stock known to rise substantially and fall in good and bad times. If you can manage those times, then Upstart looks like an intriguing investment. But if you can't, there are other stocks out there that aren't as volatile and are attractively priced.
