Investors will likely remember 2023 as the year artificial intelligence (AI) captured the market's attention. Following a brutal sell-off in the 2022 bear market, it was the AI stocks, and specifically the potential of generative AI to boost productivity in multiple industries, that led the market's comeback efforts in 2023.
Consequently, most of the low-hanging AI fruit has already been picked. However, patient investors who can tolerate some risk might have an opportunity to reach a little higher and grab some Upstart (UPST 1.14%). Here's why this stock is a buy-and-hold candidate.
Which investors need to invest in Upstart
Upstart requires patience and risk tolerance primarily because of the economy and interest rates. Both factors have negatively affected Upstart, as evidenced by its failure to meet its own revenue and earnings expectations in the third quarter of 2023. Upstart's headwinds at the moment are bad enough that management reduced its guidance for Q4.
The stock price plunged following this report. With that drop, Upstart stock traded about 95% below its all-time high from 2021. Back in 2021, revenue from its personal loan evaluation business was growing at triple-digit rates, in part, because interest rates were low.
NASDAQ: UPST
Key Data Points
Not surprisingly, as interest rates rose, the number of loan applications fell, and worries about an increase in defaults rose. Unfortunately for shareholders, moves into auto, small business, and home equity loans failed to compensate for the reduced personal loan activity.
Another issue that spooked investors is Upstart's lending patterns over the past 18 months. Upstart bills itself as a loan evaluation tool and it earns much of its revenue by evaluating applicants for partner lending institutions and collecting fees for those services. But as the company moved into new lending categories, it took on the actual loans itself on a short-term basis with the intention of transferring those loans to a partner institution. The sharp rise in interest rates made those loans less desirable and Upstart had problems unloading those loans to its partners. Upstart now holds just under $1 billion in loans it cannot get off its books right now.
Take all these headwinds together and you have a situation where investors are questioning Upstart's mission and its ability to handle a higher interest rate environment.
Why investors may want to ignore significant risks
While these concerns are admittedly significant, AI may offer some solutions for Upstart and give investors a reason to buy shares. Upstart's business model is actually driven by its AI efforts, which handle the company's loan evaluations. All indications show its AI model works better than Fair Isaac's industry-standard FICO score. This older evaluation model, which looks at a couple dozen data points, first appeared in 1989 and has only had minor revisions since. That lack of significant updates alone makes the loan evaluation market ripe for disruption.
According to Upstart, its AI-based evaluation model looks at more than 1,000 data points, and develops what it claims is a more accurate picture of lending worthiness which allows it to approve 44% more loans than FICO without increasing risks of applicant defaults. That could provide a valuable revenue source to lenders it partners with in a market where higher interest rates have reduced loan demand.
Additionally, the total addressable market for loan originations is $4 trillion annually. If a large number of banks were to replace the FICO score with Upstart's platform, Upstart would benefit from massive amounts of AI-driven growth, a factor that would almost certainly bring investors back to the stock.
Upstart's potential
Thanks to AI, Upstart holds the potential to drive massive gains from a loan evaluation market long overdue for disruption.
Admittedly, Upstart's current performance has disappointed investors, and the company has offered little hope of a near-term recovery. These factors explain why Upstart stock sells at a low price despite its considerable AI potential, and shareholders may face a wait before its recovery begins in earnest. Also, this behavior probably makes the stock too volatile for risk-averse investors.
However, that risk opens up the possibility for generous rewards. An improving economy and falling interest rates could bring back borrowers, which could bring massive revenue gains for Upstart. If more banks begin to appreciate the added revenue potential from the fintech stock's AI-driven tool, it could bring massive returns to patient investors.
