Since the start of 2023, shares of Upstart (UPST 2.76%) have soared 135%, as optimism about the artificial intelligence (AI)-based lending platform has had a boost from the investment community. Maybe the possibility of a strong economic backdrop in 2024 has been driving the gains.
This fintech stock has no doubt skyrocketed in recent times. But before rushing to add Upstart to your portfolio, investors must be aware of a hidden risk that is impacting the business.
Upstart has shown that it's extremely cyclical
Upstart was registering remarkable growth a few years ago, when the Federal Reserve was much more accommodating and kept interest rates low. Revenue jumped 42% in 2020 and 264% in 2021. And in that latter year, net income was up 2,150%, totaling $135 million. What's more, loan volume in 2021 of $11.8 billion increased 338% year over year.
It's clear that low interest rates provide an extremely favorable environment for the company to grow and generate positive net income. But on the other hand, we've seen how higher interest rates negatively impact Upstart in a troubling way. This cyclicality is a key risk that growth-minded investors might not be paying that much attention to.
In 2022, growth slowed meaningfully. This worsened in 2023. Through the first nine months of last year, revenue was almost cut in half. And in the latest quarter (Q3 ended Sept. 30), transaction volume dropped 34%.
When interest rates are elevated, demand from borrowers is unsurprisingly weaker. That's because monthly payments are higher. And from the lender's perspective, it's easy to become more hesitant to originate loans. They tighten their standards for who gets approved.
The possibility of economic troubles can also be worrying. The Treasury yield curve has been inverted since the summer of 2022. This has typically preceded a recession. What if the U.S. enters a severe economic downturn in 2024? In this situation, it's probable that Upstart will continue posting huge declines in loan volume and revenue, which is not what investors are hoping for.
Upstart has positive attributes, but it is a high-risk play
Owning a business that hasn't proven its ability to produce consistent sales growth, as well as profitability, adds unnecessary risk to one's portfolio. And this is an important reason for investors to think twice before buying shares.
To its credit, Upstart has developed an impressive AI tool. By analyzing 1,600 variables about potential borrowers, more than the five factors that the FICO model looks at, management has proven that it can better assess default risk. And for the company's more than 100 lending partners, Upstart's system can help them target a wider potential customer base.
Moreover, investors are likely most interested in Upstart's total addressable market. Executives point out that the market for personal, auto, small business, and home loans is valued at $4 trillion in annual originations. Should Upstart even tap a fraction of this huge opportunity, it could see massive revenue.
Even though shares have soared since the start of last year, they remain 92% off of their all-time high. And Upstart's current price-to-sales ratio of 5.1 is about half of its historical average, making now a relatively smart time to be a buyer.
Despite this stock's positive traits, I believe it's critical that investors understand the downside of any stock that they are interested in. In this instance, the fact that Upstart is extremely cyclical means that you should only buy shares if you accept the risk.
