Fintech Disruptors

By contrast, technology stocks have soared in 2020 and the future of finance is also where digital revolution meets the business of money. That doesn’t just mean banks; insurance, payments, alternative lending, wealth management and even real estate are all touched by the proliferation of financial technology start-ups.

Fintech, therefore, is an incredibly broad church. Buying into innovation that’s transforming how we earn, bank, invest and pay for goods and services sounds compelling, but the parts of that proposition each have their own pitfalls, and some are more easily investable than others.

Holding an S&P 500 tracker fund gives sizeable exposure to the explosion in payments technology, albeit the shares are expensive. As well as highly valued Mastercard (US:MA) and Visa (US:V), owning Apple (US:AAPL), Alphabet (US:GOOGL) and Amazon (US:AMZN) includes a play on transactions.

Likewise, many Asia funds include Chinese tech giants Tencent (HK:0700) and Alibaba (HK:9988) and the same will surely be true of payments leader Ant Group – the world’s largest fintech company – when it lists on mainland Chinese and Hong Kong exchanges in what looks set to be one of the biggest initial public offerings (IPOs) ever seen.

Smaller companies, which are often pioneers and become takeover targets for the big players, are more elusive. The same is true of so-called neo banks, such as Monzo, Revolut, N26 and Starling, although these disruptors face uncertainties in the time of coronavirus.

Pandemic aside, governance issues are foremost when it comes to upstarts in whatever sphere of finance. That isn’t to suggest impropriety, but there can be difficulty balancing tech wizards’ focus on brilliant ideas and investors retaining visibility, including over timeframes and payback, although fintech’s image has recently faced more serious issues than stereotypes of bearded hipster chief executives.

Europe’s fintech industry was rocked by the Wirecard scandal; when gross accounting irregularities at the German platform prompted regulators to freeze the assets of payment systems plugged into its infrastructure. This in turn affected thousands of small businesses using services such as Anna to manage their vital day-to-day cash flow.

Financial misconduct is not just a 21st century phenomenon, though, and, arguably, fintech innovations will ultimately make deceit harder. What’s undeniable is that this is one of the most exciting parts of the global economy. Research by CB Insights at the end of June 2020 counted 66 tech unicorns (defined as an unlisted business valued at over $1bn) backed by venture capital (VC), worth $248bn in aggregate.

That excludes Ant Group, which is aiming for a world record IPO of $35bn, because its current ownership and funding structure doesn’t fit CBI’s definition of VC-backed. The omission only serves to underline the breadth of opportunities, although with many fast-growing businesses still not publicly listed, private investors in the UK must rely on a few specialist funds to get a piece of the action.

Professional expertise can distinguish the sausage from the sizzle

As well as being able to buy a stake in companies at pre-IPO funding rounds, fund managers’ expertise in weighing up the exciting stories and harsh fundamental realities is invaluable. Neo-banks are a perfect example. On the one hand lockdowns are driving use of mobile banking apps, which is good news for companies that excel in providing that experience; but on the other hand, forcing populations into hibernation left funding conditions largely contingent on central banks.  

Some models are inherently less resilient. Monzo, for example, relies heavily on interchange income from card transactions by its millennial customer base. Shutting down expensive coffee shops and grounding city-break travellers choked off that source of revenue.

Furthermore, although deposits did increase by £930.7m in 2019-20, it is unclear what percentage of its 3.9m customers used Monzo as their primary account. If customers were just funnelling cash into Monzo to take advantage of features such as low foreign exchange commission when visiting abroad, then clearly lockdowns and travel bans will have hit the company hard.

Focusing on robust core metrics is crucial and has informed Merian Chrysalis Investment Company’s (MERI) holding of Starling Bank. As well as opening 1.5m accounts (including nearly 200,000 business accounts) since launch of the banking app in May 2017, the deposit base has swelled to more than £3bn.

Merian Chrysalis co-manager Richard Watts says: “We are extremely pleased with the progress of Starling since we invested and more recently against a tough backdrop. Starling is building a sustainable bank with proven economics, evidenced by the fact that the business is set to reach profitability by the end of the financial year.”

Building a strong position in the small to medium enterprise (SME) market is a strength, but the effects of further restrictions to contain coronavirus this winter must be considered a threat, too. Starling bank has £900m of SME loans on its balance sheet, but has been accredited for the Coronavirus Business Interruption Loan Scheme and the Bounce Back Loan Scheme, which should help it support its customers and stay resilient.

By contrast, Monzo appeared much less assured when it released its annual numbers, with the report flagging a material risk to the business as a going concern. Investor doubts were already evident when its series G funding priced the company at a 40 per cent discount to its previous valuation.

A shake-up at board level has seen youthful founder Tom Blomfield step aside as chief executive for TS Anil, a banker with 25 years’ experience, who had been heading Monzo’s expansion into the US.

Changes are to be expected both in management and strategy as fintech businesses mature and strive to become profitable. German bank N26 has shifted its commercial focus, exiting the UK market and focusing on the US and Brazil.

There is also stiff competition in larger countries. Nubank, headquartered in Sao Paulo, has grown its user base by 25 per cent since the start of 2020 despite (or perhaps because of) Brazil suffering badly from coronavirus. Likewise, in America there are success stories such as Varo out of San Francisco. It has doubled users to 2m since late 2019 and has also seen a 350 per cent rise in deposits.

Banking on lower costs and a better customer experience

Funding and solvency remain the primary questions for any bank, neo or otherwise, but for those already on a path to sustainable growth there are considerable cost advantages both in providing services and winning customers.

June’s Capgemini Global Banking Survey revealed distribution and channel costs for digital-only banks have much lower costs as a percentage of operating income and an average cost per customer acquisition of between $1 and $38, compared with $200 for incumbent banks.

Competition from nimble upstarts is yet another headwind for UK-listed banks, which struggle to move as fast to improve customer experience. Neo banks leverage partnerships with flexible open-platform technology and have built and managed their customer databases since rigid data protection rules came into force. This enables them to rapidly implement learnings to keep improving digital banking.

Hope for the incumbents could be at hand, however. More fintech businesses are now emerging not only to disrupt large banks and other corporates, but to help them adapt. For example, Yobota offers platform solutions that can help financial companies deal with legacy technology stacks. Furthermore, the open yet secure nature of technology, means incumbents could take advantage of several best-in-class vendors to solve problems.

Explaining the proposition, Yobota chief executive Ammar Akhtar says: “In an age of API [application programming interfaces] interoperability, where everyone designs their product as a service, the complex integration problem many large banks and corporates face kind of goes away.”

Potentially that means, with the right providers, big banks can rapidly improve their operations, including processing, account services, payments, credit decisions, identification checks and user experience in all important channels such as mobile. The challenge should not be underestimated, however, with the question of data (a heavily regulated area) to the fore.

The siloed nature of data capture over many years means traditional banks face a Herculean task in putting to use the vast pools of information they hold. Just over a quarter of incumbent banks were rated as data experts by the Capgemini report. Those that lag in this core competency face a serious barrier to matching the hyper-personalised experience offered by the neo banks.

When it comes to competitive advantage, the new banks with sustainable models and resilient balance sheets are in something of a sweet spot. Early-mover advantage has been had and it would be harder for further market entrants to get established.

Consolidation could be the order of the day in the current climate, although Chime bank (which is now America’s highest-valued fintech) continues to innovate. Automated savings and especially a feature speeding up the clearing of salaries, could be game changing. Furthermore, Chime’s zero fee mobile payments also cut time between transfers.

Payments the prize for Big Tech

Integrating the process of moving money with messaging apps is a cornerstone of tech companies’ strategies for emerging markets. Users want to seamlessly make payments and chat simultaneously on their smartphones without toggling through tabs.

Western businesses lag China’s WeChat (owned by Tencent), but are making huge investments. Facebook’s (US:FB) main social media platform and WhatsApp, which it owns, are integrating payments – the decision to trial in India speaks volumes. Amazon, Google and Apple are also making strides.

Emphasis isn’t just on emerging markets or remote transactions. British consumers who’ve ventured to the supermarket in person will have noted that Apple Pay and Google Pay both have bigger limits on tap payments than bank debit cards.  

Does this signal banking is the next domino to fall to big tech? Tim Levene, managing director of investment trust Augmentum Fintech (AUGM), thinks not: “They’ve been quite wary of the challenges of regulation, these are heavily regulated financial services businesses, which is not in line with the nimble attitude of Google or Amazon. [So they have] dipped their toe in cautiously.”

Traditional lending isn’t the game to get into in a low interest rate world, but big tech’s move into payments does threaten to shut high-street banks out of growth areas in retail finance, making the old banks less attractive as long-term investments.

Some high-profile merger and acquisition activity demonstrate other big businesses understand fintech is key to protecting their turf. Scale and expertise provide payment giants with competitive advantage, but they aren’t resting on their laurels. Earlier this year Visa bought Plaid, and Mastercard followed suit, snapping up Finicity; both were strategic moves for cutting-edge technology to optimise hugely valuable financial data.

Deal activity in payments businesses held steady in the second quarter of 2020, according to CB Insights.  Lockdowns have accelerated the e-commerce megatrend and, regardless of economic uncertainty, if they had the cash, companies from a variety of industries weren’t sitting on their hands when it came to embedding fintech solutions.

The rate of year-on-year growth for online retail spending increased fourfold between March and July and reducing payment friction is key to businesses not being left behind. Point-of-sale credit is also partly facilitating this acceleration, with speed, security and big data capabilities essential. Businesses such as Sweden’s Klarna (a large holding for the Merian Chrysalis investment trust) are building significant traction in point of sale (POS) credit.

There are other niche ways to play the trend, too. Investors Chronicle’s Simon Thompson uncovered Aim-traded ThinkSmart (TSL) which had a stake in payments platform ClearPay. The shares have tripled since Simon first published his Alpha report and one strand to the investment case was that ClearPay is potentially on Tencent’s radar.

Fintech intertwined with emerging market growth

China’s growing middle class and shift to a consumption-based economy is another megatrend that converges with technology. How Tencent competes with Ant Group for dominance in the enormous payments market in China and the rest of developing Asia will be fascinating. There are UK-listed investment trusts focused on exploiting such opportunities.

Austin Forey, manager of JP Morgan Emerging Markets (JMG), cites the youth population of China, which at 400m outnumbers the combined working population of Europe, as having a profound impact on the opportunity set of companies.

The shift towards social networks, e-commerce and software has been profitable for investors. Mr Forey says: “These business models are enormously profitable without needing to invest vast sums of money, in turn generating higher returns to shareholders. We strongly believe that growth in this sector is likely to continue to accelerate over the years.”

Digital growth in all emerging markets is already spectacular, and by 2022 upwards of 3bn internet users will live in these countries, but Mr Forey believes investors should take a bottom-up view of the businesses likely to achieve competitive advantage. He says: “Investors should consider the growth potential of a specific company, rather than taking a view on a country.”

Investment trusts such as JP Morgan Emerging Markets and Schroder Asian Total Return (ATR) have sizeable positions in Tencent and Alibaba (considered China’s Amazon), making big names in Asia tech more easily investable. All eyes will be on Ant Group’s listing, which is directly material for Alibaba thanks to its 33 per cent stake in the payment platform.

Fund managers will not be drawn on the Ant IPO, nor on broader issues of governance around Chinese companies. Certainly, it’s a controversial topic at a sensitive moment; the Ant listing has revived unwelcome scrutiny of the way Alipay (Ant’s old name) was spun out of Alibaba nine years ago.

Revolutionising old industries

Emerging market investments have always had a racy side to them, but that’s part of the trade-off for exposure to exciting growth stories. In the West, some previously rather dull industries are being swept up in the fintech boom, although the questionmarks here are around valuation.

Smart insurer Lemonade (US:LMD) has had a bumpy time since its IPO at the start of July, although that’s hardly surprising given its listing market capitalisation of $4bn valued it on a multiple of more than 50 times trailing 12-month sales.

The insurance business was the foundation for Warren Buffett’s Berkshire Hathaway empire, and GEICO has been one of his best all-time stock picks, but Lemonade’s listing highlights just how difficult it is to repeat Mr Buffett’s old strategy of buying quality at a low price.

In July, a tweet by Ian Sigalow, of New York venture capital firm Greycroft, noted that at Lemonade’s valuation multiple, GEICO would be worth $800bn. That’s almost twice the market cap of Berkshire Hathaway and, at that price, many investors would no doubt prefer to stick to Cherry Coke. The eye-watering price of companies once they list reinforces the wisdom of buying funds that invest pre-IPO.

The opportunity is huge, however. On the Tesla (US:TSLA) fourth-quarter earnings call in 2019, Elon Musk highlighted how learnings from smart cars can improve embedded insurance options, potentially another revenue stream for Tesla.

Investment platforms are also changing rapidly. These range from very recent upstarts that have taken the world by storm, to slightly older brands getting a fresh wind. In the former camp, Robinhood has been credited with democratising investment, especially for younger investors.

On the other side of the spectrum, Interactive Investor, which by the admission of Tim Levene whose Augmentum Fintech is a major investor, was “a bit of a sleeping digital dinosaur”. Thanks to a new dynamic focus, this profitable business now manages £36bn in assets and he sees it as offering UK investors a compelling digital alternative to market-leading platform Hargreaves Lansdown (HL.).

Being socially useful and sustainable

Bringing the opportunities of investing to a new generation and giving more people a stake in the success of capitalism ought to be applauded, but there are negative aspects to platforms like Robinhood. Grumblings that it hasn’t adequately helped investors understand risk and reward are reasonable, as are concerns that some of the app features gamify investing and encourage overtrading.

As the fintech revolution touches more aspects of our daily lives, the risks must be assessed alongside the progress. Facilitating the flow of money around the financial system and the regular economy is of huge benefit, although regulators are rightly considering downsides.

Buy now, pay later technologies such as Klarna’s point-of-sale credit facilities have attracted the eye of the Financial Conduct Authority (FCA), which is mindful of the debts being accrued, particularly by younger shoppers. Perhaps this should concern investors in POS companies, although these businesses are very different from lenders that have targeted low-income groups in the past.

For example, payday loan companies charge annualised percentage rate (APR) interest of over 1,000 per cent in some cases. Compare that with Klarna, which is interest-free and spreads payments over three instalments. The nebulous argument trotted out in support of payday loans was that they prevented low earners being marginalised in getting access to credit. That didn’t really hold water for those products, but the logic arguably is applicable to 'buy now, pay later'.

Other fintech services like such as the pay cheque advance services integrated into Chime bank’s offering in the US can be a boon to the underbanked. There are also fintech services such as Gusto, which makes it easier for companies’ payrolls to give employees early access to earned wages.

Small and medium-sized businesses will also benefit from other cash-management technology. Another Augmentum holding, Previse, was in August awarded a grant by the Banking Competition Remedies’ Capability and Innovation fund. Using artificial intelligence (AI) algorithms, Previse helps big companies identify payables they won’t dispute to be cleared quickly and helps small businesses offer targeted incentives for early payment.

Shortening working capital cycles has clear benefits for businesses and society, especially with all the damage lockdowns have done to the economy. It also gives lenders the confidence to support businesses through the downturn and in less extreme times, which could boost standards of solvency and justify expanding the market for offering loans.

Providing a boost for economies fighting back

Fintech start-ups offer many benefits for the world economy, notably improving the flow of cash and potential liberalisation of capital markets. All of this is possible thanks to secure open platforms which enable the sharing of data between sources using their own application programming interfaces (APIs).  

Services reliant in part on plugging into third-party technology, especially in sensitive areas like payments, does create the possibility of Wirecard-type failures. Although it should be remembered that this was one bad apple and wasn’t big enough to cause a systemic risk. High-profile neo banks had no connection to Wirecard at the time the scandal broke and the failure to act on warning signs is mainly an indictment of the German regulator.

For investors it’s yet another reminder of the importance of due diligence. The same is true of start-ups choosing suppliers and partners for critical infrastructure. This is probably where the naivety of founder-owners can be exposed, so other savvy backers of the companies is a good sign. Funds that take a seat on the board of fintechs also provide reassurance.

Such presence also helps bridge the culture gap between some (but by no means all) of the new wave of start-ups and investors who are more old-school. That said, you don’t have to be a hipster to appreciate that owning a slice of companies shaping the future of finance is a tantalising prospect.