LO Funds
Global FinTech

Performance Comments

The bulk of our portfolio holdings published their earnings results in February. Among the c. 80% of companies that reported, sales growth came in at around 11%, with 13.5% earnings growth. These are strong results, especially when compared to the previous year, where sales growth was substantially lower. Based on these results, one might assume a good performance during February, but it was quite the opposite. The market does not necessarily react to earnings so much as outlooks, which have become more cautious, resulting in negative returns for many of the companies that reported within our FinTech universe. There was also a degree of nervousness, given the high return volatility in the days following the earnings announcements. This phenomenon was not confined to FinTech, with the semiconductor sector and Mag7 companies, for example, having a similar experience.

The end result was that the FinTech portfolio underperformed its benchmark and handed back the outperformance from the start of the year. Within FinTech, we are the most conservatively positioned fund, and as a result achieved the best performance among our peers, with extreme swings (as high as 20% intra-month) for our high-beta peers. Our Fund is one of the few that is still up from an absolute perspective year-to-date, but the earnings season was tough. Luckily, we still have our Asian FinTech holdings to compensate. Just as in the previous month, our Chinese and Japanese holdings contributed positively to February’s performance. The Asia-Pacific part of our portfolio was up 12.7%, versus our US exposure, which was down 6.6%. Investors are reallocating out of the US and towards Europe and Asia. It also helped that the Chinese government and central bank increased stimulus via increased banking guarantees and low interest rates. It could very well be that we have seen the bottom in terms of the negative read-through from the property sector for internal consumption and that the path to economic recovery has opened. Our payment companies are among the first to benefit.

The Fund delivered negative absolute and relative returns in February. Allocation contributed positively, but our stock selection during the month pushed the total contribution into negative territory. Especially within financials (our payment companies), this effect was large. The price reactions to earnings outlooks were particularly sharp for US payment companies, with the likes of Block, Paypal and Wex all down by double digits. These companies rallied during the second half of last year, and we could see some profit-taking on some of these names, but valuations suggest the bulk of payment companies are still cheap – not only relative to their own histories but also relative to other sectors with similar growth and earnings characteristics. We believe this will need to correct going forward, but we would prefer the direction of that correction to be the reverse of what we saw in February. In terms of our FinTech categories, Enabling Technology and Upcoming FinTech performed worst (-3.4% for both), with Established FinTech only slightly better (-1.8%), as one would expect given the volatility. The stocks that contributed most to the Fund’s relative performance in February were Rakuten (+20.5%), FlatexDEGIRO (+15.9%) and Yusys Technologies (+30.8%). The worst performers were Block (-28.1%), PayPal (-19.8%) and Endava (-26.2%). The portfolio’s current positioning comprises 44% Established FinTech, 37% Enabling Technology and 19% Upcoming FinTech.

Market Review

Bond yields fell slightly in February, with the US 10-year now at 4.25%. The Bloomberg Commodity Index was up 5.5% intra-month, only to close up 0.5%. The pressure came from gold and Crude oil, both of which were down, but the swings came from soft commodities like corn and wheat, which were down 10% intra-month as sales fell short of expectations (down 50% in the last week of the month versus the prior week). It is uncertain whether this would have remained the case given the macro developments in the Oval-office during the last weekend of February. The VIX ended at around 20, up from 16 the previous month.

Thematic Insights

FinTech stocks provide natural hedges against rising inflation and a potential economic slowdown. Physical payment companies (payment processors and merchant acquirers that focus on physical stores as opposed to e-commerce) tend to benefit most from this natural hedge. Fundamentals for payment companies have been strong and the outlook remains positive. We do see a slowdown on the software side, which is why we have repositioned the portfolio away from the more expensive software names and towards the cheaper, quality payment companies. We also believe high-quality companies will benefit more than their loss-making, hyper-growth peers, as long as access to credit is declining and borrowing costs are rising. This is because quality companies can fund growth from their profits and cash reserves. Management can also make a substantial difference, and most high-quality companies have a team that has gone through several economic cycles and can navigate most market conditions.

C-suite level discussions are focused on digital strategy, which has moved from “nice to have” to “must have” to remain competitive and meet the needs of all stakeholders. Shareholder rewards have gone to digital leaders: clients expect services to be able to continue in the event of another lockdown, and staff expect the right tools to perform their jobs in a work-from-home environment.

Portfolio Activity

In February, we sold our position in Wex. The company has been a big disappointment since we included it in the portfolio in July 2022. We expected management to be able to execute on the positive developments in corporate payments as well as in their benefits segment, but the latest quarterly results showed the loss of key clients in those segments. This, combined with the challenging macro outlook, led us to sell our position in Wex. With the proceeds of the sale, we bought a new position in Tencent. WeChat Pay accounts for 50% of the Chinese payment market and the FinTech and business services segment accounts for 29% of revenues, hence meeting our purity criterium. With the addition of Tencent, we further increase our exposure to China.

Outlook

The FinTech sector benefits from strong secular growth trends, such as the move away from physical cash, the digitalisation of financial services and the rising role of cybersecurity. The pandemic accelerated these trends through both push and pull forces – businesses have started to invest more in digital infrastructure so they can remain open during any future lockdowns, and consumers are demanding digital services for reasons of health, user experience or convenience.

Our investment process aims to select the highest-quality companies that can benefit from these trends to build a well-diversified portfolio. We believe the most important factors to watch are company-specific fundamentals such as revenue and earnings growth, return on equity (ROE), cash flow return on investment (CFROI) and balance sheet strength. We also monitor macroeconomic factors such as interest rates, inflation and growth. We diversify between Financial and Technology companies, aiming to create a stable, disciplined portfolio that can weather a multitude of market conditions. Within our FinTech mandate, our portfolio management style is best described as “quality growth at a reasonable price”.

Certain segments of the FinTech market are extremely interesting from a valuation perspective. Payments, for example, is a segment that has been sold by many generalists and is only held by a handful of specialist long-only funds. Despite the extremely good fundamentals, active managers and passives all accumulate positions around the Magnificent 7 stocks. As a result, the quality growth at a reasonable price strategy proliferates, particularly in the payments sub-sector where growth (both earnings and top-line) is higher than the market, quality is extremely high (this segment produces the top 10% of CFROIs globally) and valuations show a discount to the market.

Sincerely,

LO Funds–FinTech investment team