FinTech: 3 years of pure-play, high-quality investing

In the three years since we launched our Global FinTech strategy, we have maintained a focus on quality growth at a reasonable price, helping us to outperform our peer group¹. We see five key trends driving growth for companies involved the digitalisation of finance. How has the investment landscape changed, and what key challenges lie ahead?

 

Need to know Growth in fintech is being driven by five key trends: the move to a cashless society, financial inclusion, lower barriers to entry, the rise of technology ecosystems and the need for cybersecurity Recent developments – including challenges facing traditional banks and a reclassification of payment companies as financial stocks – have helped strengthen the investment case for fintech, in our view Valuations are also extremely attractive following an excessive depression of multiples in recent years

 

Fintech, or financial technology, has transformed the financial services industry. Think of how much payments and mobile banking have changed in the past 10 years, and then imagine more changes of a similar magnitude occurring over the next decade. The fintech industry was already valued at about USD 194 billion in 2022, with estimates calling for a compound annual growth rate (CAGR) of 16.8% from 2023-2028.²

Our holdings are diversified across three categories: established companies that stand out from peers (established fintech); companies that help the financial industry develop and implement technology (enabling technology); and younger companies with potential to become established  (upcoming fintech).

In general, there are five core areas that we believe will drive investment opportunities in the industry over the next two decades:  

1. The world will become a fully cashless society. An increasingly sophisticated digital payments infrastructure is enabling this transformation. Singapore and the Netherlands currently lead with digital payments, while Italy, Greece and most emerging markets remain largely cash-based societies.
2. Digital finance will lead to financial inclusion for all. A significant number of people across the world lack exposure to financial services. For example, almost a quarter of US households – or 34 million – are either unbanked or underbanked.³ 
3. Digitalisation is lowering barriers to entry in the industry by unbundling services traditionally provided by banks (payments, lending, insurance and wealth management). This boosts efficiency and fosters the emergence of new banking and fintech services.
4. The rise of technology ecosystems is increasing the need for fintech. This refers to  companies (e.g., PayPal, Uber)⁴ that build up large customer bases and then lock them with additional services. With the Banking as a Service (BaaS) model, traditional banks can integrate digital services directly into the products of non-bank businesses. These tech-ecosystem companies need fintech expertise, creating a large B2B opportunity.
5. Cyber security is a necessity for providers of digital financial services, which are particularly vulnerable to hackers. Regulations aimed at preventing cyber-attacks are strengthening, with higher fines for businesses that lack protection. Cybercrime insurance is a growing area.

Our understanding of the technological, sociodemographic and regulatory drivers of change helps us narrow down our investment universe. We have constructed a balanced high-conviction portfolio of 40-60 companies. Our mantra of quality growth at a reasonable price has proven its value versus other fintech strategies, which implement different investment styles.

Since launch on 6 April 2020, the net annualised performance for the NA share class of the strategy is +7.6%, compared with +14.7% for the reference index, which is the MSCI All Countries World. That said, when compared with a group of peers following a similar FinTech investment strategy, the fund places first out of eight peers we monitor (see Figure 1). It also has the highest Sharpe ratio.

FIG 1: LO Funds – Global FinTech performance since inception. Past performance is not a guarantee of future results.

Source:  LOIM, Bloomberg, 6 April 2023. The peer group methodology cited herein is provided for information purposes only and may be subject to change over time. No fund/benchmark/index is directly comparable to the investment objectives, strategy or universe of our fund. Returns shown net of fees. The performance of a peer group shall not be indicative of past or future performance of any fund. For illustrative purposes only. This document has been prepared by LOIM employees who are encouraged to raise assets for their strategy and may have a conflict of interest.

 

More `fin’ than `tech’

One of the most significant developments since our launch occurred just recently. We always said that fintech would become the next generation of financial services, and MSCI made this official on 20 March with a reshuffling of the GICS (Global Industry Classification Standard). Digital payment companies were moved out of the Technology group and into Financial Services. They are part of a new sub-industry called Transaction & Payment Processing Services, which includes digital/mobile payment processors, payment service providers and gateways and digital wallet providers.

We plan to discuss the implications of this change in detail in a subsequent paper, but suffice it to say that fintech companies are likely to benefit having a new peer group of traditional banks, insurance companies and asset managers (rather than competing with Big Tech for attention). They compare favourably here, with better profitability than their traditional peers, and stronger growth dynamics.

However, the appeal of payment stocks stretches beyond fundamentals. Concern about rising interest rates in the past couple of years has depressed multiples to the point where valuations are now extremely attractive.

Figure 2 shows some of the latest earnings multiples for a selected group of payment companies. They are comparable to 2008/09 levels. While we do not believe that a 2008/09-type recession is likely, that scenario is priced in, limiting any downside. Management teams have recently reiterated their growth targets and long-term outlooks. We expect M&A to play a more important role in the payments space going forward, as companies seek to expand margins through economies of scale. 

 

FIG  2. Earnings multiples for a selected group of payment companies within fintech

Source: LOIM, 14 March 2023. Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.

 

Beyond payments

Though fintech is now more of a financial strategy than a technology one, we continue to have exposure to companies that deliver software solutions to the financial industry. Clients are demanding better, faster and cheaper service, and regulators are making increased demands. All of this requires having the right technology.

We focus only on the high-quality names, however, and not on the unprofitable, hyper-growth segment within fintech in general. In a market where credit is becoming less accessible and more expensive, we prefer companies with good free cashflow generation and stable management teams that have a track record in navigating through storms.

This focus, in combination with a strict portfolio construction discipline – limiting our single stock exposures; diversifying over sectors/ themes and geographies; incorporating ESG/ liquidity/ valuation and cyber risks in the size of positions – has resulted in the lowest volatility in the peer group. This is illustrated in figure 3.

We put a lot of effort into managing risks. In particular, we have created a multi-step process to screen companies for cybersecurity risks and engage with them on mitigation measures. We intend to add more cybersecurity screens and sources, and we are expanding into studying both software-vendor and cloud-provider concentration risks.

 

 

FIG 3. Rolling annualised monthly volatility. Past performance is not a guarantee of future results.

Source: LOIM, Bloomberg, 6 April 2023. The peer group methodology cited herein is provided for information purposes only and may be subject to change over time. No fund/benchmark/index is directly comparable to the investment objectives, strategy or universe of our fund. Returns shown net of fees. The performance of a peer group shall not be indicative of past or future performance of any fund. For illustrative purposes only. This document has been prepared by LOIM employees who are encouraged to raise assets for their strategy and may have a conflict of interest.

For more on our cybersecurity risk methodology, read our white paper here.

 

Constant change

Since launching our Global FinTech strategy three years ago, we have outperformed our peer group and experienced comparatively less volatility with a pure-play portfolio best characterised as quality growth at a reasonable price.

Successful trends investing involves the ability to monetise behavioral inefficiencies in the market, where the impact and pace of change is underestimated in the long run. With fintech, new technologies are both transforming legacy financial services providers and enabling new types of services.

The market is constantly changing, requiring a special expertise. At LOIM, we have demonstrated an ability to separate short-term hype from the companies making real earnings driven by long-term trends.

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