How to separate the contenders from the pretenders in this exciting, emerging sector.

You will not find a more divisive corner of the ASX right now than financial technology (fintech). 

To bulls, fintech companies represent a new, scalable frontier for financial services. To bears, fintechs are little more than old banking models wearing new clothes. 

The truth about fintech is somewhere in between. Some new business models have emerged and created immense value for consumers and merchants, richly rewarding shareholders. 

That said, as is typical in winner-take-most markets such as this one, many, if not most, fintechs will not reach profitable scale. The winners will win big while the rest will limp away into oblivion. 

Separating the contenders from the pretenders is key to doing well in this space but, before we get that far, let us briefly review what fintech is about and what has so many investors excited. 

Why fintech has legs

Fintech is about leveraging new tools and platforms to deliver new and or enhanced services to consumers and businesses. Three big trends behind fintech are very real. 

First, Australians are well past the point where they have become comfortable banking and transacting online. A 2018 Roy Morgan survey found that 46.5 per cent of surveyed Australians had used mobile banking in the last year compared to only 45.1 per cent who had walked into a bank branch. 

Expect the transitioning from in-person to online banking to continue – even accelerate – given the cost pressures put on banks from higher capital requirements and the recession from COVID-19. 

Second, trends towards open banking and modular software-product development via APIs (Application Programming Interfaces) both point to a democratisation of data. 

Consumers, companies, and regulators – basically everyone but the big incumbent banks – all want to improve data portability to make for a better customer experience and to improve competition. This is a one-way trend with the big banks losing. 

Third, it keeps getting easier and cheaper to start a business built on crunching big data. Back in the day, a startup spent much of its early money buying servers, which was a capital-intensive guessing game. Today, startups can lean on the likes of Amazon Web Services to only pay for the computational horsepower they need, and the costs of those workloads fall every year. 

And so fintech has some strong tailwinds at its back. Investors must still be deliberate in choosing which horses to back, though, and appreciate that many fintechs will flame out. 

Lakehouse Capital is specific about the traits it seeks in potential investments, and for brevity’s sake I will not try to cover them all now. Here, though, are some traits should be top of mind when it comes to fintech investing:

Massive growth 

Most fintechs, even listed ones, are still tiny compared to the established leaders of financial services. Practically speaking, a fintech will never deliver a big win for investors without posting massive growth in its early years. 

Consider Afterpay. We often hear that Afterpay is expensive. However, the biggest contributor to Afterpay’s share price increasing by roughly 23-fold since the merger with Touchcorp in 2017 is that quarterly merchant-fee revenue is up roughly 23-fold over that period. 

Say what you will about the valuation but, big picture, a business that grows revenue by over 2,000 per cent in three years usually works out well for investors. 

Market-share gains

We see plenty of fintechs growing at what look like strong rates in isolation, but when you zoom out, you see competitors growing just as fast (or faster) off a higher base. 

These second-tier companies are usually much cheaper than the ones gaining a greater share of a growing market, and with good reason, as companies gaining market share usually do so because they have a better product, better distribution, or both.

Odds are that those market-share gainers are delighting in finding customers more efficiently than their peers. 

Even better, not only do these rising leaders devour an increasingly large slice of a growing industry profit pie, they can have their position enhanced as ecosystem partners rally around a winner for the sake of standardisation. 

Attractive unit economics

This is an important corollary to massive growth. Almost any business can pick up a lot of customers if it is willing to let customers, partners, or employees consume all the value. 

For example, it came out in 2017 that a food-delivery startup was running with a gross margin percentage of only 0.7 per cent. While one can appreciate the long-term value of winning a market, it has and will continue to be awfully hard to create value for shareholders when employees, customers and restaurants have become so accustomed to such a sweet deal.

Another reason to focus on unit economics is that they are a better leading indicator of future profitability than the current income statement. 

For example, a well-run software-as-a-service (SaaS) business might be able to generate three dollars in lifetime value for each dollar it spends on winning customers. However, the current income statement will only show the loss involved in winning that customer. 

As longtime holders of Xero can attest, if a business has attractive unit economics and enough funding to see it through to profitability, it is possible that patient, risk-tolerant investors might be early to a good long story. 

Bottom line

Investing in fintechs is not for everyone. The space has tailwinds but many of today’s hopefuls will never reach the heights of, say, an Afterpay. 

For investors with a long-time horizon and a willingness to dig deep on understanding the opportunities, though, it is very much a space worth following.