Fintech comes of age: invest in the future of finance
The financial technology sector covers areas ranging from digital payments in emerging markets to bolstering high-street banks' crumbling IT infrastructure. Years of strong growth lie ahead, says Stephen Connolly
by: Stephen Connolly
The world's first cash machine was a key milestone in the history of financial technology
© Tom King/Mirrorpix/Getty Images
"Fintech", short for financial technology, is often dismissed as yet another buzzword – a way for companies to market themselves and raise money. But there is a great deal more to it than that. Think of it as a sector bringing together money and new technologies to improve financial services. It is closely linked to major technological advances in several other areas.
One is artificial intelligence, which can help financial services companies make decisions about loans, for instance, or help customers by installing robo-advisers to answer questions. Blockchain, the electronic ledger that underpins bitcoin, can help manage transactions more efficiently; data storage and processing advances help companies achieve more scale for less cost; and internet connectivity, through cloud computing, means they can embed their services in everyone's daily lives across all their devices.
The stockmarket sees the potential
Equity investors certainly see plenty of potential in the sector. It has generated near-10% returns this year while some markets, such as the S&P 500 in the US, are just breaking even. This is due to both the compelling long-term outlook and short-term factors. In lockdown, people were forced to change their habits and turn to online shopping, payments and e-commerce to get by. Many won't go back. All these areas of fintech were already growing; what the virus has done is accelerate the take-up. Throw in the structural tailwinds from various technologies and no wonder more and more investors think the fintech sector is a smart place to be.
Fintech was profitable before Covid-19 too. Investors have been getting a stellar 23% annual return, if averaged out over the last three years – and that's just by investing in a benchmark and not being clever at choosing individual stocks. And most studies expect the sector to expand by more than 20% a year to 2025 and beyond.
Upstarts take on the old guard
A look at recent developments illustrates the potential. One source of growth is that big, established financial services groups need the expertise of fintech businesses to help them change and adopt new technology. At the same time, however, the internet allows fintech firms that can raise funds to enter the market themselves and disrupt the old guard.
An online presence means reaching a market without investment in bricks and mortar. And platforms can be built using other providers who can offer the transaction management, the data processing and the joined-up infrastructure. It is becoming increasingly straightforward for new players to enter the sector. A good example of an early disruptor is mobile-payments company PayPal, while online, "virtual" bank Monzo offers accounts in the UK without a single branch.
Fintech can be hyped as a "David versus Goliath" battle between small, plucky upstarts armed with attractive deals and services fighting to free us from the tyranny of evil bricks and mortar banks. This narrative has been tarnished this year, most notably with the financial scandal unfolding at German payments company Wirecard. While it would seem its demise is a case of fraud rather than faulty technology or a flawed business model, it's a warning to investors and regulators. Visionary entrepreneurs, start-ups and disruptors are all well and good, but the desire to encourage them should not come at the expense of supervising them effectively.
Challenger bank Revolut, meanwhile, has lost several top-level employees this year and has been accused of having a dysfunctional work culture. Monzo, on the other hand, has been scoring highly in the customer-complaints league. The US online stockbroking platform Robinhood has had technological breakdowns locking people out of trading just as prices move against them.
It's all a far cry from the fintech of old. In June 1967 nobody waiting in the crowd outside the Barclays Bank on north London's Enfield High Street could have imagined they were about to witness a major milestone in the long history of financial technology. For them, the attraction was an appearance by Reg Varney. He is still just about remembered today as the star of ITV's sitcom On the Buses. He was there to launch what was the world's very first automated cash machine. And now, more than 50 years later, there are 3.25 million more cash machines globally.
The first cash machine built on previous advances. In 1866 the first reliable transatlantic cable was used to send foreign-exchange price data (hence the term "cable" to denote the exchange-rate between the pound and the dollar). The US Federal Reserve's Fedwire system launched in 1918 and used the telegraph and Morse code to transfer money. Credit and charge cards were appearing in the US in the 1950s, while Barclays launched Britain's first plastic card – the still surviving Barclaycard – in the 1960s.
It's not just retail banking. Finance everywhere was sped up by the major breakthrough of the handheld calculator in the late 1960s (previously they were big and generally built into desks). Electronic share trading arrived in the 1970s with the world's first digital stock exchange, America's Nasdaq. The Swift system, a name that will be familiar to anyone who makes international payments, came soon after. This international code remains a very common way in which banks talk to each other as they move funds around the world. The 1990s saw online banking, and hence e-commerce, take off.
Towards a cashless society
Despite fintech's rich past, the sector today is often associated most closely with innovations in how people pay for goods, especially online, and pay each other outside the traditional banking and financial system. Digital payment is a major theme globally and a significant driver of fintech. The world is shifting away from cash. Covid-19 has accelerated the trend. Suggesting people avoid cash to limit potential transmission of the virus has been a boon for traditional banks and credit-card companies, as well as other payment-system providers. According to the British Retail Consortium, even before the pandemic cash payments were in third place behind debit and credit cards. Retailers handed over £1.3bn in fees to payment companies in 2018. No wonder, then, that the share prices of PayPal and Square are up by 65% and 100% respectively this year.
Sweden, with a young, tech-savvy population, provides a glimpse into the cashless future. Cash usage has declined rapidly as people embrace paying electronically. At least 4,000 Swedes have even had microchips inserted under their skin allowing them to make payments with the wave of a hand. Italy, on the other hand, where cash payments are still relatively high at 86%, is actively promoting the use of cards in a bid to reduce tax evasion totalling an estimated €100bn a year by offering tax cuts for users of plastic.
The most promising sub-sectors
When it comes to profiting from digital payments, the best opportunities are likely to lie among the bigger companies building scale that brings with it greater business efficiencies and better margins. These firms should provide the strongest returns from the favourable underlying digital trend. We like the payment processor Visa, for example. The pursuit of scale is a theme that has already been playing out in the US, with a series of significant mergers involving firms such as Worldpay, First Data and Global Payments. The European landscape remains much more fragmented as individual countries adjust to digital payments at varied speeds, but the wave of consolidation in the US is likely to be repeated in Europe, particularly as some companies' funding has dried up owing to the pandemic.
Supplying financial services giants with fintech
Beyond digital payments, another attractive theme within the sector is fintechs bolstering established financial services providers' technology. A good example is Britain's high-street banks, which, owing to underinvestment and several mergers, are sitting on dated and cobbled-together software applications and processes dating back to the 1970s. IT shutdowns are frequent, with customers sometimes locked out of their accounts.
These banks need to turn to fintech companies to get the calibre of support necessary not only to maintain existing systems, but also to redesign and replace them. They can't do it in-house because fintech talent is loath to work in big bureaucracies. The longer banks sit with legacy systems the more urgent upgrades become and the more vulnerable they are to commercial and regulatory risk.
Fintech companies can also help big banks plug gaps in their IT capability. They can offer a system to run current accounts, for example, which a bank could buy and offer on its own website platform. Robo-advice is becoming more common, while artificial intelligence can help make lending decisions because such systems can absorb the relevant information and apply it. Many insurance and asset-management businesses would now find it very hard to operate without fintech support. Of course, with money – and especially money on the move – comes fraud. Fake emails, credit-card fraud and the theft of customers' data are all becoming more common. This means plenty of opportunity for companies that can stop hackers, protect data and contain viruses.
New customers in emerging markets
Fintech has already developed quite strongly in China and India, two huge countries with populations making and earning more money. In China, making digital payments is much more common than using cash or even credit cards. In 2011 only 3.5% of payments were made on mobile phones; by 2019 the figure had risen to a staggering 85%. There are big players such as WeChat (China's equivalent of WhatsApp) that offer these services and there are also several smaller companies poised to enter the market. India, meanwhile, is capitalising on digitalisation to offer financial services to its rural population. Eye and fingerprint recognition technologies help get accounts up and running quickly.
And beyond these two regions offering significant growth opportunities there are around two billion people in emerging markets who haven't got bank accounts. Fintech is helping countries get them included in the financial system more quickly, with mobile-phone payments key. Many of these countries are essentially building nationwide banking infrastructure without the need for a widespread branch banking network and unencumbered with a legacy business that needs modernising.
Ultimately, technology, whether financial or otherwise, will be – or should be – judged not simply for what it is, but also for what it achieves for its ultimate users. Bringing billions in emerging markets into banking, being able to lend to isolated communities with no presence on the ground, or helping workers pay bills online are all strong and irreversible benefits.
Fintech investors should be on their guard, however. Incumbents can be unexpectedly hard to topple (there are plenty of "old guard" businesses still in profit in spite of intense competition), while start-ups can be immature and untested, moving from being a disruptor to becoming outdated in no time. Transformation takes many iterations before settling. But the gains and successes outweigh the failures. Selecting where to invest is tricky and our preference tends to be larger businesses with strong positions and unique offerings, or a funds-based approach: diversification might blunt returns, but the overall sector is doing so well that it is still easily ahead of the wider market. We list our favourite ideas in the box below.
Stephen Connolly writes on finance and business, and has worked in investment banking and asset management for over 25 years (sc@plainmoney.co.uk)
What to buy now
Visa (NYSE: V), the card giant processing hundreds of millions of payments a day, isn't a bank or a lender. It simply uses its technology to help banks, their billions of customers and some 50 million merchants connect and settle their transactions.
Its global network has been decades in the making and can't easily be copied – a significant barrier against new entrants. It follows fintech developments closely and it buys and supports other businesses in the sector to keep itself at the sharp end of innovation. A secure business with big profit margins, Visa has a solid long-term growth outlook.
We also like Mastercard (NYSE: MA). Its recent results have been a little subdued, but we expect growth to accelerate. Like Visa, Mastercard should be a beneficiary of the so-called "new world" post-Covid-19. Already people are out and beginning to spend again and this will become apparent in future results.
Both credit-card companies are extremely well-placed to gain from the shift away from cash usage. They are deemed strong brands around the world. When it comes to financial dealings with businesses and individuals, having the backing of a trusted operator makes a huge commercial difference.
Another key beneficiary of the switch to online shopping during Covid-19 has been PayPal (Nasdaq: PYPL). It is also extending its reach, having been approved in the US as a distributor of relief funds to individuals as part of federal aid packages.
This is an important step as it shows PayPal encroaching further into traditional banking territory: many recipients of government support don't have traditional bank accounts.
The shares have been a good investment so far this year and the company has been a reliable big tech outperformer over the longer term.
Support for the stock should endure despite its strong recent performance and $206bn market valuation. Strong growth coupled with expanding margins will continue to attract investors to this ongoing success story.
Another stock ahead of the market this year is Palo Alto Networks (NYSE: PANW), a $23bn company that offers security solutions to keep online activity safe.
Recent results have been strong and events such as the recent Twitter hack are reminders that cybersecurity is a growth area. Covid-19 may have delayed some projects, but it will catch up. We would expect sales growth to keep outstripping the market and see plenty of scope for further share-price rises.
For a managed approach to the sector comprising diverse opportunities with a good geographic spread, consider the UK-domiciled AXA Framlington FinTech fund. It's not big at only £75m, but has been around for some time and has delivered nearly 10% so far this year.
It sees significant growth for the sector post-Covid-19 and further gains from the disruption that innovation and technology can bring.
It has a global remit and a broad approach, investing in established players and younger entrants across areas including payment processing, financial software and cybersecurity. The fund's total ongoing charges are around 1.6%.