This article is excerpted from Tom Yeung’s Profit & Protection newsletter. To make sure you don’t miss any of Tom’s picks, subscribe to his mailing list here.
Bed, Bath and Beyond Help?
In March, I wondered whether Bed, Bath and Beyond (NASDAQ:BBBY) was beyond help. GameStop (NYSE:GME) activist investor Ryan Cohen had just bought a stake, sending shares up 40%. But could the meme stock master work his magic on another dying retailer?
Two months later, BBBY again showed up on my stock screen as a potential turnaround. And again, I declined to add it to the “buy” list, choosing Crowdstrike (NASDAQ:CRWD) and ZScaler (NASDAQ:ZS) instead.
Here’s where the stocks published in that article stand today:
- Crowdstrike. 13% (buy)
- ZScaler. 9% (buy)
- Etsy (NASDAQ:ETSY). -4%
- Twilio (NYSE:TWLO). -11%
- Bed, Bath & Beyond. -42%
The hesitation on BBBY has since paid off. The home goods retailer announced terrible Q1 results and fired CEO Mark Tritton. Shares dropped again, bringing its total loss to 42% since my most recent recommendation.
The saga highlights the importance of common sense in buying stocks and crypto. No matter how good an algorithm is, they’re often blind to the megatrends shaping our world.
Today, I’ll introduce a new stock highlighting this fact. And though the company is a potential 5x winner, perhaps only the most patient, risk-seeking investors will buy in.
The One Stock Defying Common Sense
The success of investments like CrowdStrike and Zscaler highlights one simple fact:
When it comes to stock-picking… megatrends matter.
These are the patterns that emerge over months… years… even decades. Software businesses like Google (NASDAQ:GOOG, NASDAQ:GOOGL) and Amazon’s (NASDAQ:AMZN) web services only became possible with the maturing of the internet. And hundreds of biotech firms owe their existence to advances in genetic engineering over the past decade.
Nowhere is this clearer than in financials, a sector we covered in-depth last week.
In 2010, the Dodd-Frank Act ushered in a sea-change of regulation. Banks suddenly found themselves unable to take on excessive leverage, making it harder to earn high returns on equity.
Meanwhile, fintech firms motored ahead. In 2018, Rocket Mortgage (NYSE:RKT) overtook Wells Fargo (NYSE:WFC) as America’s largest mortgage originator. And as I noted earlier this week, Charles Schwab (NYSE:SCHW) now earns more income from bank-like lending than from its core trading business, one of the key reasons SCHW stock makes the core Profit & Protection list.
But not every fintech has turned into a champion. Robinhood (NASDAQ:HOOD) has lost three-quarters of its market value since its IPO. And even Rocket Mortgage has fallen 70% as its refinancing business dried up.
Picking fintech winners involves some skill… and quite a bit of luck. And in one special case, low valuations have suddenly tipped the scales in investor favor.
A Beaten Down Stock With 5X Potential
SoFi (NASDAQ:SOFI) is a full-suite financial services company targeting young high-income individuals. The company follows a similar strategy as First Republic Bank (NYSE:FRC) pioneered in the 1990s. High earners are less likely to default on debts than credit scores suggest, so any firm catering to them can use a different set of underwriting standards without sacrificing quality.
SoFi extends credit to those who wouldn’t ordinarily qualify. A top computer science graduate earning $150,000 straight out of school might have no credit history. But in the eyes of SoFi underwriters, it’s more important to consider a borrower’s potential rather than focusing solely on FICO scores like traditional banks.
That insight has launched SoFi into the world of finance. In 2021, the company generated $732 million in non-interest income, making it the 27th largest bank in the U.S. by that metric. And the downward march in share prices now values the company at 1x price-to-book, making it the only bank growing at 72% to receive such an award.
That makes SoFi a coiled spring waiting to go off. Analysts at Morningstar estimate SoFi’s fair value sits at 3x price-to-book, a 200% upside from current levels.
If SoFi succeeds, shares are worth far more. Valuing shares at 4x P/BV like auto lender Credit Acceptance (NASDAQ:CACC) gives a 300% upside. InvestorPlace’s Luke Lango sees an even greater potential of 20x returns over the next decade.
The Downside of Risk-Taking
Not all is well with SoFi’s stock. The company barely makes it into the top 100 of the 382 financial stocks in the Russell 3000 according to the quant-based Profit & Protection system.
- Growth: A-
- Value: B+
- Quality: B+
- Momentum: A+
- Total: A-
That would ordinarily disqualify it from any consideration. And from a qualitative standpoint, SoFi’s current business model is also shaky. In 2021, student loans comprised one-third of the firm’s total origination volume, while home loans made up another 24%.
Both business lines are highly competitive and struggling for survival. In April, SoFi shares dropped 7% after the Biden administration extended a moratorium on federal student loan repayments. The fintech firm has since cut its adjusted earnings guidance from $180 million to $100 million.
Rising mortgage rates are now creating an even larger headache. Last month, rival Rocket Mortgage reported that Q1 loan originations had cratered 48% from the prior year.
The pain will get worse.
“It is very possible we’ll see mortgage rates head towards 7% or higher, reflective of the inflationary environment of the 1980s,” notes Robert Heck of online mortgage broker Morty. “We aren’t close to being there yet, but it’s also not impossible and inflation data will be the market driver of the summer and the remainder of the year.”
These hurdles will dent SoFi management’s ambitions in the medium term. Slowing growth and sagging profits are already sapping investor confidence and driving up the firm’s cost of capital at the worst possible moment. Any cuts to the company’s marketing budget will immediately translate into fewer cross-sales.
“While we do expect the number of multi-product clients to increase, this process will take time and likely require further reward and incentive spending,” notes Michael Miller of Morningstar. “Until SoFi can build these intertwined relationships with its customers there is little to hold them to the firm beyond price and reward spending.”
Even though SoFi has built a similar target audience as First Republic, investors should remember that Lending Club (NYSE:LC) also tried the same strategy to disappointing results.
Is SoFi Worth an Investment?
Investing in SoFi is much like betting on a coin flip or a red-black roulette game.
On the one hand, SoFi could become a fintech success story. The firm already offers brokerage services, insurance, estate and financial planning, auto loans, credit cards, and so on… both directly and through partnerships.
That makes SoFi the only online integrated full-service financial firm. Creating a banking behemoth is now only a matter of execution.
On the other hand, SoFi’s management seems continuously drawn to low-margin businesses to show revenue growth. Student debt, credit card consolidation and mortgage refinancing are historically deadweight businesses of the banking world.
Until SoFi shows it can become a full-service bank, it remains out of the core Profit & Protection buy list. Rising rates could send shares down another 20% from current levels. But because SoFi also has such high potential for returns, it remains on the newsletter’s watchlist for the moment success starts showing.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.