What smart investors look for when investing in fintech companies

Despite some surprising companies, many fintechs are poor investments, beset with serious flaws in their business models and operational performance. We are in an era of extreme technological change, but the need for cheap money and growth has blinded many investors to risks.

Investors need to focus on the core product first. The key question is, what problem is the fintech firm trying to solve? Does it add value to customers and is the product better than its competitors? Surprisingly, I have seen a lot of fintechs where these basic questions are not asked. A good example is the myriad of blockchain companies, many of which are trying to find a problem that fits their purported solution. Their products may be technologically sophisticated, but are they good enough to make customers switch?

The wider problem is that many firms lack a viable strategy. Rapid product rollouts, a slick user interface or innovative technology are often cited as key competitive advantages, but are not strategies in themselves. The cost is also not low. In many cases competition can also lower its pricing, crushing returns. How long could firms such as money-transfer firm Wise plc or Revolt Ltd survive if a major incumbent such as HSBC Holdings plc started a price war by offering similar foreign-exchange rates?

A poor fundamental strategy is common and can often be detected by firms entering “red ocean” markets. A Red Ocean is an existing market with lots of competition. Typically, returns are determined by market forces and can be extremely difficult to disrupt. Unless you are trading very differently, you are going to be held hostage to these same forces and see disappointing returns. So the weak performance of European challenger banks such as Metro Bank plc, Monzo Bank Ltd or the Peter Thiel-backed N26 GmbH should dampen it. There is no surprise. They were doing nothing fundamentally different from the incumbent. As Thiel said, most firms fail because they fail to survive the competition.

In contrast, “blue ocean” strategies are overlooked. A blue ocean is one where there is a lack of competition and the opportunity to create new demand. A Blue Ocean strategy may start at one position in the current market, but may expand or even build one. Completely new market. This is often where true disruptions arise. The best example is Amazon.com Inc., which began selling books and expanded into new markets such as cloud computing.

Unfortunately, many fintech management teams lack the skills or understanding of the complexities of the markets they are trying to enter. The markets they are trying to disrupt are often highly regulated with complex dynamics. Electronic money, or e-money, payments firms have had a particularly difficult time.

Deep knowledge of financial markets is often absent. Money is probably one of the oldest “technologies” in existence, yet what many cryptocurrency proponents don’t realize is that bitcoin is essentially an old idea – private sector money – in a new form. Private sector money has a checkered history and has often been run by governments trying to protect their monopoly on money. Various well-known behavioral misconceptions abound as well, such that the enormous energy use creates the underlying value. It’s not, it’s almost a classic sunk cost.

Does this mean that the entire crypto universe can be casually written off as a useless fad? I do not think so. It seems like something will emerge from massive innovation in the digital asset space, but I suspect that until these critical issues are addressed, early-stage cryptocurrencies will prove to be the ultimate winners. It would be very unusual to get an innovation in the first place.

Many of the problems with fintech stem from the wider venture capital industry. The liquidity-filled industry has seen huge growth in recent years and there has been enormous pressure to deploy capital. Red Ocean markets already exist and their size and value can be determined relatively easily. Groupthink is widespread, and trendy investment themes attract lots of capital but increase competition. In contrast, Blue Oceans can start from unlucky places, so it’s very hard to imagine their true potential or where skilled management teams can lead companies. They also require more patience.

Starting with a flawed business model means that many fintech start-ups are focusing heavily on achieving high valuations in the next round of funding, while the need to become profitable appears to be secondary. Given the lack of profitability, valuations are often inflated. Many of these businesses will struggle in the next recession.

Technological revolutions often come in waves, and we may be only half way through a multi-decade. They can make a profound difference in how business and even societies are structured in ways that are hard to predict. The expansion of the auto revolution enabled suburbanization and changed the way we shop. Based on valuations, Walmart appears to be a bigger winner with automobiles than the car companies themselves.

It can take years for winners to emerge, and the biggest winners may be from other industries entirely. Instead of chasing trendy topics at exorbitant prices, investors should perhaps consider more Blue Ocean opportunities or simply be patient. Some of the best times to invest in technology in the past cycle were after the crash and history may repeat itself.

This story has been published without modification in text from a wire agency feed. Only the title has been changed.