Upstart Stock: New Concerns Emerge (NASDAQ:UPST)

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Shares of Upstart Holdings (NASDAQ:UPST) are down 75% over the last 6 months alone and investors are wondering if this is a good time for bottom fishing. Many bulls feel that the stock is grossly undervalued and offers a good risk-reward ratio at current levels, whereas others believe that rising demand for the company’s AI platform will power its growth and fuel its rally for the years to come. While these make for compelling investment rationale, latest data reveals that shorting in Upstart Holdings has surged to all-time highs. This suggests that the stock can still fall further and investors may want to exercise restraint.

Elevated Shorting Activity

For the uninitiated, short interest is basically the total number of short positions that are open and are yet to be covered. A sharp rise in the figure indicates that market participants actively initiated short bets against a stock as, perhaps, they anticipate it to rapidly decline in value in the near future. It’s a good way to make money off of depreciating stock prices, although its susceptible to margin calls and short squeezes as well, if the price action reverses. But overall, the short interest metric is a handy tool to gauge the Street’s ever evolving sentiment pertaining to any given stock.

As far as Upstart is concerned, its short interest at the end of the latest reporting cycle amounted to 19.08 million. This figure may seem insignificant on a standalone basis. So, to put things in perspective, the company has just over 67 million shares floating in the market. This means that about 28.5% of its entire public float stood shorted at the end of the last cycle.

Upstart short interest

Wall Street Journal

What exacerbates the problem is the fact that short interest in Upstart rose 38% sequentially, and up 595% since last May, to reach its all-time highs. It’s also worth noting that the recent short interest buildup is continuing in spite of Upstart’s stock plummet to its 52-week lows. This indicates that bears are more convinced now, than ever before, that Upstart’s stock price will continue to drop further in the near future.

Upstart stock price

BusinessQuant.com

Next, I wanted to confirm if short-side traders were zeroing in specifically on Upstart, or if its peers were also seeing a rapid buildup in shorting activity. If it’s the latter, and the bets are industry-wide, then Upstart wouldn’t come across as the odd one out in its peer group after all. But that wasn’t the case. Note in the table below that shorting activity in Upstart is particularly elevated when compared to its peer group.

Short interest for Credit Services companies

BusinessQuant.com

This leads us to the question – why are market participants so bearish on Upstart in the first place?

The Bearish Rational

The largest concern surrounding Upstart Holdings, is that we’re in a rising interest rate environment and nobody knows as to how adversely it’ll impact the company going forward. Upstart’s management says they’re prepared for rising interest rates and many investors also feel that the worst is priced into the stock. But here’s where it gets interesting.

Upstart’s artificial intelligence model was trained on data pulled from recent years, when the economy was doing well. But it’s important to note here that its AI hasn’t been trained on data from recessionary periods. What this means is that Upstart’s AI may be adept at spotting rising default rates ahead of time, during times of economic growth, but there’s no telling how its predictions will fare when we enter recessionary times due to the rising interest rates.

The company, in fact, warns investors about this very risk factor in their latest 10-K filing:

While our AI models have been refined and updated to account for the COVID-19 pandemic, the bulk of the data gathered and the development of our AI models have largely occurred during a period of sustained economic growth, and our AI models have not been extensively tested during a down-cycle economy or recession and have not been tested at all during a down-cycle economy or recession without significant levels of government assistance.

This could have serious consequences for the company and its shareholders. See, Upstart-powered loans are unsecured in nature. Borrowers that are on the verge of defaulting on their payments, amidst rising interest rates, may prefer defaulting on unsecured loans than the secured ones. So, any miscalculation by the company’s AI algorithm can potentially lead to catastrophic levels of default rates in Upstart-powered loans. Maybe this scenario takes place, maybe it doesn’t. But the point I’m trying to make here is that Upstart is surrounded by extreme levels of uncertainty and its future prospects remain murky at this point in time.

Secondly, if default rates for Upstart-powered loans turn out to be unexpectedly high, then its banking partners might terminate their working relationship and switch back to their older methods of risk assessment. Another possibility is that the untapped pool of banks might decide to pass on Upstart’s offerings entirely. These scenarios stand to limit and even hurt the company’s growth prospects. Again, Upstart has disclosed this risk factor in their 10-K filing:

Higher default rates by these borrowers may lead to lower demand by our bank partners and institutional investors to fund loans facilitated by our platform, which would adversely affect our business, financial condition and results of operations…Failure to accurately predict demand or growth with respect to our new products and services could have an adverse impact on our reputation and business, and there is always risk that new products and services will be unprofitable, will increase our costs, decrease operating margins or take longer than anticipated to achieve target margins.

This dire situation has encouraged analysts to downgrade Upstart Holdings in recent weeks (such as here and here). I contend that more such downgrades are likely to follow suit and hurt investors sentiment along the way, with more interest rate hikes later this year.

Final Thoughts

To be fair, shares of Upstart Holdings seem undervalued at current levels. The company has been growing at a rapid pace and yet its shares are trading at a steep discount compared to some of the other high-growth credit services firms. So, it’s understandable why many investors think that Upstart is an attractive growth investment.

Upstart peer valuation

BusinessQuant.com

Having said that, if the stock were truly undervalued and bottoming out, market participants would be actively winding up their short positions. But that clearly didn’t happen. What we saw here instead, is that short-side traders are actively betting against the stock with the expectation that the security will quickly depreciate in value in the near future.

Besides, this elevated shorting activity isn’t without merit either. The company can turn unprofitable and its growth momentum can wane quickly, if its AI-based predictions prove to be unreliable during recessionary times. So, in light of all these risk factors, risk averse investors may want to avoid investing in Upstart Holdings for the time being at least. It seems like the stock can still fall further in the coming weeks and months. Good luck!

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