Why I bought SOFI under $8

Disclosure: The author owns shares in the referenced company. This is not financial advice or a recommendation, and not a substitute for due diligence. 

SoFi Technologies, Inc. (SOFI) might be one of the more controversial names that I’ve bought recently, and plan to own for years to come. The stock is extremely volatile and has a strong meme-like following. Given that, why did I buy SOFI? Well, I believe they could be the biggest winner in the aftermath of last year’s Silicon Valley Bank failure.

What is SOFI?

What I like most about SOFI is that the bears do a very poor job of explaining what SOFI actually does when discussing their argument. SOFI began as a student lending organization. At the time of its founding, direct to consumer lending was in its earlier stages. Their success was partially due to the timing of being founded in 2011– although it was three years following the Great Recession that crashed the financial system, there was still significant work being done to rebuild the debt markets. Direct-to-consumer lending at scale via technology was new-ish and its access to capital was growing.

Student lending was a particular mess during that period. You had a lot of the online universities getting sued for offering predatory financing and promoting worthless college degrees. For-profit universities such as ITT were giving student lending a very bad name.

SOFI differentiated itself by focusing on lending to the students at top universities and built a successful niche within the space. The idea of lending to these students– who would likely end up with high paying jobs– was smart.

And it is exactly this part of the company’s history that the bears dwell on when they articulate their thesis. First, you commonly hear them discuss SOFI as if it’s an originator of loans. It’s instead a bank with a broker-dealer arm. Second, SOFI has grown out of being primarily a student lender. Below is the loan mix for SOFI as reported in the most recent quarter. Note that the loan mix has moved toward personal vs. student loans, with personal loans making up ~75% of the loan book. 

How to think about a loan book

Loan mix for a bank is everything. Personal loans as the highest part of that mix means that it is exposed to the highest spread. For a person to correctly assess this book, you need to understand the following:

1. Credit Quality - What is the probability of default or writing a bad loan? 

2. Spread - The rate you are charging vs your funding cost

3. Interest Rate Dynamics - Are you lending into a rising or falling rate environment? Do you have the ability to change the rate on the loan if the funding rates change?

4. Funding Sources - From a funding risk perspective, can the bank even make competitive loans to begin with? Are you able to off-load existing loans to the secondary market? Do you have the ability to hold the loans on the balance sheet in the event that the secondary market for loans becomes a problem?

In this regard, SOFI has been forthcoming about their strength in all these areas. While they do not write about this in the filings, they commonly suggest on earnings calls that the credit quality of their loan book is far above 700, typically suggesting that it is closer to 750. In contrast, a typical big bank will suggest credit scores closer to 650. These 50-100 points are everything when it comes to the default rate of such loans and means that they are originating mostly high quality investment grade personal loans.

Moreover, spreads on personal loans are typically far higher than spreads on other types of loans. In this regard, SOFI has benefited from the fact that the higher end of credit scares has held up considerably better than the lower end. Simply put, SOFI’s risk exposure is where you’d want to be if you are worried about both the future of rates and the shape of the rate curve.

A changing interest rate environment affects every single lender. While some have over-simplified it to the Fed increasing or decreasing rates, you also have a dynamic related to the fact the current yield curve is inverted.

Right now, banks are disincentivized to lend mostly because the approach to hedge that loan is not straight forward. We will discuss the implications of an “inverted yield curve” in greater detail in a different article. 

Simply put though, if the shorter period rates are offering a higher rate of return than the longer period rates, then it pays to have more liquid assets vs long term lending. Currently, even with a declining interest rate environment, it’s unclear whether the curve would revert to “normal” or stay inverted. For banks to start lending again en masse, you would need the curve to revert back to a steeper, upward trending curve.

Given this, Point 4 (funding sources) becomes a competitive advantage for SOFI. One of the unique dynamics of SOFI is that its book not only has very high credit quality, but it also has deposits mostly under $250k. This means that greater than 90% of its total deposits were FDIC insured. 

SOFI’s business is primarily consumer-oriented. Unlike other banks, they do not get the bulk of deposits from large corporations. Most FDIC-Insured banks have 60% or less of their deposits qualifying for FDIC insurance. Deposits are also a lower cost funding source.

Thus, this made SOFI a safer bank for someone looking to move their deposits during the SIVB period. Additionally, SOFI is well-known on the West Coast where SIVB was dominant, and they were already accustomed to paying higher rates to consumers on deposits and you end up with an improved funding mix. Even with higher money market rates, deposits are a cheaper funding source than debt. 

Below you can compare the effect of the shift in funding from debt to deposits. If you are just comparing from 2022 to 2023, you get the wrong picture of how to think about how much SOFI has benefited post SIVB. Yes, the cost of deposits went up a lot. But notice how much the cost of debt increased on a relative basis. The spread between debt funding vs deposit funding went from ~75bps to ~100bps (increasing costs by ~0.25 percentage points). 

It becomes even clearer when we look at Net Interest Margins. This increased from 5.40% to 5.88% or 48bps. Even with increased costs, their margin improved. And this occurred during a period when other banks were in a state of cleaning up their balance sheet, (and not lending at the same levels). 

Even more incredible is that during this period, many banks experienced net outflows, while for SOFI, we see inflows of over $9B in interest-bearing deposits. At the exact moment when other banks could not lend, SOFI both increased and improved its source of funding. This is why I have been saying on YouTube and on Twitter/X that SOFI was a net beneficiary of the bank failures of 2023. 

Business Growth

But what makes me excited for SOFI is that they took their 2022 upside windfall in customers and funding mix to invest in the growth of their financial services business. This is (largely speaking) a self-service asset management business. Typically these businesses are far less rate sensitive. 

They can be market sensitive, however. Asset management, even in a bad market offers predictable, low-risk cash flows. In a bull market, it offers significant upside. And in all cases, you have a large fixed sunk cost with mostly variable costs and limited credit risk. Moreover, the growth of this business allows them to have an available pool of investors to seek out investment banking business once rates decline and the capital markets rebound. 

Bear Considerations

No story is perfect though. Traditionally this stock was not valued with other larger and more established financials. You have the old group of investors focused on metrics that only make sense for young start-ups. Things such as subscriber growth still are bandied about on earnings calls. But this is a bank, not a media company or some kind of tech startup. The analyst Q&A portion of the call is still littered with those that ask these types of questions.

This is a problem as banks typically receive lower valuations to book. The last bank that received outsized valuation above book value was Silicon Valley Bank and that ended badly. However, if one compares SIVB’s funding mix (mostly VC deposits), and SOFI (a far more diverse and stable mix), it should be clear they are not the same animal.

Final Comments

Under $8, you are still trading far above book value. However, there is still significant growth potential. An easy credit environment creates loads of earnings possibilities in both lending and financial services. Add to that the fact that SOFI doesn’t yet have a meaningful commercial business despite being fairly stable and you get an exciting picture of what is possible at SOFI. 

Above $8, given that these dynamics will take time to materialize, you will need to have a more exuberant view of the timing of Quantitative Easing (QE) (i.e. 2024 vs 2025). Still, if you’re holding long-term, the perfect entry point may be less important. SOFI will likely continue to take market share as it enters 2024 one of the strongest players of its size.