Is this small-cap star a better banking buy than Barclays plc?

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Barclays

Financial technology (fintech) stocks have the potential to cause big disruption for established players such as the big banks.

Today I'm going to look at a fintech stock whose share price has doubled in six months. Should investors look for a long-term growth focus on businesses like these, or do big banks such as Barclays (LSE: BARC) still have a role to play in growth-oriented portfolios?

Profits could explode

In its 2016 results statement, payment services provider FairFX Group (LSE: FFX) describes the mainstream foreign exchange sector as "low-tech" with "poor transparency".

By contrast, FairFX says that by operating online only and using peer-to-peer (P2P) technology, it can provide low-cost and competitive foreign exchange services for the UK market. The group's revenue rose by 27.9% to £10.2m in 2016, while gross profit was 31.2% higher at £7.5m.

Although FairFX still reported an operating loss of £1.4m last year, this was 58% less than the £3.4m loss a year earlier. Encouragingly, the group reported a net profit for the final quarter of 2016, although this feat wasn't repeated in the first quarter of 2017.

This could work

FairFX appears to be building a strong brand. Customer numbers rose by 80,802 to 588,192 last year, and a further 15,070 new customers joined the group during the opening quarter this year.

Although the group didn't manage to breakeven last year, I was encouraged to see administrative expenses fell from £9.1m to £8.9m in 2016. That's impressive, because it suggests that the bulk of the group's costs are fixed, even during rapid expansion.

This has the potential to create an effect known as operational gearing, where a company's profits rise very quickly once its fixed costs are covered.

Is the price right?

FairFX is targeting a net profit for 2017. Based on the firm's 2016 figures, I estimate that if FairFX can deliver another 28% rise in revenue this time, it could generate a pre-tax profit of about £850,000. That's roughly equivalent to a P/E of 70, depending on tax costs.

That looks quite expensive to me. Although I think this is a decent business, I'm not convinced that now is the right time to buy. I'm also concerned that FairFX could face tougher competition as it gets larger. So for now, I'd hold.

Forget the past

Investors traditionally chose banking stocks for their prudent management and reliable returns. It's harder to make that argument since the financial crisis, but I think it's time to look forward, not back.

Banks have spent the last eight years repairing and strengthening their balance sheets. Most legacy issues are out in the open and many have been resolved. In my view, banking stocks are starting to look very tempting.

My pick is Barclays. The bank's stock currently trades at a 25% discount to its tangible net asset value of 290p. Profits are rising and a P/E of 10 is forecast for 2017, falling to 8.8 for 2018. The dividend yield is expected to rise from 1.5% in 2017 to 3.9% in 2018.

I believe a real recovery is underway. In my view, Barclays' shares could be worth as much as 40% more than their current price so I continue to rate its stock as a buy.

Don't make this big mistake

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Roland Head owns shares of Barclays. The Motley Fool UK has recommended Barclays. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.