Digital payments have been growing rapidly in recent years, attracting a flood of capital to companies that create software and processing systems enabling such payments. We believe that this is not evidence of a short-term product cycle nearing its high, but rather of a secular global growth trend with a long runway ahead of it.

A Long-Term Secular Trend

Since 2010, financial technology (fintech) firms have garnered more than $100 billion in investment, with start-ups developing payment and lending products taking the bulk of the total. In the first half of 2018, global investment in fintech surpassed the $27 billion total for all of 2017, largely as the result of two large deals: US-based Vantiv’s acquisition of UK-based Worldpay and the $14 billion venture capital raise by Alibaba’s Ant Financial.

Such floods of capital often signal the beginning of the end for investment fads. We think that’s not the case here. Our analysis shows that the shift from cash to digital payments is a long-term secular trend that will endure and remain rapid, especially outside North America, creating significant long-term sustainable growth potential for many digital payment software and processing companies. Our view is that this long-term secular trend also increases the likelihood that companies with competitive advantages in this realm will deliver above-average earnings growth, even in more challenging economic environments.

Not Even Halfway to Universal

The shift from cash and checks to digital payments began in the US with broad acceptance of credit cards in the 1960s, and eventually expanded globally because it offers benefits to consumers, merchants, and governments. Consumers gain convenience, security, and enhanced access to rewards. Merchants thrive on innovations that make accepting digital payments simple, inexpensive, and ubiquitous. Governments can benefit from vastly improved tax collection, due to the availability and reliability of digital payment records.

Recent rapid growth in e-commerce and mobile commerce accelerated this decades-old shift, due in part to innovations that PayPal, Square, and Stripe introduced and many companies now offer. PayPal allows customers to make purchases linked to credit card, debit card or bank accounts, without typing in account numbers and other details each time. Square enables a microbusiness, such as a personal trainer, to accept credit cards using a free card reader so small it can fit into one’s pocket, rather than the traditional and expensive point-of-sale terminals found in stores. Stripe gives merchants the ability to easily incorporate payment functionality into the software used to run their businesses. Regulations that mandate improved security and cut transaction costs for merchants have also spurred growth in digital payments.

Yet 85% of all transactions globally still involve cash, according to MasterCard. That includes 77% of transactions in Europe, and more than 90% of transactions in much of Asia and Latin America. Even in the US, where mobile-reliant Millennials barely seem to use cash, 54% of all purchases are in cash (Figure 1). We think it will take many years—even decades—for cash transactions to fade into the background.

How rapid has growth in digital payments been? The number of non-cash transactions grew an estimated 11% from 2016 to 2017. Global growth in such transactions is forecast to accelerate to a 12.7% compound annual rate for the five years ending in 2021. In Emerging Asia, Eastern Europe, and the Middle East, growth rates are expected to be north of 20%. (Figure 2).

Overseas Growth

The particularly rapid growth in digital payments in the developing world reflects the rapid growth in mobile commerce in many countries, such as China and South Korea, where most consumers have mobile phones but not personal computers, or in other countries, such as India, where few consumers have bank accounts.

In China, Tencent’s WeChat (similar to WhatsApp) users who link their bank accounts or credit cards to a messaging platform can pay utility bills, hail a taxi, buy movie tickets, order food, or book a doctor’s appointment. AliPay, a unit of Alibaba, offers payment services, as well as loans and insurance. It may offer a long-term threat to China’s traditional financial institutions.

In India, digital payments are growing at an astonishing 40% rate, according to the Internet and Mobile Association of India (IAMAI). In a country where 95% of payment transactions are made by cash or check, only 20% of the population of 1.3 billion has a bank account, yet 900 million mobile phones are in service. The Indian government has promoted mobile payments as a vehicle of financial inclusion critical to the country’s economic development. It has mandated a two-factor authentication process for digital payments to boost user confidence and reduce fraud. Additionally, significant investment from companies such as Paytm and Google are helping to drive usage of mobile wallets.

In the developing world, regulation that cuts costs for merchants and improves security for both merchants and consumers has boosted digital payments. In 2018, for example, the European Union implemented its revised Payment Services Directive. Known as PSD2, the directive requires banks to give third parties access to customer accounts through open application programming interfaces (APIs), allowing European digital-payment processors, such as Adyen and Wirecard, to take share from traditional retail banking players. In some European countries, caps on per transaction fees for debit and credit cards have also boosted digital payment growth.

Not all the companies and new technologies seeking to take advantage of this long-term trend will succeed. Investors have to identify firms with sustainable competitive advantages and carefully monitor their progress as the industry evolves and new technologies emerge. Generally speaking, software providers and payment processors tend to have stronger competitive advantages than hardware companies or financial services firms extending credit.

Anthony Sneag is a Senior Analyst on MacKay Shield’s Fundamental Equity team; Carlos Garcia-Tunon is Head of the Fundamental Equity Team.