Virtu Financial (NASDAQ:VIRT) is an interesting company. It’s not that old, not much of a history to the stock or its dividend, but it’s come far in a very short time.
An investment in Virtu would have mostly kept pace lock-step with the market, at 8-year returns of around 7.6% on an annualized basis. Nothing to write home about on that front – but there are underlying trends that might make this 3.1%-yielding Banking/brokerage stock interesting to you.
As always, it’s about understanding.
So, let’s first understand Virtu Financial.
Virtu Financial – Understanding the company
Basics first, because I’m fairly sure most readers will have very little idea what Virtu financial actually does.
The firm is described as “leveraging cutting edge technology to deliver liquidity to the global markets and innovative, transparent trading solutions to our clients.” This tells us pretty much almost nothing.
What does a “market maker” do?
A market maker such as Virtu provides what’s known as “deep liquidity” to securities, such as stocks. In Virtu’s case, for 25,000 securities in 36 countries. On a high level, the company provides financial services, trading products and market-making services. These market-making services are, among other things, providing quotations and services to buyers and sellers.
Essentially, Virtu offers the ability for clients, through technology and its liquidity and products, to trade. They offer this in over 50 countries and across multiple classes of assets, including but not limited to global stocks, ETF’s, Foreign exchanges, futures, fixed income, and other commodities.
The company offers post and pre-trading services that help clients trade as well as manage their risk across global markets.
Virtu Financial does this with proprietary technology and what they see as a low-cost structure, which provides the potential for scale.
So, the company’s revenue is made by commissions, fees, and execution/market-making services. A trader using Virtu Financial is paying for the services, for the liquidity, for trades, etc. The company also makes money on the bid/ask spread when they buy/sell securities.
Virtu is extremely tech-heavy. As mentioned, the company has developed what they call proprietary multi-asset, multi-currency technology platforms which is integrated directly with exchanges, liquidity centers, and clients. Virtu’s products interact with hundreds of retail brokers, registered advisors, private client networks, sell-side, and buy-side institutions.
The company reports in two segments which work as follows:
- Market making focuses on cash, futures, options fixed income, FX, and commodities across the global market. Virtu financial wants to offer the most cost-effective liquidity and price competition in its markets. The company commits its capital by offering to buy/sell securities to banks, brokers, and institutions. The company also operates in the OTC market. The company states it makes the markets more efficient by standing ready to, at any time, buy/sell substantial amounts of any one security in their geographies. Virtu trades Global Equities, Global Fixed Income, Currencies, Commodites, Options, and “other” products. The company’s global teams survey and monitor the markets and systems 24 hours a day, five days a week in offices around the world.
- Execution services focus on providing transparent trading, including things like execution-only trading done through Algo trading, principal trading, and using programs/software to match client orders with the market. It offers workflow technology through broker-neutral trading tools across the globe (Order/execution management) and it also offers trading analytics, enabling traders to improve pre-trade analytics and execution performance. It also enables portfolio construction, optimization, and valuation services.
Clients include mutual funds, pension plans, hedge funds, trusts, broker deals, banks, and the like. Virtu’s client-side exposure is well-managed, with less than 10% from any one singular client.
On a very high level, Virtu Financial is a primary beneficiary of a volatile market. This is because, in a volatile market, the ask/bid spreads widen, and with uncertainty comes greater profits. This is also why, when looking at company income trends, volatile markets have the potential to 4-5X company earnings in a very short time, only for them to go straight back down once the market calms down. It gives them an almost-cyclical character, but with an “anti-cyclical” component, wherein they move the exact opposite as some cyclical stocks which go down in volatility and up instability.
This means that there’s high importance for the company’s services that aren’t reliant on market volatility to make money – such as fees not focused on trade, but on products/services outside of the market, in order to cushion some of these ups and downs.
Virtu financial, on a high level, has what I would consider being sub-standard fundamentals. The company has around 44% debt/cap and is rated only at a BB-, well within junk territory. At a market cap of around $5.7B, it’s not all that big to some of the bigger banks and brokerages out there. However, its dividend of 3.1% is well-covered for the foreseeable future, and in 2020 it had a payout ratio of less than 20%.
It’s important to mention, however, that Virtu financial lacks any direct public competition, at least insofar as its full suite of product offerings go. Individual products do compete, but not the verticality of the company’s offerings. There are market-making companies that do compete with Virtu, and these include Broadridge Financial (BR) and Corelogic (CLGCX) as well as companies like Citadel Securities, Two Sigma, etc. To be frank with you, Broadridge is around 5 times as large as Virtu, and Corelogic is about twice as large in terms of valuation and market cap. Broadridge is even BBB+ rated. So while there are certain arguments why Virtu’s products are fairly unique and Virtu is a market leader in high-frequency trading, handling around 1/5th of the day’s volume, the competition for Virtu is fierce. The high capital costs from developing these technologies prevent anyone without deep pockets from entering the market, and this does provide some protection from competition.
So, that is what Virtu Financial does, who it competes with, and how the company makes its money. From a financial perspective, its revenues flow primarily from trading income revenues and commissions, and its expenses are primarily on the brokerage side (clearance fees, payments for order flows, etc). The company’s EBITDA and operating margins have been very volatile. Pre-pandemic numbers at around 60% on an adj. EBITDA basis, down to less than 45% in 2019, up to 72.6% in 2020.
The company’s income is highly tilted towards market-making, with over 70% of the adjusted net trading income flowing from market-making. This means, and confirms the company’s reliance on the daily flow of the market, and the volatility found therein. While execution services do see volatility as well, Market-making trading income almost tripled in less than a year going into 2020. The implications here are clear.
Recent results have come in at relatively good levels, but there’s no helping that current market trends do not equate those of early 2020-2021. 2021E is expected to be a major EPS-negative year for the company – dropping around 28%, though this is after a massive 500% EPS growth in 2020.
Other forecasts from S&P Global confirm this overall analyst view, and I concur. I expect EBITDA and EPS to drop at least 20%, and potentially as much as 28% during this year, and I expect the 2022E trend to be negative as well, based on current trends in interest rates and fund flows on the market.
The company has reported some good financials, reduced debt, good overall EBITDA, and a margin that’s close to the 60% of an adjusted EBITDA level. Virtu is also buying back stock, up to $750M of it with an expansion of the already-finished repurchase program. Virtu has bought back and retired more than 7% of its float, which is important to consider when viewing valuation.
However, nothing can change the fundamental fact that Business/order growth is declining. It may be up significantly on a long-term basis, but the peaks of 2020-2021 are over.
The company’s return metrics are not o be trifled with, with record-high ROIC, buybacks, and good payouts.
We’ve seen a vastly changing dynamic over the past 2-3 years. Retail flow in the US alone makes up for 20% of the total market volume, and with commission-free retail trading made possible across multiple venues despite wholesalers being required to commit capital or sourcing liquidity externally, the underlying market conditions for market makers like Virtu are good. It’s also extremely beneficial to US retail investors. There is an estimate from Schwab (SCHW) that Exchange trading fees alone would have been close to $1B in 2020, for Schwab alone, if they had charged it. There are clear flaws currently on the market, which Virtu are pointing out, and which could improve things in terms of wholesalers/retail brokers. Now, these are what I would consider extremely advanced investing concepts – so if you’re interested in these, I can recommend the company’s filings and material – but we won’t delve deeper into them here.
Let’s just say there are potential efficiencies to be made.
Virtu believes that the combinations of its median through-cycle earnings, with organic business growth and its return on capital management, will be able to drive growth, dividends, and share repurchases. I do not disagree entirely with these assumptions – I just don’t think they hold the same validity as they did when the market was more volatile, and I don’t think that Virtu can transcend its reliance on market volatility as an income driver.
The reason that Virtu Financial “won” in 2020, is that it quotes buy/sell prices for stocks and securities that it trades, and earns on the spreads. When there’s a higher demand for liquidity, high-frequency trading firms like Virtu do extremely well. They would not like me as a client, because I do maybe 2-5 trades per month. That’s it.
I’m not sharing any “secret sauce” by telling you the business is cyclical and Virtu doesn’t perform well in smooth waters. Anyone with eyes can see that by looking at any sheet. Income drops and revenue drops during these conditions are meteoric in their character. As an example, Virtu financial was down 38% when the S&P was up 28%.
It’s fair to say that Virtu Financial has a high historical correlation to the CBOE Volatility Index (VIX). However, at the same time, Virtu has been trying hard to smooth out its curves and some of these trends through diversification into Execution services. They bought ITG back in -19, and they’re starting to really drum up business for these things.
Unfortunately, as I see it, history is a harsh teacher when it comes to investing in this business.
We’re moving down to earth. Let’s recap.
Virtu Financial is a junk-rated (BB-) Banking/brokerage firm with a focus on high-frequency trading. It currently relies heavily on market volatility to make outsized returns. Barring these market conditions, Virtu has performed very poorly, and its historical returns on an 8-year basis do not beat the market. It has a 44% long-term debt/cap, and its share price over the past few years has been bolstered by buying back more than 7% of shares outstanding in generous buyback programs – which are continuing.
If you’re unfamiliar with the high-level impacts of share buybacks, let me quickly tell you, that the boosts this action gives to ratios like EPS, RoA, RoE are not because of a sudden increase in profitability. It’s not because of profit growth. Share buybacks can give unrealistic pictures of a company, painting a very rosy view of the economic reality.
The danger that I see in Virtu is exactly what I said. It’s a BB- rated company in an earnings high, buying back excessive amounts of shares to keep that “sugar high” going for as long as possible. While I’m sure there are other reasons for this, and from a 2-4 year EPS average, Virtu bulls will argue that the company is “cheap” here, I maintain my stance that we’re seeing a too-high valuation for the company distorted by large amounts of buybacks.
Furthermore, the current timing where we’re just moving out of a very volatile, earnings-high period for Virtu is probably one of the worst times in history to buy Virtu Financial.
When would be a good time to buy Virtu?
Pretty much a day after a crash.
As you can see, buying the company when we expect massive spikes in fear and high-frequency trading can be an excellent idea. However, at current levels, I will argue with you that the FactSet forecasts for the company, no matter their positivity, do not matter.
The analysts have worse accuracy than a coin toss (10% MoE) and have, on a 6-year basis, not once managed to forecast company EPS within a 10% margin of error accurately. it’s either below (60%) or above (40%). This makes the forecasts as volatile as the company’s earnings, and they should, in my view, barely be considered indicative.
Given its junk rating status, I will discount Virtu heavily. I will accept that Virtu’s EPS may stabilize at higher levels than pre-pandemic, and will discount S&P Global 2023E by 10%, reaching around $2.6/share, which is significantly higher than 2018 and includes some of the positive considerations for the company’s long-term growth, but I won’t want to pay more than 10X P/E for such a company, given the volatility and reliance on some of these trends. This reflects the company’s short-term earnings multiple. Therefore, I would price Virtu at around $25-$26/share, which is a significant discount to analyst averages, and in line with the analyst target range lows for the company (Source: S&P Global). I will point to historical analyst trends, which have a history of around 10-15% overvaluation for the target mean here.
It’s important to note that I wouldn’t necessarily buy Virtu at those valuations either. Because of its volatile trends and poor credit rating, I would want a higher yield before investing, as other alternatives on the market give me far better conservative upside potentials than Virtu does.
Due to this, I call Virtu a “HOLD” with a $25-$26 PT range, and not a necessarily attractive option even then.
My thesis for Virtu is:
- The company is an interesting market maker, and one of the major high-frequency ones in the world. At the right price, it would be attractive.
- However, the way its earnings flow and its reliance on VIX make this incompatible with what I see as my investment approach. I would “HOLD” here with a PT of $25-$26 – at most.
- Making money on Virtu is possible – but I’d stick with ridiculously underpriced-strike Put options. If you can grab June 2022 @ $23 strike put options for a cash-covered put at a premium of no less than $0.75, you can make 9.32% annualized, which I would view as more than expected from the investment until then. You would then be buying Virtu at no more than $22.25, which even I would consider interesting.
- However, the common share is a no-go for me. I say “no” here.
Remember, I’m all about :
1. Buying undervalued – even if that undervaluation is slight, and not mind-numbingly massive – companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
3. If the company doesn’t go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.
4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.
This process has allowed me to triple my net worth in less than 7 years – and that is all I intend to continue doing (even if I don’t expect the same rates of return for the next few years).
If you’re interested in significantly higher returns, then I’m probably not for you. If you’re interested in 10% yields, I’m not for you either.
If you however want to grow your money conservatively, safely, and harvest well-covered dividends while doing so, and your timeframe is 5-30 years, then I might be for you.
Virtu Financial is currently a “HOLD”
Thank you for reading.