Every Investor Should Own Knight Capital Group

| About: KCG Holdings, (KCG)

Knight Capital Group (NYSE:KCG) is an electronic and voice trading company whose main business is providing liquidity to the equity markets. They are also market makers in the options market. They have a popular institutional Forex ECN, Hotspot, and are expanding their asset management business. KCG would be a great addition to an investor's portfolio because: It is very cheap, Earnings will grow significantly in 2011, and it provides returns that are negatively correlated with the overall market.


KCG is cheap based on almost any metric at which one looks. It trades at 0.8x's Book Value, 1.2x's Tangible Book Value, and 12x's last years depressed earnings, and their balance sheet is very liquid. About 80% of their balance sheet is either cash or instruments easily convertible to cash i.e. long/short positions in listed equities. This is important because KCG trades in sympathy with many of the larger financial institutions like Goldman Sachs (NYSE:GS), Citigroup (NYSE:C), and Bank of America (NYSE:BAC), but KCG has almost none of the balance sheet, liquidity, or credit risks that the other financial institutions face. While KCG does not operate on a strictly agency basis, their inventory risks and daily VaR are below any single day's revenue. By comparison, GS's VaR can be 3 or 4 times any single day's revenue. Large financial institutions tend to trade at or near book value because of their extreme aptitude for losing tremendous amounts of money very quickly, KCG doesn't face the risk "Black Swan" events (more on this below), and therefore should not be valued the same way other large financial companies are valued.

Earnings Growth

2010 was a difficult year for companies in the trading business because trading volume and volatility were lower than normal. This was exacerbated at KCG because at the same time business was slow, they were investing in new initiatives such as growing their fixed-income team, switching to self-clearing, and integrating Astor Asset Management, according to their Q4 2010, and Q1 2011 conference calls which can be accessed here, the investment phase of growing their various operations are complete, and the real revenue and earnings phase will begin. The compensation expense ratio on the FICC desk will come down in 2011 while revenue will increase due to many more reverse mortgage deals on the desk. Also, the move to become self clearing will be finished in 2011 which will greatly reduce execution and clearing expenses. In the equities business, options trading volume is multiples of last year's volume. Options are a much higher margin product than regular equities trading. While volume is down, KCG has been continually improving their trading algorithms to increase their revenue capture. Revenue capture is up 12% y/y in Q1 2011. Q1 2011 showed 9% y/y earnings growth while trading volumes and volatility were down from the previous year. Even if volume and volatility remain weak, earnings will continue to grow in 2011, and if there is an increase in either of them, earning will be up dramatically in 2011.

Negatively Correlated Returns

Finding assets with positive expected returns that are uncorrelated or (better yet) negatively correlated yields the only free lunch in investing, namely higher expected returns and lower portfolio volatility. Typically, investors have to settle for lower returns in the search for negative correlation e.g. Treasury bonds, or gold. But, KCG provides investors with negatively correlated returns while providing the same expected returns as any other stock in the market. While other financial service companies were receiving government assistance, KCG's stock price climbed from 16 to 22. Admittedly, KCG's performance since the financial crisis has been abysmal. It has fallen from 22 to 12.70, where it is trading today. I think, going forward, it doesn't matter if the overall markets remain stable, KCG will gradually appreciate in 2011 due to an increase in earnings and investor's realization that this stock is extremely cheap. And if another financial crisis strikes, KCG will doubly benefit from the increased volume and volatility. People who trade options always have to struggle with the tradeoff between having a negative Theta (an option's value decreases every day, ceteris paribus) and a positive vega (options values increase if the expected volatility of the underlying increases, ceteris paribus). Investors holding KCG don't face this tradeoff because if volatility increases, KCG increases, and if nothing exciting happens in the world, KCG increases.

Disclosure: I am long KCG.

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