Last week at the Delivering Alpha Conference investor and founder of Pershing Square Bill Ackman revealed his latest investment idea. In a presentation running over 100 pages Mr. Ackman articulated his investment, which is to go long the Hong Kong dollar. With CNBC sponsoring the conference there was significant build up to the announcement of Mr. Ackman’s new idea. At no point did anyone suggest that it could be a currency trade! I would encourage you to read the presentation.
If you read the presentation and agree with Mr. Ackman’s logic there is a problem. One, the reason it is such a great trade for Pershing Square is inherent in the medium they have used to place their trade. Pershing Square has purchased long dated call options on the Hong Kong dollar. Since the currency has been pegged to the U.S. dollar for years the volatility used to price the options is low. This creates a mis-pricing in the options – while historical volatility is low, future volatility if the peg ends and the HDK appreciates will be significant. By using options Mr. Ackman creates a scenario in which if he is correct and the HKD appreciates 30% versus the U.S. dollar before his options expire, he stands to make over 60x his investment, a 6,000% return! However, the minimum notional amount required to purchase a call option like this is $1 million dollars. This is nothing to a multi-billion dollar fund like Pershing Square but out of reach of most individual investors.
Now an individual could go to his or her bank and exchange U.S. dollars for Hong Dollars and, if the HDK is revalued by 30%, you would make a 30% return, not bad at all but is a far cry from the 6,000% Mr. Ackman stands to make.
But there is another way for an individual to participate in this trade. An individual investor can use an online retail foreign exchange (FX) broker such as FXCM Inc. (FXCM).
FXCM is an online provider of foreign exchange trading and related services. The company offers access to over-the-counter FX markets through a proprietary technology platform. The platform offers price quotations on up to 56 f/x currency pairs from up to 25 global banks, financial institutions and market makers, or FX market makers, allowing customers to trade f/x.
FXCM utilizes agency execution which means that when a customer executes a trade on the best price quotation offered by FXCM’s market makers, the company simultaneously enters into offsetting trades with both the customer and the FX market maker and does not act as a principal.
FXCM has a dual class structure and Holding Units that can be converted into class A shares. As a result the market capitalization of FXCM should be calculated using 77.6mm shares (the structure is well documented in the IPO prospectus).
The market capitalization at the current stock price of approximately $13.23 per share is approximately $1,026mm and the enterprise value is $850mm. With $180mm of cash on its balance sheet, the company has over $1.00 per share in cash. The company generated $80mm in free cash flow in 2010 for a free cash flow yield of almost 10%. Wall Street consensus cash flow per share for 2011 and 2012 are $1.17 and $1.58, respectively. This implies that by the end of 2012 FXCM will have approximately $3.75 per share of cash, almost 50% of their current share price.
In actuality they will use this cash along the way to fund their $0.06 per share dividend to buy back shares. In May the company announced a $30mm share repurchase authorization. FXCM also will look to make strategic bolt-on acquisitions and recently acquired Foreland Japan, which added 18.5K tradable accounts and $190mm in client equity.
FXCM also has a robust institutional business that is growing significantly. In August, FXCM’s institutional customer trading volume increase 100% versus July 2011, and 96% over August 2010.
There are also risks to the FXCM story. It relies on the volume of FX trading and generates more revenue in periods of FX volatility, one of the reasons it is having a tremendous third quarter. Before investing I would highly suggest reviewing the filings paying special attention to the risk factors.
Coming back to the Hong Kong dollar trade, FXCM is a great way to make this investment. FXCM allows you to use leverage of 20x. Therefore for every $1,000 U.S. dollars you can effectively control $20,000 USD worth of Hong Kong dollars. Now a 30% appreciation in the HKD versus the USD results in a profit of $5,000 or a 500% return. While still not as profitable as Mr. Ackman’s trade it is far better than the 30% you would receive by converting cash into HDK.
Disclosure: I am long FXCM.