Virtu: So Much More Than Just A Play On Volatility
Summary
- Virtu's value as a counter-cyclical play on market volatility is only a part of what drives the stock.
- Market infrastructure is quickly creating more long-term opportunities for Virtu and the broader industry.
- Virtu's billionaire founder is still the largest owner of stock, and is aligned with shareholders.
- I like the stock no matter how volatility trends in 2020.
Virtu Financial (NASDAQ:VIRT) is one of the only institutional market makers listed & traded on the public exchanges today, focused on providing liquidity to markets across the geographic and asset class spectrum. The company divides itself into 2 primary segments – market making and execution services:
(Source: Virtu 2019 10-K)
Market Making (~67% of revenue) – The core value of any marketplace is the ability to match buyers and sellers of a particular type of good or service. Investors come to the financial markets expecting to find an active venue to buy or sell stocks, at any point in time, instantaneously. For example, let's visualize what the market for shares of Apple (AAPL) looks like during the trading day. Different participants, from endowment funds & hedge funds to retail traders & speculators, come to take positions in AAPL at different points in time. If no 2 participants enter the market at the exact same time with the exact same quantity of shares to trade, there’s an imbalance, and the market – at least in theory – lacks the liquidity needed to meet demand:
(Source: author)
Virtu’s job is to risk its own capital and meet all participants at the exact time they enter the market, taking the other side of the trade and meeting the demand, collecting a small premium (the bid-ask spread) in the process:
(Source: author)
While each trade itself results in an extremely small profit, when multiplied by tens of millions of trades per day, the pennies add up quick. The now infamous chart from Virtu’s S-1 filing in March 2014 shows that, between 2009 and 2013, Virtu had only 1 losing trading day, and made on average between $1 - $3 million per day from its market-making activities:
(Source: Virtu S-1 filing)
Today that figure stands at ~$4 million in average daily net trading income, which is a testament to the speed, scale and flexibility of Virtu’s trading & market making systems. While Virtu makes markets across most electronic asset classes and geographies, most of its market-making revenue comes from US equities.
Execution Services (~32% of revenue): In addition to its role as a liquidity provider, Virtu also provides “execution services” to primarily institutional customers, acting as an agent to help fill large block orders across multiple trading venues:
(Source: author)
Apart from helping large orders make their way through exchanges, Virtu also sells execution management systems (NYSE:EMS) to help clients automate low-complexity trades, integrate needed market data into trading strategies, and generally improve efficiency.
Dispensing With the Obvious – The Volatility Angle
Because Virtu’s business directly intersects with the ebb & flow of the equity markets, the company’s short term performance is modestly correlated with different measures of volatility & trading volume. If macro events bring more traders & notional into the market, Virtu benefits from meeting the increased demand for liquidity. Virtu management frequently emphasizes realized volatility – slightly different from CBOE’s VIX index – as a good proxy for better trading performance.
For example, as the global pandemic caused investor fear to spike in March, realized volatility exploded, and Virtu’s earnings estimates rose sharply along with it:
(Source: S&P Global)
At the above 2020 earnings expectations of ~$4.90 per share, Virtu is trading at a forward multiple of ~4.5x. What’s more, volatility is expected to stay reasonably elevated throughout 2020, with the coronavirus pandemic stretching into the fall, continued central bank commentary dictating market reaction, and the contentious November presidential elections quickly approaching.
So if EPS estimates jumped so much amid the March rout, why didn’t the stock go up more? Why aren’t people scrambling to scoop up Virtu at 4.5x this year’s earnings? Because even though volatility has been extreme this year, it doesn’t change the long-term narrative for the company or the stock. Investors know volatility has been high and that it’s a boon for Virtu’s business; they also know this kind of action is not a new normal worth banking on, and that a ~40% gain for the stock YTD is justified enough given the short-term performance. It’s near-impossible to predict what the volatility landscape will look like a few weeks from now, let alone quarters or years down the road. An investment in Virtu today shouldn’t be based on volatility forecasts alone.
If investors are looking to buy Virtu at current prices, there are 3 key narratives I think should be the focus of a long-term investment thesis:
- Electronification of new asset classes
- International Growth
- Scale
Electronification
A key long-term secular trend playing in Virtu’s favor is the advent of electronic trading across a growing list of asset classes. It’s no coincidence that Virtu’s largest business, US equities, also happens to be the most liquid electronic marketplace on earth. As more traders move onto the screen, Virtu’s market-making algorithms and trading systems can profit from a greater number of trades with little incremental cost.
There are many different markets in existence today that don’t have robust electronic liquidity, which serve as growth frontiers down the road as infrastructure changes. Below chart from the Bank of International Settlements lays out where each asset class is in the analog-to-digital transformation:
(Source: BIS)
Virtu has a large presence in the markets closer to the left of the chart – namely futures & options, equities, and FX. When it comes to the middle and right side of the chart, like repo, corporate bonds and CDS, Virtu does not currently have a significant business in any of these markets. As exchanges like Tradeweb (TW) and MarketAxess (MKTX) work to improve electronic liquidity in some of these asset classes, Virtu will start to see more demand for its market making services. Virtu’s CEO, Doug Cifu, has echoed this opportunity during investor conferences – below dialogue from a Goldman Sachs conference in late 2019:
(Source: Virtu Investor Relations)
“if it’s electronic, we will market-make it” is the general message from company management, and the number of electronically-tradeable products is expected to only increase as market infrastructure improves over the next 5-10 years.
International Growth
Similar to the point above, apart from additional asset classes to trade, Virtu is expected to capitalize on improving liquidity in international markets. We’re increasingly seeing US market infrastructure companies – like CBOE, MSCI, S&P Global, etc… - investing & expanding overseas in an effort to grow the size and quality of financial markets overseas. CBOE in particular is investing in European derivatives with its acquisition of EuroCCP against the larger narrative of an untapped financial market in developed international economies. According to CBOE, while EU and US GDPs are comparable in size, US market activity dwarfs that of Europe:
(Source: CBOE Investor Relations)
If CBOE’s expectations and investments play out as planned, liquidity providers like Virtu are in a position to benefit immensely. In Asia we’re seeing a similar narrative – as countries like Japan & China develop more robust financial markets and embed further into the global economy, Virtu’s addressable market grows.
Scale
In addition to the macro factors expected to make Virtu a more valuable company in the future, there are controllable, company-specific strengths worth highlighting as well – most notably, scale of operations & all-powerful network effects.
Virtu made 2 large, opportunistic acquisitions in the recent past – Knight Capital Group in mid 2017 and ITG in early 2019. Both purchases produced very attractive expense and revenue synergies – Virtu was able to leverage newly purchased market-making algorithms and liquidity to improve its trading strategies and enter new markets (ETFs most notably), while cutting hundreds of millions in annual costs. These kind of purchases underscore the value of Virtu’s network effects – when the company is able to expand to new asset classes & geographies, it’s able to do so at very little incremental cost and high incremental margin. Even if volatility does not improve in the coming years, Virtu’s earnings can still thrive as revenue growth is spread across a smaller percentage of fixed costs.
An Added Bonus: The Vinnie Viola Wildcard
Virtu’s core business strengths & macro tailwinds form the foundation of what I think is a solid thesis to own the stock. The cherry on top comes from Virtu’s ownership structure, although it’s not without risk.
Vincent Viola, the billionaire co-founder of Virtu, still ranks as the largest company shareholder by a mile – Viola owns ~36% of the stock – worth ~$1.5 billion – and controls ~82% of company voting power. On the downside, this concentrated ownership by Viola means if his interests are contrary to that of public shareholders, there’s not much that can be done to overturn his decisions. Virtu even clearly states this dynamic in its 10-K:
“We are controlled by the Founder Post‑ IPO Member (Viola), whose interests in our business may be different than yours, and certain statutory provisions afforded to stockholders are not applicable to us... The Founder Post-IPO Member’s interests may not be fully aligned with yours, which could lead to actions that are not in your best interest.”
Additionally, Virtu has a rather complex ownership structure, where public shareholders own stock in Virtu the holding company, which does not fully own Virtu the profit-generating asset:
(Source: Virtu S-1 Filing)
This chart is a bit outdated and reflects the structure at the company’s IPO, but the core complexity has stayed roughly the same. I bring these points up to make clear the potential risk of owning the stock if Viola sells his stake in the future, or if his vision for the company begins to differ materially from the visions of public shareholders.
However, I currently view Viola’s control & huge ownership as a material positive for the company and the stock. Viola has a massive portion of his personal wealth invested in Virtu, and is fully aligned with shareholders in his goal to drastically improve shareholder value over the long term. Companies with this kind of insider ownership and shareholder alignment tend to have a longer-term horizon and make decisions that preserve capital and wealth, rather than meet short term goals to trigger compensation packages. Viola has built Virtu from scratch and has lead it into today’s success – I’m willing to trust that this track record is likely to continue with him as the majority shareholder.
Conclusion
Virtu’s value as a counter-cyclical play on volatility has come into the spotlight amid the global pandemic and March market meltdown. While choppy equity markets might stay around for the foreseeable future, I think a long term investment in Virtu should be built on more than a volatility forecast. The company is positioned to benefit from improving market structure around the globe, with exchanges investing in new asset classes & regions for Virtu to work with. The company benefits from a scalable network model and has strong insider ownership that is aligned with shareholders. I think investors can add Virtu to their portfolios and be satisfied with returns going forward.
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This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
This article should not be taken as investment or financial advice and is for informational purposes only. Consult a financial advisor before making investment decisions. This article discusses public information sourced from SEC filings and public websites. Future performance could differ from what is estimated in the article.
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Comments (29)
Temasek holdings has 9% now iirc, with this pension fund's investment they would own between both of them 24.5%.Regardless, i see this an a positive.
-HNS