You vs. the Market [Fool on the Hill] June 30, 2000

FOOL ON THE HILL: An Investment Opinion
You vs. the Market

By Zeke Ashton (TMF Centaur)
June 30, 2000

Summary: The market has knocked down Knight Trading in a big way, and probably for a lot of good reasons. But in Knight's case, there's at least one writer who thinks the market's got it wrong. Still, Zeke Ashton warns that while the rewards for spitting in the face of the market can be fantastic, the flameouts can be equally spectacular.

I took a personal stand against the market recently over a company called Knight Trading (Nasdaq: NITE). I'm not normally big on grudge matches, but Knight is a company that I've been watching for a long time. I don't know about you, but sometimes I can only watch a good company get kicked by the market for so long before I get a sense of righteous indignation and determine to do something about it.

I will admit my most satisfying moments as an investor come when I know I'm flouting the market consensus, and the market ends up blinking first. But is this a rational move as an investor? I'll come back to this question shortly. First, let me show you why I think the market's got it wrong when it comes to Knight.

Knight Trading is the leading U.S. market maker for equity securities. Through its various subsidiaries, the company makes markets in over 6,700 securities listed on the Nasdaq and the OTC Bulletin Board of the National Association of Securities Dealers. In addition, the company trades New York Stock Exchange and American Stock Exchange listed securities. Knight's own press releases state that the company executes more than 40% of all securities trades placed via the Internet, and the company reported market share of almost 20% of Nasdaq/OTC securities as of December, 1999.

In the first quarter ending March 31st, Knight turned in some blowout numbers. Total revenues jumped 152% year over year to $513 million. More impressively, pretax operating profits jumped 192% to $213 million, translating into an operating profit margin of 42.3%, a nice improvement over the 36.5% the company managed last year. EPS jumped 177%, and the net profit margin was 26.7%, meaning that more than a quarter from every dollar in sales dropped to the bottom line. Knight ended the quarter with $450 million in cash on the balance sheet, and operating cash flow for the quarter came in at $157 million.

The market wasn't impressed, and the stock is now down more than 35% year to date. At the current price of just under $30 per share, Knight is trading at 13.6 times trailing 12 months earnings, and under 11 times the First Call consensus projection of $2.70 per share earnings for 2000.

At the current price, there are some pretty strong assumptions built into this stock. First of all, the market is saying that it doesn't believe that this company can keep growing at its previous breakneck pace. That $2.70 per share 2000 consensus estimate implies an 85% year over year growth rate from Knight's 1999 EPS of $1.46 per share, and the 2001 estimate of $3.14 per share implies an additional 16% growth rate from there.

If you subscribe to that old valuation rule of paying a P/E in rough approximation to the expected forward growth rate, you'd certainly expect to pay more than 9 times 2001 estimates for that kind of growth. Even at these low prices, as of June 8th, short sellers accounted for more than 12 million shares. That's 15% of the total float. Obviously, the market is telling us it doesn't really believe that Knight is going to be able to pull it off, and in addition that there is a good chance that Knight is going to hit a brick wall in the near future. That brick wall could take one of many forms.

1) The first concern I hear is that Knight's growth is going to slow dramatically because the company is no longer turning in sequential (i.e., quarter-to-quarter) sales growth.

2) The second potential snag is the coming decimalization of stock quotes, which will narrow the spreads on most actively traded stocks. Since market makers like Knight make their money on the spread between the bid and ask prices, this would obviously appear to be a major threat to the company's future profits.

3) Yet another potential threat is the expected rapid growth of ECNs, or electronic communications networks, which automatically match buy and sell orders, thus playing the traditional role of a market maker. It is widely perceived that ECNs will eventually account for a much larger proportion of transaction volume than they do today, with the obvious losers being traditional market makers like Knight.

4) Finally, the recent move by blue-chip investment bank Merrill Lynch to increase the size of its market maker operations with the recent acquisition of one of Knight's largest competitors, Herzog, Heine, & Geduld, could surely hurt Knight.

While any or all of the above factors could lead to a worst-case scenario for Knight, I'm willing to take the other side of this bet. I reviewed each of the above factors, and came to the conclusion that the market is just way too sure of Knight Trading's imminent demise.

While there is no question that Knight's hypergrowth stage is over, I don't believe it is reasonable to expect revenue increases every quarter when the market's trading volume is so seasonal. What is important is year-over-year growth. Knight's $513 million in first quarter revenue is almost 65% of its revenue from all of 1999, so I am feeling pretty confident that this company is growing revenues at a fast clip.

In addition, there are a lot of great opportunities for new growth. The company is moving rapidly into the options markets, which in my opinion has some tremendous growth potential. Knight is charging hard into Europe and Asia, which is a good distance behind the U.S. when it comes to electronic trading. I've read that total online stock trading accounts in Japan number less than one million. That's going to change, and Knight will probably be one of the players that provokes that change.

Decimalization and ECNs may hurt the company at some point, but Knight actually owns 8.4% of one ECN (Brut), and I suspect that the lower transaction costs brought on by a change to decimals will increase trading volume accordingly. Finally, many analysts, including one from investment bank Robertson Stephens, believe that the Merrill Lynch deal doesn't hurt Knight nearly as much as initially thought.

While I'm willing to back my belief that the market has got it all wrong when it comes to Knight, I'm also cognizant that the chances are pretty high that it's not. As Michael Mauboussin writes in his brilliant essay, "The Invisible Lead Steer," the market tends to be much smarter than the average person. In the vast majority of cases, a consensus opinion will be much more accurate than any single viewpoint because the sum total of information factored into the current stock price is likely to be much more complete than the viewpoint of any one player. While it's true in the vast majority of cases, Mauboussin notes that there are three ways to beat a market based upon consensus opinion: Get better information, interpret the information more completely, and avoid emotional decisions, which invariably pull an investor in the wrong direction.

While spitting in the face of the market is something I've done a couple of times now, it's not a course of action I'd recommend. You see, in this case, it truly is betting against the consensus view. And, much as I'd like to think I'm right, the rational side of me knows that chances are not insignificant that the market will eventually prevail. When I've been right, the gains have been awesome -- when the market changes it's view, it can be a real sight to see.

When I've been wrong, the flameouts have been equally impressive. In the case of Knight, I believe the possible upside should the Street change its view will be more than sufficient to compensate me for the risk I'm taking. On the other hand, I'm fully prepared to lose a significant portion of my investment if I'm wrong.

If there is a lesson for investors in all this, it's this: If your investing style has you consciously flouting the market consensus, be aware that you're not going to win all the time, so be prepared to have the market prove you wrong.

Suggested Links:

  • Knight Trading Discussion Board
  • Michael Mauboussin's Frontiers of Finance