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1 Reason Virtu Financial Is Beating the Market

By Brent Nyitray, CFA – Jul 9, 2020 at 7:02AM

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Volatility is this company's friend and its stock price jump in 2020 is proof.

This year has been particularly rough for financial stocks, as evidenced by the underwhelming performance of the Financial Select Sector SPDR Fund (XLF -0.91%), which is down nearly 25% year to date.

The United States hit a brick wall when COVID-19 forced governments to enact shelter-in-place orders that shut down vast swaths of the economy. Banks were hit particularly hard on fears of credit losses. The real estate investment trust (REIT) sector was sold as well, as many of their office and retail tenants were unable to make rent.

Stock exchanges have fared better, and one company integral to the exchanges has seen its stock do extremely well, rising almost 58% year to date. It is not an exchange, but a wholesaler. 

Picture of a trading floor

Image source: Getty Images.

A high-frequency trader that provides liquidity

Virtu Financial (VIRT -0.76%) is one of the leading high-frequency trading firms. It's one of the biggest market makers, which means it is a liquidity provider to the financial markets. A liquidity provider is one that stands by ready to buy or sell a security to meet the second-to-second demands of the market.

Virtu makes competitive markets in 25,000 securities across 235 exchanges. The company has two operating segments: market-making and execution services. Market-making is its liquidity providing segment, while execution services provides algorithmic trading services mainly to professional institutional traders. 

Volatility has driven higher revenue

Virtu Financial has benefited from the increased volatility in the market. In the first quarter we saw a sizable increase in volatility as evidenced by the Chicago Board Options Exchange (CBOE) Volatility Index (VIX), which spiked from 13.7 in mid-February to 83 at the end of March. Take a look at the chart below, which shows the VIX index over the past year.

^VIX Chart

^VIX data by YCharts

Wider bid-ask spreads increased profits per trade

The company reported in its first-quarter earnings presentation that bid-ask spreads tripled and even quintupled, depending on the market capitalization of the company. Other securities markets like currencies and commodities saw the same phenomenon.

As a market-maker, Virtu earns revenue from buying on the bid side of the market and selling on the offer side of the market, which is pretty much the opposite of most market participants. The bid-ask spread should be looked at as an approximation of the expected profit on a round-trip trade. Between higher trading volumes and the increase in bid-ask spreads, revenue increased almost 150% from the fourth quarter of 2019 and 177% from the first quarter of 2019. 

Zero-commission trading will drive equity trading growth going forward

Another aspect of trading has been the introduction of zero-commission trading. On the earnings conference call, CEO Douglas Cifu attributed much of the company's revenue growth to zero commissions.

"Our results are more than just a function of market volumes and volatility," Cifu explained. "Higher retail engagement remains a key driver of our customer Market Making business, which has benefited from the growing trading volumes fueled now by zero commissions and, more recently, new, as well as seasoned traders working from home and taking advantage of market volatility."

Massive spikes in volatility are generally rare events

It is important to remember that markets tend to spike and then slowly return to normal. Volatility spikes like the March-April time frame are rare events. The spikes in volume and increases in bid-ask spreads should revert back to normal levels. That said, the volume increase from zero-commission trading should be considered a permanent change in the marketplace. Note that Virtu is an investor in the Member's Exchange, which is a low-cost stock exchange slated to open in September. This has the potential to be another source of organic growth. 

Virtu is trading at a low multiple to what may be peak earnings

Virtu is trading at five times its estimated 2020 earnings per share of $4.86. The low multiple is telling you that the market thinks this could be an earnings peak, based on a few rare events. The company also pays a quarterly dividend of $0.24 per share, which works out to be a 4% dividend yield. The 20% payout ratio is pretty conservative as well.

Virtu's massive increase in revenue is one reason why the stock is up almost 58% year to date while the rest of the financial sector has underperformed. While this earnings pace may not necessarily continue, the stock has an extremely low multiple and a dividend yield that should provide some downside protection. 

Brent Nyitray, CFA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Virtu Financial, Inc. Stock Quote
Virtu Financial, Inc.
$20.77 (-0.76%) $0.16
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$30.36 (-0.91%) $0.28

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