The S&P 500 has gotten off to a lackluster start in 2022, down 8.8% since the year started. During that same time, Virtu Financial (VIRT -1.77%) has crushed it, up 22% year to date and recently hitting a 52-week high.
The firm recently posted fourth-quarter earnings that crushed analysts' predictions, beating revenue expectations by 32% and earnings per share (EPS) estimates by 48%. Investors were also encouraged by its quarterly earnings growth after it lagged for much of 2021. I think Virtu is positioned well to keep going higher from here. Here's why.
How Virtu makes money
As a market-making firm, Virtu provides liquidity to global markets. Market makers make it easy for traders to easily open and close positions in stocks or other types of assets, standing ready to take a position on any order that comes across. If you want to buy a stock or sell an option, they are there for you.
This ability to immediately open or close a trade is a service to markets, but it's not without cost. Because market makers must be willing to take a position, they maintain a book of stocks and options. So these companies make money on the difference between the buy and sell prices in the transactions they facilitate, or what's known as the bid-ask spread. During calm markets, bid-ask spreads are narrow, so these firms make less money. During volatile markets, these spreads widen, and market makers make more money. Market making made up 78% of Virtu's total revenue last year.
Its earnings can be volatile
Market makers can see earnings swing as volatility swings. Virtu Financial's 2020 performance is a perfect example. The onset of the coronavirus pandemic caused heavy volatility early in the year, and Virtu posted a blowout year as a result. 2021 saw volatility fall, and Virtu's earnings fell too. Revenue for the year was down 13%, due primarily to a 15% decline in market-making revenue.
However, investors have been more bullish on Virtu recently due to volatility, which picked up in the fourth quarter, helping Virtu grow its market-making revenue 7.3% from the year before. Markets have gotten off to a volatile start in 2022, and volatility has risen as investors keep tabs on inflationary pressures.
Why investors care about inflation and rising interest rates
In January 2022, the consumer price index (CPI), a measure of inflation, came in at 7.5%. While the Federal Reserve will tolerate a 2% level of inflation, we've been above that level for over 10 months now. Fed officials react by raising interest rates to slow down demand and bring down inflation.
Rising interest rates are not necessarily bearish for the stock market. For example, from 2016 to the end of 2018, the Federal Reserve raised the benchmark federal funds rate from near-zero levels to 2.4%. The S&P 500 delivered a 30% total return during that same time.
But this time could be different. Before, the Federal Reserve was raising rates into a growing economy with minimal inflationary pressures. This time around, the Federal Reserve is raising rates to curb inflationary pressures. The concern is that interest rates could rise faster this time around, stifling demand and slowing down the economy. If that does happen, expect volatility to persist in markets -- which would be a tailwind for Virtu Financial's market-making business.
Virtu is a buy as long as inflation persists
You must keep in mind that Virtu Financial is a cyclical stock that relies on volatile markets for profits. The firm looks to continue growth by diversifying its income streams. For example, the company expanded its market-making service to more symbols on more trading exchanges last year. The company also has a massive ongoing stock repurchase program that could boost its share price. From November 2020 through January 2022, it repurchased $483 million in stock -- and it can purchase another $737 million as authorized by its board of directors.
Virtu Financial is a solid stock to own as long as uncertainty looms over the markets. The most significant uncertainty is inflation and just how long it sticks around. As long as inflation looms large, the Federal Reserve will need to do something to address it, and markets may not like what they do.
However, if inflationary pressures subside, the Federal Reserve will not have to raise interest rates as quickly, which could bode well for the economy and markets -- but not so much for Virtu's business.