Markets Could Rise or Markets Could Fall... This Company Wins Either Way
Volatility isn't going away...
The CBOE Volatility Index ("VIX") – the stock market's "fear gauge" – has remained above its key level of 20 for most of 2022.
Put simply, a higher VIX indicates higher option prices in the market. And investors use these options to purchase protection for their portfolio. So when the VIX is elevated – like today – it's a sign that investors expect more price swings in the near future.
We've seen these wild fluctuations play out in the major indexes recently. Between January 3 and January 27, the S&P 500 Index fell 9.7%. It then rebounded more than 6% in about two weeks before dropping sharply again – finishing 13% below that January high on March 8.
Increased volatility is a good thing for today's company, which had one of the longest winning streaks the market has ever seen...
Imagine trading millions of shares for 1,485 straight trading days... and only losing money on one day.
The computer-based "market maker" Virtu Financial (Nasdaq: VIRT) did exactly that from 2009 to 2014. It touted its nearly unblemished profit streak as it prepared to go public.
Essentially, market makers provide liquidity by matching bids and asks on exchanges. These companies make their profits off the small difference between the bid and ask prices (called the "spread"). So it's easy to see why Virtu makes money slowly, eking out small gains on barely more than half of its trades.
When an astrophysicist analyzed the data in Virtu's initial public offering ("IPO") filing, the scholar estimated that the company made just $0.0027 per share traded, on average. That's less than a third of a cent. But Virtu makes these infinitesimally small gains on hundreds of millions of executed trades per year through high-frequency trading ("HFT"). It all adds up and amounts to sizeable profits.
What's more, it's consistent... Day in and day out, about 51% to 52% of Virtu's trades turn a small profit. And that's practically built into the business. If the win rates were higher or the spreads were larger, more HFT competition would step in to close it back up. But if HFT market making became unprofitable, the firms would stop providing liquidity – instantly widening spreads and creating a fresh opportunity for profit.
Virtu's technology also gives it a highly scalable business. That's the beauty of being almost entirely electronic. If Virtu wants to trade a new security or market, it can copy computer code and adjust its algorithms ("algos"). There's no need to hire traders or salesmen and pay them salaries and bonuses or give them benefits.
Bid-ask spreads in the market may be narrow. Counterintuitively, Virtu has wide margins as a whole. That's because its operational costs are so low... another benefit of everything being automated.
Virtu's revenues surged to a record $3.2 billion in 2020, before dropping to $2.8 billion in 2021 on lower volatility.
Market making accounted for roughly 78% of Virtu's revenues last year. Stocks are its bread and butter, but it also trades bonds, currencies, exchange-traded funds, and derivatives, such as futures and options.
The remaining 22% of revenues (good for $600 million) came from "execution services," like when Virtu handles large trades from institutions. These types of trades aren't easy to carry out. Institutions can't just sell a block of shares all at once without causing a significant shift in the market.
So they turn to Virtu instead because of its experience carrying out these orders smoothly.
The firm's biggest expenses are payments for order flow to brokers and exchange fees. Essentially, Virtu pays brokers to route orders from retail investors to it, instead of to an exchange. Last year, these types of expenses equated to around 25% of revenues.
It also has significant communication and data processing costs. Those expenses include the network infrastructure that connects the company's data centers to trading venues, and market-data subscription fees Virtu pays to the exchanges.
Finally, relatively low operating expenses and minimal capex leaves Virtu with a lot of free cash flow ("FCF")...
FCF margin is FCF as a percentage of sales. Virtu's FCF margin, which excludes changes in trading capital, has averaged about 28% over the past five years. By comparison, the median FCF margin in the S&P 500 (excluding banks) currently sits at about 15%. And the long-term average for the S&P 500 is around 10%.
Despite volatility looming on the horizon for investors, Virtu's future is bright. Its algos continue to extract value from spreads across myriad trading venues. And those spreads add up – quickly. So Virtu is pumping out cash flow as trading volumes increase from volatility. That should serve as a tailwind for shares.
Sometimes investing is simple.