VIRT - ABC Arbitrage: An Intriguing Hedge But Viel Is A Better Option

Summary

• ABC Arbitrage is a French small-cap company that engages in arbitrage strategies in financial markets.
• ABC Arbitrage is one of the few stocks that benefit from volatility. As such, it offers diversification, and it also pays a generous dividend of about 6%.
• The shares are not cheap, though, and the dividend coverage is not great due to a high payout ratio of 80%.
• For investors willing to invest in foreign small caps, my preference goes to Viel & Cie, another stock that gains from market turbulence.

ABC Arbitrage: ticker ABCA.PA (Euronext Paris)

Market cap: €380M ($400M)

A few years ago, I introduced ABC Arbitrage (ABCA.PA, OTCPK:ABCCF ), a small-cap French stock with a very specific business model: arbitrage strategies, whereby the company takes advantage of mispriced assets in financial markets. These trading strategies thrive in times of elevated volatility, meaning that ABC Arbitrage performs especially well in downturns.

The company's performance has been satisfactory, but not outstanding, in my opinion. It offers a generous dividend of about 6%, but this yield comes with a high payout ratio. With the stock too expensive for my liking, I prefer another Paris-listed stock, Viel & Cie (VIL.PA), which also benefits from volatility. Viel's steady performance and undemanding valuation make it an excellent choice for income investors.

Not all retail investors will have access to ABC Arbitrage or Viel, given that the stocks only trade on Euronext Paris (the OTC ticker ABCCF for ABC Arbitrage has very little liquidity). For those seeking exposure to larger companies in the long volatility niche, let me mention Virtu ( VIRT ), Flow Traders ( OTCPK:FLTDF ) and BGC Partners ( BGCP ). A thorough analysis of Virtu be found here .

ABC Arbitrage: Making Money Out Of Market Volatility

ABC Arbitrage was founded in 1995. It is headquartered in Paris, France, and also has offices in Dublin and Singapore. The company defines itself as a quantitative asset manager. It deploys a variety of arbitrage strategies, using both managed money and its own equity.

These trading strategies can be broken down into four categories, per the company's website :

• Liquidity arbitrage: detecting and correcting differences in trading prices between linked assets.
• Risk arbitrage: taking advantage of risk mispricing in capital markets.
• Statistical arbitrage: pair-trading within an industry, lead-lag effects (e.g. interaction between commodity prices and inflation).
• Derivatives arbitrage: detecting mispricing in options and other derivatives.

ABC Arbitrage has a successful track record, having generated 27 consecutive profitable years, with a ROE (Return on Equity) in excess of 10%. These results have convinced institutional clients to entrust the company with their funds, to the tune of €350M. In total, including its own equity, ABC Arbitrage manages around €500M - a rather small amount, but enough for the company to fund its arbitrage operations (some of which couldn't be scaled up anyway).

The main driver of the company's performance, unsurprisingly, is volatility. Volatility, in fact, increases trading activity (velocity) and creates price dislocations that arbitrage strategies can exploit. The table below shows various drivers and their typical impact on ABC Arbitrage's financial performance.

After muted volatility levels for most of the 2010s, including some "no life" years, as the company calls them, the Covid crisis finally woke up financial markets.

This resulted in strong financial performance for ABC Arbitrage in 2020, and, to a lesser extent, in 2021 and 2022 YTD. The record results of 2008, during the Great Recession, are further proof of volatility's impact on ABC Arbitrage.

Note: 2022A above is just an extrapolation of H1 performance, the actual yearly results of course remain unknown.

ABC Arbitrage : A Generous Dividend Policy, But A High Payout Ratio

Based on its track record, ABC Arbitrage is seen to be a decent portfolio hedge, which tends to do especially well in periods when many stocks underperform. Financial performance in the first half of 2022 was satisfactory, though one might have expected the company to capitalize even more on the volatility generated by the war in Ukraine, and by the monetary tightening from central banks.

Central banks' behavior, in fact, makes the company's management hopeful that markets in the 2020s will be more favorable for arbitrage strategies than the previous decade: "The year 2022 seems to outline the end of the central bank paradigm established since 2012".

What about the distributions? The dividend history suggests a rather generous dividend payer, with a yield generally around 6% in the past couple of years. For 2022, based on the expected €0.40/share dividend (€0.1 quarterly), the yield is 6.25% at the current share price of €6.40.

Investors need to be aware, though, that ABC Arbitrage has a high payout ratio. In 2021 and 2020, it was around 80%. During the volatility lull of 2017-2019, the payout ratio exceeded 100% of earnings, and the distributions were made in part as return of capital to shareholders.

ABC Arbitrage is a good company with an original business model that it masters well, but at the end of the day, I make my decisions based on valuation. At a trailing P/E of 13, ABC Arbitrage is not cheap for a French small cap. Many European blue chips trade at multiples lower than this. I don't consider this valuation attractive enough for me to buy ABC Arbitrage's stock at this point, even if I used to have some in my portfolio a few years back.

Instead, I prefer another French small cap stock that offers the same kind of disconnect from the economic cycle and positive exposure to volatility. This stock is Viel & Cie (VIL.PA).

My Favorite Volatility Pick: Viel & Cie

Viel, which also trades on Euronext Paris, is a holding company whose main asset is a controlling sta ke in Compagnie Financière Tradition (SW:CFT, OTCPK:CFNCF ), a Swiss entity that is one of the top 3 interdealer brokers in the world. Tradition operates across many asset classes:

I will not detail here the thesis supporting an investment in Viel, but readers can refer to my earlier article : Tradition: How To Get This Swiss Inter-Dealer Broker On The Cheap. In short, I like Viel for 3 reasons:

• Tradition performs well in volatile times, thus fulfilling the same function as ABC Arbitrage, Virtu, Flow Traders and peer BGC Partners, as a portfolio hedge.
• Viel enables investors to buy Tradition at a steep discount, thanks to the holding company discount.
• The other holdings of Viel, though minor compared to Tradition, perform well too.

On the back on Tradition's strong performance in H1 '22, Viel posted excellent interim results. Net profit was €42M for the half-year (Group share).

Furthermore, when compared to other volatility plays, Viel gets an additional, direct, favorable impact from higher interest rates:

A shift in central-bank monetary policy, away from quantitative easing and rate hikes, was beneficial for the Group’s operations. This positive trend was reflected in all regions, and particularly in foreign exchange and interest rate products and securities and security derivatives.

Source: Tradition's earnings release

This bodes well for Viel in the coming quarters, even if volatility itself abates. For the full year 2022, even if we assume a conservative net profit (Group share) of €60M, Viel's shares are currently trading at a cheap P/E of 7 (based on the market cap of €420M). To be honest, I expect the company to do even better than this, given the strong Q3 '22 revenue announced by Tradition.

In terms of distributions, Viel has paid a growing dividend in recent years, and offers a 5% yield based on the 2021 distribution. What's key is the low payout ratio of only 35%. Finally, I like the fact that the number of shares has been going down in recent years thanks to buybacks being performed at an attractive share price.

Takeaway

ABC Arbitrage and Viel share some common performance drivers, above all the level of volatility in financial markets. They trade on the same exchange, have more or less the same market cap, and their dividend yields are pretty similar.

However, their valuations differ greatly. I like to look at my stocks through the prism of earnings yield: at a P/E of 7, Viel's earnings yield is ~14% (1/7). In the case of ABC Arbitrage, it is 1/13, meaning less than 8%. This is why Viel is by far my preferred option when it comes to small-cap stocks bringing something different to the portfolio.

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