VIRT - Virtu Financial: From Volatility To Tranquility

2023-12-27 23:56:03 ET

Summary

• Low volatility poses challenges for market makers like Virtu, whose income is tied to trading activity.
• Earnings are driven by volume and bid/ask spread, with lower volatility leading to lower earnings.
• Virtu's business is less affected by interest rate volatility, and the company consistently pays dividends and conducts share buybacks.
• As earnings of the company display option-like behavior, times of low volatility are most opportune to buy this stock.

After a tumultuous start of this decade, volatility has been hovering at relative low levels during this year. Low volatility is a nuisance for market makers like Virtu (VIRT) as their income is tied to trading activity. This relation implies earnings, and potentially stock price, behave in a contrarian manner.

This contrarian behavior has more analogy with options rather than other equity. After all, the value of an option decays over time until the moment volatility spikes. With Virtu however also in less volatile times a decent dividend is returned with potential upside if markets face unexpected events.

Earnings drivers

Virtu is a market maker, meaning that earnings are generated when trading is done. More specific, earnings are based on a combination of volume and bid/ask spread. When either volume or the spread is high, the company makes decent money. When both volume and spreads are high, the company makes an exceptional amount of money.

A large difference in bid/ask spread typically occurs when markets are volatile. This was aptly visualized in the earnings presentation of Virtue after the first quarter of 2020, see figure 1.

As volume and volatility drive earnings for Virtue, and other market makers, it is worthwhile to have an understanding of both.

Volatility

To gauge volatility, the well-known VIX can be used;

The VIX Index measures the level of expected volatility of the S&P 500 Index over the next 30 days that is implied in the bid/ask quotations of SPX options. Thus, the VIX Index is a forward looking measure, in contrast to realized (or actual) volatility, which measures the variability of historical (or known) prices.

A similar, but less well-known, indicator is available for the fixed income markets, the Merrill Lynch Option Volatility Estimate ( MOVE ):

The MOVE Index is a well-recognized measure of U.S. interest rate volatility that tracks the movement in U.S. Treasury yield volatility implied by current prices of one-month over-the-counter options on 2-year, 5-year, 10-year and 30-year Treasuries.

Volumes

For volume Virtu presents an overview in the quarterly updates of different market metrics such as US Equity Consolidated volume for example. By default, I personally use the statistic Global Exchange Value Traded ((EVT)) which is provided by Flow Traders (FLTLF) on a monthly basis. Although the numbers may differ, the goal here is not to know exactly how much has been traded, but rather to get an idea of the trend in volume. To that end figure 2 shows how volatility and volume have developed over the last eight years.

Clearly volume has taken flight and remains elevated compared to the pre-corona era. As pointed out in another article ; current volatility may be perceived as low, but in aggregate there is a distinction to be made pre- and post-2020. In aggregate volatility traded at relative high levels since 2020 compared to the previous decade.

While the volatility in equity markets returned to 'normal' levels, the MOVE signals bond markets are still in turmoil. Unfortunately, when it comes to trading income, it is important to note Fixed Income markets are a growth area for Virtu. In other words, the business cannot yet fully capitalize on the bond market volatility. That means more weight should be given to the VIX. To reference income against (equity) volatility and volume metrics, figure 3 has been generated.

The data in the figure indicates Average Net Trading Income ((ANTI)) remains elevated, mainly supported by higher trading volume and supplemented by growth initiatives in block chain and fixed income. Yet, referencing current performance against 2019, the doubled EVT does not translate itself into twice the earnings. Without a spike in volatility earnings remain rather flat.

Options

As market makers benefit from volatility, earnings and potentially stock price, behave in a contrarian manner. After all, tranquility in markets is a harbinger for lower earnings. Conversely, increased volatility commends higher earnings. As argued in an article on European market maker Flow Traders, instead of considering the company as equity or insurance, a more correct analogy can be made to options . After all, the value of an option decays over time until the moment volatility spikes.

The same holds for Virtu where shareholders probably welcome volatility to prop up earnings and consequently its stock price.

Interest rates

While both Virtu and Flow Traders are in the same business making a living out of volatility, the former is the more constant factor. For example, in aforementioned article on Flow Traders it was noted high interest rates weighed on the performance of the company. In the case of Virtu however, this effect is not present, see figure 4.

On the back of a higher Federal Funds rate, the cost of interest is indeed increasing. For example, FY2022 interest and dividend expenses were US$231 million, whereas after 3Q23 this number already reached US$343 million. On the other hand, the company also benefits from the higher interest rates as is clearly visible from the line item Interest and dividends income . The beauty is that Virtu is hardly affected by the volatility of the interest rate environment, it literally takes volatility out of the market.

In addition, a distinction must be made between the interest income and expenses as a result of trading activity versus the expenses to service its US$1.8Bn debt. Here the company books very constant performance as the line item financing interest expenses is rather constant quarter over quarter, again see figure 4.

Shareholder returns

Since 2016 Virtu paid an annual dividend of US$0.96. Whatever the state of the market, the dividend was there. As with the interest rate example, Virtu shields its shareholders from the ebbs and flows of the market. To aid predictability even further, Virtu management has tied the annual buyback target to the Average Net Trading Income, see figure 5.

As the data in figures 3 and 4 already showed, the Full Year Adjusted Net Trading Income will likely be around US$1.3Bn. As buybacks up to 3Q23 already amounted to US$167million, additional buybacks in the fourth quarter would be well above guidance and can therefore not be taken for granted.

More important however is the outlook. Since 2020 Virtu spend more than US$1Bn on buybacks. As figure 3 shows ANTI has been normalizing over the last year to an average of US$300 million per quarter, going forward this implies the rate of buybacks will be reduced in absence of any events causing spikes in volatility.

Even so, at the current price of US$20.50, this company yields 4.7 percent and on top of this annually retires 3 percent of its market capitalization. If this makes you sleep well at night, you will certainly do so under the notion that any volatility elevating event will support Virtu’s ANTI and thereby additional buybacks.

Risks

As noted before the global value traded doubled after the corona pandemic. The increase in ANTI, but also the emergence and IPO of e.g. Robinhood (HOOD), can’t be seen separately from the pandemic and the subsequent surge in trading activity. And therein also lies a risk as blindly assuming trading activity will remain elevated would be a mistake.

The potential of lower trading volumes is reflected in the trend of EVT. Taking the 1Q22 high as a starting point the trend is clearly pointing down, see figure 2. As trading income is the product of volatility and volume, Virtu ANTI has shown a downtrend as well, currently hovering around US$300 million per quarter, as demonstrated in figures 3 and 4. In absence of events that will make volatility increase significantly, a further downtrend of earnings can’t be ruled out. After all, pre-2020 markets behaved very tranquil as well for an extended period of time. While it seems the dividend is safe, buybacks would have to be suspended if income would revert to e.g. 2019 levels.

Besides a downturn in income, the SEC investigation into alleged False and Misleading Disclosures Relating to Information Barriers must be mentioned as well when risks are considered. Quoting the SEC;

Virtu Americas allegedly failed to safeguard a database that contained all post-trade information generated from customer orders (…) including customer identifying information and other material nonpublic information.

The SEC’s complaint alleges that this database was accessible to practically anyone at Virtu Americas and its affiliates, including their proprietary traders, through two sets of widely known and frequently shared generic usernames and passwords.

According to Virtu , the lawsuit does not allege actual improper use of data but rather only the access to it. Furthermore Virtu indicates it voluntarily disclosed this information to the SEC. Based on the information available one could argue the effect will be little and Virtu has good chances to win. On the other hand, the financial industry depends on trust to a large extent. A look at the balance sheet of the Fed since 2008 and the spike in March 2023 (US banking crisis), underlines the importance of this trust. It is therefore to be hoped the case will evolve around the actual safeguarding of access to data rather than extending the feud to the point where the trust put in financial institutions is debated.

Conclusion

Whatever 2024 may bring, chances are tranquility in markets will persist meaning Virtu’s trading income will continue to remain under pressure. What’s more, exceptional volatility does not happen often, although investors in Virtu have been spoiled in this decade so far. Yet, volatility can’t be taken for granted which is the reason a clear distinction has been made pre- and post-corona in this article. After all, the previous decade was marked by low volatility.

As volatility is hard to predict, it has been argued investors are better off focusing on the dividend rather than volatility. In this respect Virtu does a wonderful job taking volatility out of the markets. Although company earnings reflect the state of the market, returns to shareholders in the form of dividend have been very constant, and additional earnings consistently have been used to buyback shares.

As earnings seem to be normalizing after a few tumultuous years, the stock price may trend lower in spite of the recent uptick. But as the case has been made earnings of the company display option-like behavior, I personally view times of low volatility as a buy signal. Also in less volatile times a decent dividend is returned with potential upside if markets face unexpected events.

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