To date Huddlestock1 is up +7.87% versus -0.06% for Europe2, +10.90% for the US3, -1.04% for Emerging and Frontier Markets4. Huddlestock was up +1.41% in July.
As discussed in our previous Investor Brief, given our view on the global economy we are shifting our investment approach from being top-down and growth-driven to being bottom-up and quality-oriented. In this Brief, we are going to discuss a specific investment idea in greater depth. The company we’ve selected is Flow Traders NV, a global financial technology company based in Amsterdam, the Netherlands.
1Estimated actual performance of all strategies/themes on the Huddlestock platform on an unleveraged basis since November 2017.
2As defined by the iShares MSCI Eurozone ETF (EZU) which seeks to track the investment results of an index composed of large and mid-capitalisation equities from developed market countries that use the Euro.
3As defined by the S&P 500 (SPY) which seeks to track the investment results of the S&P 500 index.
4As defined by the Global X Next Emerging & Frontier ETF (EMFM) which seeks to track the Solactive Next Emerging & Frontier Index.
The Big Picture: Containing Instability
The Fed is currently facing the challenge of navigating two risks: Raising the federal funds rate too quickly, which will needlessly shorten the expansion, and raising it too slowly, which will keep the expansion going, but increases the likelihood of introducing instability via overheating. Communications from the Fed over the past few months suggest that they are having some difficulty in reading the myriad interaction effects that the withdrawal of monetary accommodation, late-cycle fiscal stimulation, an unsustainable federal budget deficit, the trade dispute and geopolitical manoeuvring5 are having on the US economy in real-time. Given the healthy state of the US economy the Fed, as we have argued in previous Investor Briefs, is very likely to remain cautious, transparently continuing along their stated path of gradually raising the federal funds rate, while reacting to (as opposed to pre-empting) any manifestations of instability as they arise. The complexity of the situation makes the likelihood of a policy misstep very high.
The view from the top is that we have entered a period of greater economic uncertainty, fraught with inflection points, risk concentrations and heightened sensitivities. These uncertainties are transmitted through the global economy via currency and debt markets, amongst others. These considerations recently led us to change our investment approach to one that is more focused on quality and more tactical in nature. Specifically, in the case of Flow Traders, we were attracted to a quality investment that is primed to benefit from instability.
5Not to mention the possibility of Trump’s impeachment and a mid-term election in November.
Flow Traders NV
Flow Traders’ primary business is providing liquidity for Exchange-Traded Products (ETPs), making them easier and cheaper for both institutional and retail investors to trade. ETPs are investment products that derive their value from an underlying portfolio of assets like stocks, bonds, commodities or currencies and trade as a single instrument on an exchange. Unlike mutual funds which actively try to outperform an index, ETPs are typically designed to track them cheaply. These products have grown enormously in popularity over the past few years with the ETP market expected to grow to $6 trillion by 2020 (from roughly $3 trillion in 2016). The ETP ecosystem can be divided into a primary and a secondary market, and Flow Traders participates in both. The primary market is where issuers and authorized participants create and redeem ETPs in response to market demand. The secondary market is where ETPs are traded, on- or off-exchange, like ordinary shares at prices determined by the market.
Reduced to its essence, the company comprises a sophisticated technology platform, with access to more than 100 trading venues in 36 countries, that hosts market-making and (statistical) arbitrage6 algorithmic strategies that seek to profit from small pricing discrepancies in these products. Abstractly, every business defines a probabilistic mechanism that converts input into output, costs into revenues, with the aim of maximising profit to which shareholders have a claim.
Simply put, the algorithms hosted by the platform seek to accurately identify and optimally exploit profit-making opportunities that are created when supply and demand for an ETP causes its value to deviate from the weighted sum of its constituent assets. A (statistical) arbitrage opportunity arises when this difference is large enough to cover the costs of exploiting it while over-compensating the arbitrageur for any risk taken. In practice, this boils down to setting accurate, competitive quotes (both in terms of shape and speed) for ETPs at profitable levels while adhering to strict risk limits and complying with various regulations and contractual obligations.
Reduced to a few sentences the task at hand seems straightforward but that conclusion couldn’t be further from the truth. This is an area of intense competition where the latest advances in maths, statistics, computer science and physics are used in an ultra-high-speed, algorithmic, game of poker.
The profitability of this mechanism is directly related to both the number and size of the profitable opportunities it can capture. These are in turn mostly a function of turnover in the securities that Flow Traders cover combined with the level of competition. Two sources of turnover are instability and the flow into and out of ETPs. Our investment thesis is that instability and late-cycle volatility will lead to higher turnover while allowing for the possibility that if volatility remains at historically low levels the cost of being wrong is limited. Flow Traders’ track record, including the growth of its global market share, is evidence of its competitiveness while the profits it made during the implosion of inverse volatility ETPs in February demonstrated the potential upside that instability could bring.
6Arbitrage is defined as riskless profit.
The company has built a complex, scalable, modular, high-capacity, proprietary technology platform that comprises low-latency data feeds that pump real-time data through algorithms, hosted on co-located servers, that identify and then attempt to efficiently capture profitable, precisely-hedged trading opportunities7. It does this subject to parameters and constraints set by traders, compliance and risk managers who can monitor trades and positions in real-time. Ideally, perfectly accurate data is sent over the shortest possible distance before being funnelled through speed-optimised, highly-precise algorithms that can respond by capturing the profit before any competitor can. The scalability of the platform is critical for minimising the incremental cost of adding new securities, asset classes or markets to the mix while the modular nature of the platform allows for continuous improvement which is required to maintain an edge on the competition.
The complexity, cost and inter-disciplinary competence required to build, manage and improve a platform of this scale define significant barriers to entry. To prevent the leakage of intellectual property, access to the internal workings of the platform is strictly controlled and contractually enforced.
Flow Traders does not hold or manage client assets and clears its trades through highly-capitalised, regulated prime brokers. These prime brokers effectively assume all the risks contained in their portfolio conditional on their posting enough collateral to cover the risks the prime broker is exposed to. A critically important risk for this business is liquidity risk, which is the risk that the company lacks enough trading or regulatory capital to operate normally. Given its importance, unsurprisingly, this risk is carefully and constantly monitored and managed by a dedicated risk management team.
Generally, when investing in a company it is critically important to trade-off the prospective upside against the risks that the investment will be exposed to, including understanding management’s ability to manage and monitor these risks. Being a financial technology company, other risks that are relevant to Flow Traders include credit, counterparty, market and regulatory risk on the financial side and IT (and IT Security) risk on the technology side.
Credit risk is the risk that a counterparty defaults on an obligation, thus harming the company’s financial position. This risk is being managed by constraining the exposure of the company to each counterparty, product and settlement type while explicitly accounting for the duration of each exposure and monitoring the creditworthiness of each counterparty.
The financial instruments that the company holds on its books while trading is subject to market risk which is the risk that an unfavourable market move causes a loss in value. Flow Traders’ policy is to aim to perfectly and instantaneously hedge the market risk exposure of each opportunity it is exploiting.
Companies like Flow Traders operate in a highly regulated industry and costs are likely to be incurred keeping up with any regulatory changes. The recent drive towards greater transparency by regulators, where they are pushing more trading onto lit venues (as opposed to OTC trading and trading in dark pools), is positive for the company, so these changes don’t have to be net negative for the business.
Given the company’s reliance on its IT infrastructure, its profitability is highly dependent on the integrity and security of its platform. It has a very solid track record of keeping the cogs turning with very little downtime over the past few years.
7Many of the buildings around exchanges have become server hotels which cater to high-frequency trading operations.
Valuation and Timing
Historically, this stage of an economic cycle sees a rotation out of ‘growth’ stocks into ‘quality’ stocks (de facto this is a rotation out of stocks that are sensitive to rising interest rates into stocks that are less sensitive to rising interest rates). At this stage, we’d also want to invest in companies whose earnings are virtually certain to be higher over the coming few years than has been priced into the stock by other market participants. We think Flow Traders ticks both boxes.
Flow Traders has a Return on Capital of 35.2% (ranking it 26th out of 397 companies in the European Investment Banking and Investment Services Industry) and a return on Equity of 44.8% (which is 18th highest) while its gross operating margin is 74.3%. These solid numbers reflect both the profitability and efficiency (i.e. quality) of its platform and management’s skill in driving overall business performance.
A confluence of two recent dynamics have set the stock price up such that it is likely under-priced relative to fundamentals. The first is that the company profited handsomely from the implosion in short volatility ETPs in February while the second is that a 3-year post-IPO lock-up period expired in June. The result was a bout of profit-taking which has resulted in a 30% drop in the share price since June.
The analyst reports we’ve studied on the company seem to focus on two superficial factors that they believe define future profitability. The first factor is some simply extrapolated projections of the growth in passive investing via ETPs and the second is an oversimplified insight that earnings are correlated with the VIX Index (which reflects the market’s expectations of 30-day volatility and is based on the implied volatilities on S&P 500 index options). The assumption is that a higher VIX implies higher turnover i.e. more arbitrage opportunities. While this is broadly true, we believe, and as noted above, these analyses largely ignore style/thematic/industry/country rotations, the likely move into more actively managed ETPs, the possible implosion of other leveraged ETPs (such as the concentrated short exposures that have built up in the bond markets), as well as, the possibility of market dislocations and the resultant outflows in ETPs if there is a rush for the exit at some point. Also, keep in mind our hypothesis in previous Investor Briefs, that these products are going to be materially involved in how the current cycle ends.
What does this mean for an investor?
We believe our investment in this company checks the right boxes given where we are in the current economic cycle, the quality of the company and tailwinds like the continued electronification of trading and the growing use of ETPs. We are convinced that we’re getting the shares at a good price given the competitive moat the platform engenders and are convinced of the quality and insights embedded in managements growth strategy. Finally, the company has a solid governance structure where a Supervisory board advises and monitors a management board on one side and prime brokers and other institutional counterparties carefully monitor the company’s risk exposures out of self-interest.
New Features: Faster Onboarding
This month our Apple iOS app has been upgraded to onboard new users more efficiently. This means that signing up to Huddlestock now takes under one minute, which is important as we grow.
On the lookout, we can announce a new Android app and a way for investors to connect and follow their personal network on Huddlestock shortly.
As always, if you have any feedback, please email us at email@example.com.