Flow Traders: Buy this Antifragile Stock When its Cheap

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I held a position in Flow Traders at the time of writing.

Key Reason to Purchase

In 2012 Nassim Nicholas Taleb published the book Antifragile. Nassim defines antifragility as:

“Simply, antifragility is defined as a convex response to a stressor or source of harm (for some range of variation), leading to a positive sensitivity to increase in volatility (or variability, stress, dispersion of outcomes, or uncertainty, what is grouped under the designation "disorder cluster").”

One company which fulfils Nassims definition of antifragility is the company Flow Traders, a proprietary trading firm. When financial markets in which they operate become more volatile (as measured by VIX for this article) Flow Traders make much more money and when they are less volatile Flow Traders make less money. 

Over the past twelve months volatility has been relatively low in financial markets, this has hit Flow Traders earnings and Flow Traders stock price has reached record lows. In addition Flow Traders valuation as a function of earnings is at a low level. This is despite Flow Traders antifragile characteristics, acting as a type of market insurance which makes high profits and pays high dividends when markets are volatile. As well as growing its business and continuing to pay out dividends when markets are less volatile. Such a stock that gives investors more money when they need it most should trade at a premium rather than a discount relative to its earnings, due to its antifragile characteristics.

What Do Flow Traders Do?

Flow Traders was founded in 2004 by Jan Van Kuijk and Roger Hodenius, two former partners at Optiver. Flow Traders is a market maker, which provides liquidity in financial markets using High Frequency Trading (HFT) and quantitative strategies. Their business is divided into two segments in the first “on screen” is conducted on stock exchanges where they provide continuous bid ask prices for a range of financial products with a focus on Exchange Traded Products (ETPs). The second part of their business called “off exchange” trades bilaterally with institutional counter parties often through request for quote platforms. More recently they have diversified from their initial focus on ETPs into other financial products including fixed income, crypto currency, foreign exchange and commodities. 

As an example they will track an Exchange Traded Fund (ETF) and its underlying securities and whenever the price of the underlying securities varies enough from the ETF they will buy one and short the other. These variations are generally small, but occur enough times that all these small returns add up. 

Moat

Since being founded Flow Traders has built out a trading platform to efficiently make trades in its areas of expertise. This platform makes lots of very small returns without taking a real position in the market, but just taking advantage of the bid ask spreads. All of these small returns add up over time to make very good returns on Flow Traders capital. This is a highly complex and optimized platform, which is difficult to replicate from both a cost perspective as well as experience in the markets. 

Another difficulty of replicating the Flow Traders platform in their largest revenue center of Europe is the complexity of European financial market structure, relative to the US. Europe being made up of many different countries has many exchanges, clearing houses and regulators. This complexity deepens even further in the case of ETPs, tracking underlying assets across the world in different time zones and regulatory regimes. One way Flow Traders has found around this complexity is building relationships with European buy side firms (counterparties). So that if one of these counterparties wants to offload a large number of shares it can try to offload them to a market and hope the market absorbs them, or it can trade them with Flow Traders. Flow traders can then offset this trade across its network by trading with other firms across its off exchange network or hedging. The more counterparties added to this network the more profitable these trades. 

Finally Flow Traders has a much more robust system of risk management than most market makers. In an interview with the co-CEO’s in 2017 Denis Dijkstra and Sjoerd Reitberg said “the idea was to get a good night's sleep”, even admitting the part of the company name “Traders'' was misleading “We are not traders”  "We are operators''. Most market makers use a stochastic approach to model potential outcomes and hedge against these potential outcomes. However Flow Traders uses a more mathematically intensive approach, which allows them to eliminate more forms of risk. 

Industry/Competitors

Flow Traders as described earlier is a market maker, which uses HFT and quantitative strategies. Within this industry it is difficult to get information on competing firms as most of them are private such as Optiver, IMC BV, Susquehanna or Citadel Securities. The only other publicly traded firm is Virtu Financial. The aforementioned firms similarly to Flow Traders offer bid ask prices, as well as other proprietary strategies on most financial instruments creating liquidity in financial markets. 

While different market makers focus on different areas of financial markets Flow Traders focuses on ETPs. ETPs are baskets of assets the largest category of which is ETFs, which is a basket of stocks. In recent years ETPs have grown rapidly as investors have sought to gain exposure to particular financial markets or sectors without focusing on any specific company. 

Earnings and General History

One aspect of Flow Traders earnings which I appreciate is one reason the stock price is so low, its revenue and earnings are quite lumpy. When volatility is high in financial markets, bid ask spreads and differences between the value of ETPs and their underlying assets can become quite large allowing for greater potential profits for Flow Traders. Alternatively when volatility is low the bid ask spreads and value differences between ETPs and their underlying assets are smaller meaning less potential profit for Flow Traders. Since volatility varies so much from year to year Flow traders profits do not advance smoothly. 

Currently this is seen as a bad thing by financial markets as in general financial analysts and investors like businesses whose earnings are easier to predict and more stable. This is if you think of it as a regular stock rather than thinking of it as portfolio insurance that over earns and pays out those over earnings to shareholders when there is higher volatility in markets. 

For example in 2020 when the world was suffering from Covid19 Flow Traders paid out a dividend of 4.55 Euros after starting the year at about 21 Euros stock price, in addition the stock price rose to 34 Euros a 62% increase. So its earnings volatility, seen mostly as a problem, can also be seen as portfolio insurance that pays you whenever the market is volatile, which is often usually when the market presents opportunities and cash is at a premium. 

Since Covid19’s first impacts in 2020 volatility in the stock market and Flow Traders earnings have gone down. Investors have as a result sold the stock and the price has fallen to record lows despite growth in Flow Traders main ETP markets and Flow Traders entering and expanding into new markets (such as China and Crypto) and generally creating a better business for when volatility rises again. 

Two other factors besides volatility have affected Flow Traders earnings this year making this year a perfect storm to their earnings: 

The first is “net financial expenses related to trading activities” is up about 48 million Euros for the first six months of 2023, this increase is related to higher interest rate due to “...credit facilities with the prime brokers calculated on the drawn amount during the year.” With about 45 million shares outstanding this translates to about 1.07 Euros per share for the first six months of 2023. 

The second impact on earnings this year are currency effects reducing earnings for the first six months of 2023 by about 4.3 million Euros. 

Flow Traders earnings are currently being lower than prior years due to lower volatility, higher interest rates and currency effects. As a result, earnings in the first half of 2023 and perhaps the second half of 2022 are only representative of Flow Traders earnings in a bad year with multiple factors negatively impacting earnings relative to prior years. 

Future Prospects

Since Flow Traders IPO’d in 2015 its stock price after a brief rise has fallen from a high of 36.2 Euros to today's price of 18.02 Euros. This is despite large growth in its major market of European ETP products and expansion of Flow Traders into new markets. Flow Traders isn’t the only HFT experiencing lower profits either, Virtu Financial (NYS:VIRT) the only other publicly traded HFT is also experiencing significantly lower profits over the past twelve months. 

As a result Flow Traders as well as other high frequency Traders should benefit in the medium term from higher volatility, as well as in the case of Flow Traders more favorable currency movements. 

In the long term Flow Traders' major market of ETPs in Europe, as well as the rest of the world continues to rapidly grow at a 20% annual growth rate annually since 2011.

In addition Flow Traders has been successfully expanding into new ETP markets. It has a 27% share of global crypto market ETPs. Being a market maker it is not taking a position on crypto but simply providing liquidity. In addition it has expanded into the Asia Pacific and gotten a QFII license opening a Shanghai office. Thus Flow Traders isn’t just enjoying its privileged position market making in European ETPs but is expanding into other financial markets across the world growing and diversifying its business. 

Competitors

In purely economic terms I would classify the markets in which Flow Traders participates would likely be oligopolistic competition. This means in the main market Flow Traders contests there are a small number of large players who dominate the market. 

There are quite a few HFT firms, some of these include Citadel Securities, Optiver, Two Sigma, Virtu and IMC Financial. All of these firms have their own strategies and many likely operate in the same markets as Flow Traders, Its two largest competitors operating in similar markets are Optiver and IMC financial who are also highly active in European financial markets. But Flow Traders also has operations in the USA, which would overlap with many of the others such as Citadel, Two Sigma and Virtu. So all markets in which Flow Traders operates are contested by competitors. 

The only competitor who is also publicly traded is Virtu Financial, they are mostly based in the USA. Their performance in recent years has been very similar to Flow Traders, with much lower earnings and falling share price, despite volatility adjusted growth in their underlying markets. Relative to Flow Traders investing in Virtu has pros and cons, Virtu has been much more aggressive in buying back shares during this significant downturn in their industry, which is a benefit. However, one aspect of Virtu I do not like is their different classes of shares which give the founders extra voting rights, which is one of the reasons I’m more interested in Flow Traders Stock. In addition I believe the lower centralization of the European market creates greater barriers to entry for new competitors lowering competition. 

Balance Sheet

Flow Traders does not have a significant amount of long term debt. It does partake in short term borrowing based on its trading activity, which is correlated with its trading activity. 

Management Team

The two founders of Flow Traders are Roger Hodenius and Jan Van Kuijk, they own 10.07% and 12.22% of Flow Traders stock. They have both largely stepped down from management responsibilities but are on the board and based on their holdings have interests aligned with shareholders.

Mike Kuehnel is the Chief Executive Officer (CEO) of Flow Traders and was appointed in February 2023. He replaced Dennis Dijkstra who stepped down after ten years as CEO of Flow Traders. Kuehnel joined Flow Traders in 2021 after working as a management consultant at Bain and Company and an executive director in the financial institutions division of Goldman Sachs. 

Hermien Smeets-Flier is the Chief Financial Officer (CFO). She has served as chief financial and risk officer of Achmea Investment Management and CFO of Aegis London. 

Valuation

Flow Traders valuation is cheap regardless of which way you look at it. On a high level Flow Traders is currently trading at 14 times earnings or 7 times free cash flow. Generally I would attach those earnings multiples to a company that is shrinking and although Flow Traders earnings are down over the last few years this is due to factors that are unlikely to repeat such as further falls in market volatility from its current level. Despite that the company has expanded into new markets and the markets it participates in are growing and so Flow Traders is able to make more money from a given level of volatility (VIX level) than they could in the past when their share price and valuation multiple was higher.

If I put together a discounted cash flow model, which over the long term assumes a discount rate of 10%,  levels of growth well below those of the ETP sector ranging between scenarios from 2% to 8%, as well as relatively low earnings multiple I get a fair value of 30.11 Euros, which puts Flow Traders at a discount of about 67% today. The closest scenario I have to Flow Traders' current price assumes 2%-3% growth (one tenth of the growth of the ETP sector). In addition this doesn’t account for the added utility of Flow Traders outperforming when the market is volatile. I believe for that reason Flow Traders should trade at a relative premium to its cash flows rather than its current discount due to the unpredictability of market volatility. 

So based on Flow Traders current valuation not much needs to go right to make money from this investment. 

Risks

Flow Traders is a relatively small company in a sector that is very competitive and potentially risky. As a result an investment in Flow Traders carries a number of risks some of which are outlined below:

Mistakes: Algorithms performing large numbers of automated trades can potentially lead to large losses in very short periods of time. This was highlighted for the industry in 2012 when Knight Capital a US market making firm suffered massive trading losses leading to its bankruptcy. This was a mistake caused by a technician forgetting to copy a program to one of their computer servers. These mistakes can happen and that is why Flow Traders has a robust risk management framework to try to mitigate such incidents. Although no program is perfect based on publicly available information from Flow Traders public history there have been no major incidents where a mistake has led to significant financial losses at Flow Traders. In addition, based on information from an article on Flow Traders in 2017 (can’t find any later information) Flow Traders hadn’t lost money on a single trading day in 34 months up to the publishing of that article.

Competition: Flow Traders works in a competitive industry with many financial institutions hiring very intelligent people to build trading algorithms. These high levels of competition can potentially lead to lower bid ask spreads, for which Flow Traders depend on for profits. I believe this is always a possibility as in many other industries profit margins being eroded away are as well. However the structure of the market making industry is oligopolistic, although there are many market making firms most of these firms specialize in a particular financial market area or areas. Within each of these areas large market shares are controlled by individual firms. So any overly aggressive firm in trying to take market share with lower bid ask spreads would be significantly lowering their own profits to do so and it wouldn’t be very rational to do so. In addition I take further comfort in Flow Traders main market being the ETP markets of Europe, which although they are much smaller they are much more decentralized and require Flow Traders network of counterparties and other experience to profitably trading, giving them a greater moat in my view than similar US market markers. 

Regulation: Another area which could potentially harm Flow Traders is regulation, which is still developing for this sector. The role of market maker was once fulfilled by specialist firms, but this role is now fulfilled by a range of investors. This increased competition, as pointed out by empirical studies has reduced bid ask spreads leading to more efficient functioning of markets. However one drawback is unlike traditional market making firms who are committed to remaining in the market HFT firms can leave at their own discretion. In addition algorithmic trading firms have in the past directly led to volatility such as the flash crash of 2010. As a result HFT is likely an area of greater regulatory flux than more traditional financial industries. There is always the possibility of regulation that could make these firms less profitable or even shut them down. However the firms dominating this industry are now large enough and generating enough value for financial markets that a regulator's job would not be complete without considerable consultation with the incumbent firms. Generally unless a firm is doing something that is not generating utility for markets, any additional regulations will add additional costs to ensure greater safety, which can be better borne by incumbent firms who can spread out the cost of these regulations across more revenue than small start ups. This makes it more difficult for start ups to disrupt the industry making incumbent firms moat wider.

Conclusion

Flow Traders is currently trading around record lows, with a low earnings multiple and lower financial market volatility holdings earnings down. I have argued above that such a business that is antifragile and provides its investors with more money when volatility is high should trade at a premium to its volatility adjusted earnings. So now it's possible to buy portfolio insurance that will add an element of antifragility to my portfolio at historically cheap rates.