Smart Money is Divided on This Stock

Meena is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In sports, being the weakest member of a weak conference is doubly insulting.  Not only is the team bad, but the same team cannot beat other mediocre teams.  Applying this analogy to the stock market of the past three years, you might just come up with Investment Technology Group (NYSE: ITG) as being the analogous aforementioned cellar dweller.  Since the stock market meltdown of 2008, the financial sector has notably trailed the subsequent comeback of the S&P 500.  Within the broad financial sector, those companies directly tied to the capital markets, trading, and brokerages have been even weaker relative performers. For investors not already using market-beating strategies like these, this presents an obvious problem.

Digging further within this group, ITG’s price performance has been sadder still.  From pre-crash 2008 levels of the mid $40s to $50s, ITG fell into a trading range from the mid $20s to the high teens for the rest of 2009 and 2010.  As the broad market stabilized and then rose, ITG continued slipping; the issue fell to new lows in the high $7s before riding the back of a broad financial sector rebound starting in late 2012. The stock now sits in the $12 range. 

The weakness in ITG has been brutal but hardly surprising.  The company offers a broad range of execution broker, trade analysis, and research services to global portfolio managers.  Buffeted by negative domestic fund flows since the crash, the company’s top line has been decimated.  Yearly total revenue has fallen from the $750 million level in 2008 to $500 million for 2012. Trading volumes executing through ITG have been essentially flat since 2009.  Recently announced fourth quarter 2012 earnings reflected these trends; adjusted quarterly net income fell to $0.02 per share from $0.07, and revenue fell to $121 million from $130 million.

However, problems with top line revenue have not been necessarily endemic to all financials over the last several years.  Looking across a cross section of financials, top lines have often grown. FXCM Inc. (NYSE: FXCM), a currency brokerage for retail and institutional customers, has grown revenue about 30% since 2009.  GAMCO Investors (NYSE: GBL) and Jefferies Group (NYSE: JEF), investment houses offering a wide range of brokerage related services, saw revenues rise nearly 50% and 40%, respectively, since 2009.  NASDAQ OMX Group’s (NASDAQ: NDAQ) flat revenues over the same period seem downright impressive compared to ITG’s.

What should investors do going forward?

Despite this track record, two hedge funds have been making big bets that ITG will benefit from a comeback in mutual fund inflows.  Parameter Capital Management (see full holdings here) ended 2011 with no position in ITG.  In its June 31, 2012 filing, the fund had established a 380,000-share position.  As of the September reporting period, the position had grown to 530,000 shares.  Mega-fund AQR Capital, meanwhile, had ended 2011 with 453,000 shares, and by Sept. 30, 2012, the fund had increased this position to 977,000 shares. 

However, like any trade, someone takes the other side.  Continuing with our sports analogy, one hedge fund may be worrying that ITG will spend more time in the cellar. In this case, Third Avenue Management has spent most of 2012 reducing a sizable position in the stock; they whittled down an end-of-year 2011 position of 3.4 million shares to 1.2 million shares as of September 2012. 

What could be driving Third Avenue’s actions? 

These hedgies may be concerned about issues within ITG.  One such issue is the judgment of management.  For example, the company has continued to invest heavily in the face of difficult market conditions—ITG acquired Ross Smith Energy Group in 2011, Majestic Research Corp in 2010, and made a major purchase of software from ESP Technologies in December 2010. 

The heavy investment by ITG management can be seen in ITG’s cash flow statements. Cash flows from investing activities have been strongly negative the past three years. As of yet, this investment has yielded little, and measures of return on equity and assets are strongly negative; return on equity is in the -50% range, and return on assets is in the -10% range. These numbers not only easily trail the S&P 500 as a whole, but even the averages of most of its peers.

Additionally, the company has produced a yearly deluge of earnings charges resulting from restructuring, employee reductions, goodwill write-downs, and acquisition-related matters.   Comparing ITG to our sample of four financials—GAMCO, FXCM, Jefferies, and NASDAQ OMX—none have negative ROE or ROA.

This divergent opinion by certain hedge funds is not without value to the retail investor as it focuses on the background factors driving each side of the market.  In this case, investors need to weigh the efficacy of ITG management versus any sign of an uptick in mutual fund inflows. This is just one of the key values of tracking hedge fund activity that is available on Insider Monkey. 

Given the recent dramatic up move in ITG, investors may want to step back, let the stock come off an overbought condition, and carefully track the issues discussed here before initiating new positions.

This article is written by John Guba and edited by Jake Mann. Insider Monkey's Editor-in-Chief is Meena Krishnamsetty. They don't own shares in any of the stocks mentioned in this article. 

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