Initiated position for 1300 shares at 458.7 GBX on 6 December 2016
Adding to position periodically below 550 GBX
Who can tell me an example of over-reaction? No-one? Let me try. How about the 40% collapse of IG Group (LON: IGG)’s share price on 6 December 2016? For those of you that are unfamiliar with IGG and the event surrounding 6 December 2016, let me attempt to shed some light.
IGG is a UK-based company and is also the leading provider of contract for difference (CFDs) globally. On a high level, a CFD is a derivative whereby the value movement largely corresponds to the underlying asset. Therefore, for example, if you were to long a CFD on Apple shares, the CFD payout profile would be largely identical to owning Apple shares. So why not just buy the underlying share and not bother with CFD you ask? The answer lies with leverage. CFDs allows you to employ significant leverage to amplify your gains(losses) which may otherwise not be available in normal share trading. On the downside, you are exposed to counterparty risk (as the contract is with the CFD provider) and the possibility of margin calls.
With obvious reasons, the UK regulator (FCA) is looking to introduce policy measures to protect retail investors from such ‘dangerous’ products. The main recommendations are better disclosures regarding risk profile and capping of leverage for novice and experienced retail clients.
Often, the best investments are those that are made on the market’s over-reaction. After news of the FCA’s recommendations were released, IGG’s share price were hammered by a 40% drop in value. Let me please point out, these are recommendations by FCA and still undergoing a consultative process. My guess is that the final product will be watered down and right now, the market is pricing in a total disruption in IGG’s business model. Don’t get me wrong, there may be risks with the CFD business. IGG derives its revenue from commissions and spreads when a client executes trades and it also earns financing revenue on clients’ outstanding positions. What IGG have to content with is residual risk from client’s position which is dealt with by its hedging strategies. Therefore, IGG may suffer significant losses if those hedges are not implemented properly. However, this is a known issue with financial institutions and the FCA’s announcement has done nothing to exacerbate it.
IGG’s business is highly cash generative and there is no reason to suspect otherwise going forward. It has 68M GBP of cash left after all business expenses and dividend payments in FY2016 which increased its cash and financial investments to 330M against market capitalisation of 1.8B GBP. Put it another way, close to 20% of IGG’s market capitalisation is backed by cold hard cash. Its NPAT and cash position will only get better with future growth e.g. it is currently expanding to various countries and offering new products (e.g. shares trading and ETF).
As of FY2016, IGG’s NPAT is 164M GBP which gives it a historical PE of 11. UK contributes to around half of NPAT and if we were to consider a ultra conservative scenario of a total collapse of profit from UK as a result of FCA’s recommendation (i.e. zero profit from UK) , the PE would be 22 and a corresponding dividend yield of 3% at today’s price. The questions a prospective investor should ask is that:
- Do you have concerns with IGG’s business model?
- Would there be a total collapse of UK earnings?
- If the answer to question 1 is yes, are you uncomfortable with a PE ratio of 22 and dividend yield of 3% for IGG?
I know my answer to all questions is no. I will be looking to add to my position at a price below 550 GBX.