15
Mar
2015

How to bet on casino capitalism

Apparently it was a Chinese Communist Party official who quipped: “The stockmarket is like champagne, if it didn’t have bubbles, people wouldn’t pay so much to drink it.” Some of my more idealistic friends like to rail against the iniquities of capitalism and markets.  Instead, I try hard to accept the markets can be irrational, and then see if I can work out what opportunities this presents for profit.

For several years I have been a customer of IG Group, the electronic trading platform that allows leveraged speculation (gambling if you like) on the stockmarket, currencies and commodities using derivatives and spread betting. It is a weird business, but highly profitable and highly attractive. In the last decade, the share price has gone from around 100p to 730p, a “7 bagger”. This is despite the fact that the FTSE 100 is up less than 20% over the same time period, and trading volumes in cash equities are down significantly. IG Group has done well at a time when traditional stockbroking, such as that done by Seymour Pierce or Panmure Gordon, has really struggled.

Similarly the casino part of universal banking, the Fixed Income Currency and Commodity (FICC) divisions, have had a tough time off late.  Even if they were enjoying good times, most of the rewards in FICC go to the employees, not the shareholders.

The infographic below comes from the Bank of England Quarterly Bulletin showing a revenue breakdown of how the ten largest investment banks generate revenue. Notable is the fact what most people consider “the stockmarket” (secondary trading in equity shares) is just $7bn or 5% of total revenues for investment banks.

investment banks picture

So IG Group seems to me to be a reasonable way to recognise that we will always have financial speculation, and to bet with this, rather than against.

Let me be clear: this isn’t a bubble, where valuation has divorced from the underlying economics of the business. IG Group has an impressive track record of revenue growth, returns on capital employed in the mid 30% (that is, the company returns a high amount for the money originally invested), and an operating margin above 50% (that is, operating profit to revenue, that is the company has low costs relative to sales). IG Group doesn’t speculate itself, or act as a counter party it makes it money on the trading commission. That is a great business because leverage allows position sizes that traders take to be much larger AND the leverage seems to encourage customers to trade more often.

Not even the 30% one day devaluation of the Euro against the Swiss Franc seems to have blown it off course. Some of IG’s high roller clients lost money, and given that they were giving 100 to 1 leverage, this means that IG also lost money and is trying to recover the debts from their clients. IE the clients have lost a lot more than their original stake, and the group is trying to recover the money it’s owned.

The company does spread betting and Contracts for Difference (CFDs). I have been playing around with investing small sums with CFDs, which are a derivative contract, which means unlike investing directly in companies’ equity, that with CFDs you don’t have to pay stamp duty. I am not sure why this is allowed (it isn’t in the US), but it seems to be a transfer of value away from the tax man to the financial services industry. Not the first time that has happened, but as long as the tax break exists, I might as well think about sensible ways to take advantage of it.
But the products are risky, not just currency trading where 100 to 1 leverage is available. Equity investing using CFD’s where leverage tends to be 10 to 1 can bankrupt wealthy, experienced investors. Sean Quinn, once the richest man in Ireland, famously took out a huge position CFD in Anglo Irish Bank’s shares, which when the bank collapsed meant he lost everything and more. The lure of steep upside for a minimal outlay encourages even the most successful people to take risks that ruin them if the bets go bad. So the trick is to accept that you can lose money, and only follow strategies that guard against being ruined – the first rule is to cut your losses before they become unmanageable (something those IG clients that owe money to the group didn’t do.)

Most of the literature on CFDs suggests that it is a short term trading profit. This is because it is leveraged, and speculators have to pay interest on any long position. But I think this is a myth, perpetrated by the industry that benefits when customers trade too much. It seems to me there is no difference between buying and holding one gradually appreciating stock for a year, and trading lots of different stocks over time, except your transaction costs are much, much higher with the latter strategy. IG Group is currently trying to discourage people like me, who don’t trade much, so if the “house” is trying to discourage my behaviour, like a casino trying to stop card counters at Blackjack who only bet when they are reasonably sure the cards are in their favour, then I think that probably I’m doing something right.

The difficulty is finding stocks that will steadily appreciate over time. In retrospect using a CFD with a trailing stop loss to buy IG Group’s shares would have been a fantastically successful strategy. Perhaps it still will be? I’m not so sure, there seems to be more competition entering the sector (eg Plus500), and new rules like MIFID II might make life harder in future.
The thing about leverage is that the more confident you are, the more comfortable you should be using leverage. However, many of my better investments have been highly uncertain, that is what enabled me to buy Legal and General at what turned out to be the wrong price in Q1 2009. I certainly wouldn’t have bought it with 10x leverage, even in retrospect – so CFDs mean changing my investment style a bit.

With this in mind, I thought about using CFDs to buy IG Group, but didn’t – I like the irony of using leverage to bet on “the house”, but feel that the attractive economics of CFD trading are now so well understood that competition is likely to increase. Future results might not be as good as the spectacular past performance.

Instead, I’ve thought about if there was anything more addictive than gambling. And I came across Indivior – which is a Reckitt and Benckiser spin off. It has similarly high operating margins to IG Group, but much higher Return on Capital Employed (in part because it is a spin off, so capital employed is bound to be a flattering number, because it doesn’t take account of all the unsuccessful projects that Reckitt and Benckiser invested in that didn’t work out.) What does the company do? Indivior helps people with opioid (ie heroin) addiction. There are still a lot of uncertainties, but I think if I was going to invest in human frailty, rather than IG Group, I’d prefer to bet on a firm that helps people with heroin addiction.
NB – I have a small position in Indivior, and I’m obviously talking my own book. Do Your Own Homework before investing.

1 Response

  1. Andrew Latto

    Bruce,

    Interesting post. Have you seen this article:
    http://www.bloomberg.com/news/articles/2015-03-13/how-100-to-1-leverage-built-market-in-chile-that-s-taboo-in-u-s-

    I think IG is a bet on the UK government not changing regulatory or tax regulations on spread betting or CFD’s. The risk of competition isn’t that high, in my view, as most serious users will gravitate to the largest provider as it has less chance of going bust. I think it was Worldspreads that went bust and some other firms recently.

    It is interesting to invest in a business where most of the clients lose money. It may not seem a good idea but gambling shops have been around for a long time.

Leave a Reply