Could This Market Maker Make Your Portfolio?

The goal of a great value investor is to find a good company at a great price. With Knight Capital Group (NYS: KCG) trading well below a fair price. value investors will be watching how the company responds to its recent fumbles in the upcoming months -- and you should pay attention, too.

Knight Capital is a financial services firm that specializes in market making. For those of us who don't speak "bankanese," a market maker quotes buy and sell prices for stocks, options, commodities, or foreign currency. Knight Capital's bottom line is largely driven by market making in equities. Market makers like Knight make profit on the difference between the buy and sell price for each trade. Since the spread for each individual trade is low, companies like Knight rely on on computer algorithms to make thousands of trades in a matter of minutes.

If the name Knight Capital is ringing a bell, you may be remembering it from its big snafu on Aug/ 1. For a more in-depth look at what happened, check out fellow Fool Matt Koppenheffer's piece on "The Glitch." The quick and dirty explanation is that Knight installed new software in its algorithmic trading department, and an installation issue with the software caused the program going haywire. The malfunctioning software bought stocks at a fervent pace, many at very inflated prices. When Knight had to then sell off these stocks, it took losses all the way to almost the point of insolvency. Nearing a collapse, a consortium of companies led by The Jefferies Group (NYS: JEF) swooped in and made a $400 million acquisition of preferred stock shares. This bailout of sorts gave Knight enough liquidity to keep the doors open while it sorted out the mess.

The third-quarter earnings release this week gave the final tally for the glitch. On a pre-tax basis, the company lost $461 million from the trading meltdown. On top of that, the bottom line was battered by the accounting treatment of the preferred stock that Knight issued to its new investors. Because the conversion price of the new shares was lower than the market price at the time of issuance, the conversion feature was treated as a dividend and hit net income to the tune of $373 million. When all was said and done, Knight Capital took a $764 million loss for the quarter, compared with a $27 million gain in Q3 2011. Now that the dust has settled, the stock is trading 80% lower than in August.

Picking up the pieces
After the August incident, trading volumes for the firm took a sharp nosedive, but they are recovering. Three of Knight's largest customers -- TD AMERITRADE (NYS: AMTD) , Vanguard Group, and E*TRADE (NAS: ETFC) -- have returned their trading activity to Knight following a post-glitch pullout. During the quarterly earnings call this month, CEO Thomas Joyce stated that October trading volumes in market making for equities are back to 95% what they were before the August collapse.

Source: Company website.

There are several reasons Knight Capital might not be the best long-term investment, but the technical glitch is not one of them. If you remember the flash crash back in May of 2010, then you also remember that the Dow recovered almost all of the drop resulting from the high-frequency trading in the same day. Also, some financial institutions, such as JPMorgan Chase (NYS: JPM) , have shown that despite a bad result in a quarter, they can come back with resiliency. The $5.8 billion loss seems to be behind JPMorgan, as the bank just posted healthy Q3 earnings. While Knight will need to regain some of its clients back to resume pre-glitch trading, it is likely this was a one-time event from which it can recover.

Where value investing comes into play
There is a dicey situation when valuating this company, because you need to keep in mind that one of those preferred shares from the bailout can be converted into 666.66 shares of common stock. Jefferies converted most of its preferred shares to common shares at the end of August to the tune of 81 million common shares, almost doubling the shares outstanding. Keeping that in mind, let's do a quick evaluation. Here are two important tidbits you should know before looking at the following table.

• Knight's current book value of the firm is $1.19 billion.

• When the company's stock price remains above $3.00 for 60 consecutive trading days, all preferred shares are converted to common stock.

Sources: company 10-K, author's calculation.

Knight recently traded at $2.60. This means that even when share prices pass the conversion trigger point, Knight's shares are still worth less than the tangible book value of the company. The low share price to tangible book value is a signal that the company could be undervalued.

That being said, there are no guarantees in investing. As expected with all big financial problems, a pending class action lawsuit was filed that could result in a fine or two. A more important long-term threat for Knight to watch is the potential for buy sell spreads to drop into the range of a fraction of a penny. These smaller spreads could squeeze profits and will compromise the sustainability for all market makers. In the short term, though, this could be a good value play. I will be making a CAPS call on this company because I believe the issues related to the glitch will be a one-time writedown and the company should be able to rebound.

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The article Could This Market Maker Make Your Portfolio? originally appeared on Fool.com.

Fool contributor Tyler Crowe has no positions in the stocks mentioned above. You can follow him on Fool.com under the handle TMFDirtyBird, at Google +, or onTwitter, @TylerCroweFool.The Motley Fool owns shares of JPMorgan Chase. Motley Fool newsletter services recommend TD AMERITRADE and Jefferies Group. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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