Knight Capital Offers Potential for Growth at a Bargain

The increased activity has helped shares of Knight Capital Group (NITE), which executes trades for commissions and buys and sells shares from its own account for spreads. We made a case for the stock in April 2004 after it turned up in a search for insider buying. It's up 50% since then, just about double the S&P 500 index's increase. The stock looks poised to head higher, and not just because of increased stock trading volume. Details in a moment. Knight turned up recently in our Bargain Growth screen.

Bargain growth stocks are those with attributes that appeal to both value- and growth-style investors. They have modest share prices relative to the profits they're producing, but also prospects for generating fast earnings growth in coming years. Central to our screen is the PEG ratio, which divides a stock's price/earnings ratio by the rate at which analysts project its earnings will grow over the next several years. The lower the resulting number, the better. Our screen looks for PEGs of 1.0 or lower, which suggests the companies it produces are discounted by more than a third to the broad market.

The screen also looks for recent upside earnings surprises, rising earnings estimates, manageable debt levels and a smidgen of share price momentum. See the recipe of criteria for details on all the demands and use our stock screener anytime to run the search for yourself. It recently identified eight potential bargains among a starting database of 8,000 companies.

Based in Jersey City, N.J., Knight ranks second in market share for trade execution in Nasdaq stocks, eighth for exchange-listed stocks and first for stocks on the over-the-counter bulletin board. Over the past year it has produced sales of $892 million. Trading commissions account for just over 40% of its sales and trading proceeds, just under 30%. Knight's trades involve minimal risk, since they're mostly executed in seconds in order to capture the difference between a stock's bid price and ask price, otherwise known as the spread. Deephaven Capital Management, which manages money for investors, brings in about 20% of sales. The rest comes from investments and interest.

Over the past two years Knight has increased its sales by 20% a year and its profits by 49%. Among the keys to its success are investment in efficient trading platforms — it bought Attain ECN, a stock trading system, in October 2005, and Hotspot F/X, a foreign-exchange trader, last January — and its unbiased approach to exchanges. The New York Stock Exchange and Nasdaq still control a combined 70% of stock trading volume, but are set to see more competition from 30 or so smaller trading venues, thanks to industry regulations that ensure trades will be sent to whichever platforms have the best prices. Securities traders, say analysts, will be increasingly looking for companies that can efficiently route trades among the many new contenders.

"As the buyside reliance on technologies and best execution grows, independent technology execution providers are likely to benefit," wrote Deutsche Bank analyst Scott Appleby in a Dec. 19 research note. "NITE, as a leading execution solutions company, should continue to benefit from this trend."

Shares presently fetch 15.2 times forecast 2006 earnings. The company is expected by analysts to increase its earnings by 16.5% a year over the next several years. Those numbers make for a PEG ratio of 0.9, a 40% discount to the broad market. One wildcard: Plenty of smaller electronic trading platforms have changed hands in recent years as exchanges and financial firms look to increase their execution power. "NITE's market share would look good to any investment bank seeking a stronger foothold in the U.S. market," notes Appleby.