When we speak about the financial markets of today, we sound very much like William Wordsworth lamenting the onset of the industrial revolution: “The world is too much with us...” Intellectually, we are still romantic believers in the notion of well-informed, long-term investors meeting underneath the buttonwood tree for the occasional trade. But, instead the world has embraced an ever-accelerating explosion of financial “innovation” in which too often, in our view at least, trades aren’t even initiated by humans, knowledge of the underlying company is superficial at best, and “investment” time horizons are measured in nanoseconds. Rather than bemoan the state of affairs in iambic pentameter, we prefer to figure out a way to make a fat profit. Always struggled with poetry, anyway.
At a high level, our entire investment program is premised on taking advantage of traders less informed, less patient, and less tolerant of short-term volatility (which is only a problem for those who aren’t informed and who can’t be patient). But in buying Interactive Brokers Group (“Interactive”), we’ve gone one step further. We’ve invested in the premier arms dealer to those wishing to wage war against their fellow traders using derivatives, leverage, algorithmic trading, global arbitrage and the like.
To appreciate, Interactive’s future, one needs to understand its past. Its founder, Thomas Peterffy, arrived in this country essentially penniless as his family evaded communist takeover of Hungary. Peterffy taught himself how to program computers and built trading software for Wall Street firms. He used his savings to buy an exchange seat and developed innovation around trading, compliance, and risk management technology to the point that by 2000 his company had captured 20% share of the worldwide listed options market. As profitability in the options world began to decrease due to smaller spreads, Peterffy realized that his automated platform would be perfect as a low-cost brokerage platform for active traders, and Interactive Brokers was born.
While other brokerage platforms were busy collecting accounts through innovation-killing consolidation or by spending a fortune on brand building advertising, Peterffy followed the only playbook he knew: automate, automate, automate. This focus on productivity explains why the company’s revenue per employee is ~$1.3M compared to ~$0.5M for Charles Schwab, and it explains why 70%+ of the employees at Interactive are programmers as is the majority of senior management. The barrier to entry that comes with a multi-decade start
on automation is hard to overestimate. Not only does this radically lower Interactive’s cost structure, but it drives consistent share gains through the ability to offer a superior product offering and tools for the customers that other brokers will never be able to offer. For example, their costs are so low and the pricing they offer so competitive (pricing in this case refers to interest charged on margin, interest paid on idle cash, amount shared from proceeds from security lending) that if other public brokers were to match Interactive’s pricing effectively all of their brokerage profitability would evaporate. Today, for example, on a $300K margin loan Interactive charges clients 1.21%, while TD Ameritrade charges 7.50%. But beyond being low cost, Interactive offers a superior platform given their integration to vastly more markets and products, and the ability to update leverage
limits real time so as to allow clients to maximize leverage in a way that does not expose Interactive in its role as lender, to excessive risk.
Interactive is a great example of our desire to invest in businesses that profit because of innovation and vision as opposed to exploiting some profitable but perhaps sordid gap in the markets. Any discussion of this industry and any discussion of why we think Interactive will dramatically grow market share for decades to come must include a discussion of the practice of payment for order flow (“PFOF”), which accounts for a significant share of
the profitability at most public brokerage firms. In PFOF, the broker doesn’t directly execute your trade at wherever he thinks you will get the best execution but instead sells your order to someone who reports back the price at which it got executed. Somehow, this brain child of Bernie Madoff is supposed to be good for brokerage clients even though the brokers profit mightily from this and the largest buyer of this order flow is Ken Griffin’s Citadel Securities, who is buying homes for $238M a pop, which I guess makes it fair to assume that buying order flow is also profitable for him. So, who is getting screwed here? As per usual, the brokerage client. The applicable proverb for any customers of Schwab, TD Ameritrade, E*TRADE et al., is “There ain’t no such thing as a free lunch.” For almost all of their accounts, Interactive charges a modest commission on trades, but in exchange bypasses the PFOF practice and uses the trade router they’ve developed over the years to find the client the best execution, which saves them much more than the commission. Additionally, we have always been repulsed by the brokerage community’s inclusion of small print in client agreements which forces clients to agree to allow the broker to lend the client’s securities but allows the broker to pocket all lending proceeds. Interactive splits any lending proceeds with the client. And they pay much higher rates on idle cash, and as already mentioned charge much lower margin rates.
With fewer than one million accounts globally including only ~280K accounts in the United States and only ~$200B of client equity, Interactive has enormous room to grow as they apply their low-cost advantage to a much larger portion of the overall market. New product innovations are coming and will increasingly include more consumer services such as banking. In fact, to us, discussing Interactive versus TD Ameritrade in the competition for active traders is akin to the 1997 discussion of Amazon and Borders competing over the book market. Some ice cubes melt faster than others, but there is no lack of ambition at Interactive and there is no lack of awareness of what can be done to leverage such a strong base. The company is already growing rapidly internationally and has growing businesses serving introducing brokers who white label Interactive’s platform, and along with financial advisors who value that Interactive is low-cost and is not in the business of competing
with them in financial advisory, as Schwab and others are. With its high productivity and profitability, Interactive enjoys 60%+ pre-tax margins and management has made it clear they intend to invest in every adjacent market opportunity that they can, if they feel they can uniquely automate it and use that automation to drive competitive advantage and profitable growth.
Given its competitive strength and investment virtues, Interactive has been on our radar screen for a long time. In Q2 we finally got the entry point we’ve looked for following a fundamental headwind that coiled the economic drivers for future growth and depressed sentiment around the stock. With countless workers all over the world at home and figuring out how and where to trade, Interactive is a short and long-term beneficiary of COVID as
evidenced by its remarkable acceleration in account growth. New account growth in May 2020, for example, was more than quadruple that of May 2019, and the overall number of accounts in June 2020 was more than 35% higher than where it stood a year earlier. However, the COVID-inspired slashing of interest rates has dramatically impacted Interactive’s current earnings given that approximately 30% of their net revenues comes
from the yield on clients’ idle cash. They give a much better share of the interest earned on those funds to their clients than other brokers, but nonetheless they were still earning ~100 bps on those billions last year. It is impossible to earn that much with rates cut almost to zero. Additionally, in the downdraft clients reduced profitable margin balances significantly shrinking Interactive’s profits. The company has also gotten negatively caught up in the trade war with China, which represents a huge potential market for them, as over 8,000 new Chinese accounts are set up weekly. However, the Chinese government has severely curtailed the ability of its people to fund accounts with foreign brokers, so the 16% of accounts that are Chinese only account for a portion of their latent potential. Lastly, a bizarre, one-time event occurred in April that cost Interactive a lot of money, but in our mind just reinforces how difficult their business is to replicate and what a huge barrier to entry exists. Interactive’s systems contemplated the price of oil going to zero, but not actually negative (where the physical delivery price briefly traded). When this occurred, certain clients took losses that Interactive felt obliged to make whole. The process cost them a little over $100M and punished the stock to an even greater degree. This will only make Interactive stronger from a risk perspective going forward, and this event reinforces why two clever guys in a garage will never be able to create anything remotely competitive. As a result of all this, IBKR stock traded down 30% from its pre-COVID levels and at roughly half the levels it traded two years earlier, despite the rapid acceleration in account growth. We believe history will show that our patience and discipline were rewarded with a great entry on a great long-term grower.
So, while “financial innovation” may be a “sordid boon”, we expect the profit that comes from Interactive to be noble and unalloyed. And maybe somewhere Wordsworth is smirking because perhaps unbeknownst to everyone at the time, he was actually a worldly polymath and made a killing furtively reinvesting his poetry proceeds in canal stocks, the internet/SaaS stocks of early 19th century Britain.
The World Is Too Much With Us
BY WILLIAM WORDSWORTH
The world is too much with us; late and soon,
Getting and spending, we lay waste our powers;—
Little we see in Nature that is ours;
We have given our hearts away, a sordid boon!
This Sea that bares her bosom to the moon;
The winds that will be howling at all hours,
And are up-gathered now like sleeping flowers;
For this, for everything, we are out of tune;
It moves us not. Great God! I’d rather be
A Pagan suckled in a creed outworn;
So might I, standing on this pleasant lea,
Have glimpses that would make me less forlorn;
Have sight of Proteus rising from the sea;
Or hear old Triton blow his wreathèd horn.
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