Description

I recommend a long position for IBKR; the closing price of yesterday was $61.72

per share. IBKR was last written up by punchcardtrader on Oct 13 2018 at $51.76.

Over the past three months, the share price has since dropped 25% from the

recent high amid general market decline and 2021 Q4 earning miss; which provides

a good entry point for us to buy into a low cost, high margin, conservatively

financed electronic brokerage business.

If you go to wsj.com you will see shares outstanding 98.28M instead of 418M.

This is because the public company is organized as a holding company for the

underlying operating company IBG LLC; currently the public company holds 23.5%

interest in IBG LLC; so essentially IBG LLC has 98.28M / 23.5% = 418M shares

outstanding. Founder Thomas Jefferffy still holds about 75% of the company and

this is the majority of his net worth. In the following discussion, IBKR, EPS,

market cap, etc all refer to the underlying operating company.

Interactive Brokers is widely know by VIC members because many of us use it on

a daily basis. IBKR is an automated global electronic broker; it provides

custodian and trading services for hedge funds, mutual funds, ETF, RIA,

individual investors, etc. The company was founded in 1977 doing market making

for options; at the time of its 2007 IPO (IPO price $30) 87% of its business

was in market making. The market making business has since declined and

eventually sold; now IBKR is 100% automatic electronic brokerage; this explains

why its share price from 2007 IPO to now is sub-par compared with the general

market. However, the brokerage service, which is what IBKR doing 100% now, was

growing very rapidly:

    YEAR  #acct_in_1000  Client_Equity_$B

    2008           98.5               9.3

    2009            114               8.9

    2010          137.7              15.9

    2011          164.2                24

    2012          192.2              28.3

    2013          214.5              34.7

    2014          247.3              48.6

    2015          289.7              60.3

    2016          339.7              66.1

    2017          397.9              92.9

    2018          507.8             130.5

    2019          614.2             143.7

    2020          719.7             170.1

    2021         1265.1             329.9

    2022         1764.3             348.5

Competitive advantage over other brokerage companies: technology

IBKR was built and is ran by programmers / engineers. Automation is in its gene.

If something cannot be done automatically, it will not be pursued at IBKR at

all. It's very difficult for competitors to catch up in this area; in fact, they

are not even trying.  This "tech" focus has three important consequences:

a. It allows IBKR to run a lean organization with very high pre-tax margin, 67%

   for 2021, which is the highest in the industry by a wide margin. For example,

   IBKR has 1.7M customers but less than 100 sales people; it doesn't want the

   non-scalable component of "sales" when acquiring new customers; and it's

   essentially the only choice for introducing brokers.

b. It allows IBKR to offer the lowest all-in cost to customers.

   Despite aggressive claims from zero commission brokers like Robin Hood, some

   one has to pay for the middle man's service; "zero commission" is actually

   substantially more expensive than IBKR Pro. This is a subtle point so let's

   explain in more detail.

     b1. Payment for order flow (PFOF). Companies like Robin Hood offers zero

         commission trading because they sell client order flow to trading firms

         Citadel, Virtu. This PFOF accounts a large share of income for several

         major brokerage companies; see this page for 2021 statistics:

             https://daytradingz.com/payment-for-order-flow

         In total, these companies made $3.6B from PFOF in 2021 and Robin Hood

         is the 2nd place with $974M. IBKR Pro does not do PFOF. IBKR recently

         launched "IBKR Lite" which does PFOF. The overall trading cost of

         "IBKR Pro" is much lower than "IBKR Lite". "Lite" is much smaller than

         "Pro" and intelligent investors will all switch to "Pro", no brainer.

         So what is this PFOF? When you submit an order on TD Ameritrade to buy

         100 shares of AAPL; TD Ameritrade will not directly send this order to

         exchanges; instead, it will send it to companies like Citadel, Virtu,

         etc and they will execute it for TD Ameritrade; they can either trade

         it against their own inventory, or send it to exchanges, maximizing

         their (not your) profit. Executing these trades is very profitable so

         trading firms need to "pay" a large amount of money to retail brokers

         to receive this "order flow". For example, Robin Hood made almost $1B

         selling its client order flow in 2021.

         Why is this "order flow" valuable for trading firms? Two reasons.

         First, retail flow is "un-informed" from the short term trading

         perspective; except for quant trading firms, no one is building short

         term alpha when executing their orders and retail flow is certainly not

         doing that; this makes the flow very profitable to trade against for

         companies having very strong short term alpha.  Second, unlike SDP

         (single dealer platform) which is built by trading firms to serve large

         hedge funds, etc, which usually specifically prohibit the SDP from

         using the order flow in its alpha construction (because, well, hedge

         funds are sophisticated investors...); there might not be such

         prohibition when brokers negotiate PFOF deals with trading firms.

         Brokerage companies have an incentive to receive higher PFOF payment

         and trading firms buying PFOF have an incentive to make more money from

         that order flow; therefore, retail customers end up with higher all-in

         transaction cost. This is often not obvious, because wholesale trading

         firms can often provide some "price improvement"; people feel good

         about it as long as the "price improvement" is positive; but the

         correct metric should be computed by comparing this "price improvement"

         against the price improvement you would hypothetically get by sending

         your order to exchanges directly.

         If PFOF is so good, why brokerages don't use it themselves? The simple

         answer is that they are unable to. Obviously there are laws prohibiting

         brokers front running client orders; but if Robin Hood knows how to do

         it they can simply build an internal team with a Chinese wall acting

         as a "wholesale execution service". Doing this profitably is extremely

         difficult; a very large share of this profit pool is taken by the top

         few high frequency trading firms. As an example, IBKR was 87% market

         making at its 2007 IPO but now is 100% brokerage, because its trading

         strategies are so much worse than real players in this area.

     b2. IBKR margin rate is a lot lower compared with competitors. Depending

         on account balance (higher balance leads to lower margin rate), IBKR

         margin rate is 0.75% - 1.59%, compared with fidelity's 4% - 8.33%,

         E-trade at 5.45% - 8.45%, etc (for equities).

         IBKR is able to offer such low rate not only because of low cost

         structure, but also because its platform is very efficient at handling

         margin call, automatic liquidation (to avoid clients entering negative

         equity territory), etc. For example, IBKR lost only $120M during the

         2015 Swiss Franc decouple, and lost $104M during the negative oil price

         episode during 2020; many companies were totally wiped out by these

         two events. Other less tech savvy brokerages would suffer huge losses

         during market turmoil if they charge lower margin rate.

         IBKR definitely has room to increase its margin rate substantially.

         But it won't do that during the growth phase; brokerage switching cost

         is extremely high, IBKR must offer a very large incentive to lure

         people to switch. Increasing margin rate could become a growth lever

         when IBKR reaches a more mature stage.

c. Its trading platform is very versatile and flexible. IBKR allows you to trade

   on hundreds of exchanges across the world, covering equities, futures, FX,

   commodities, options, crypto, etc. Also very importantly, it offers API

   access so that quant firms can trade through its platform.

     c1. Building infracture to access exchanges directly is very costly and

         difficult, and is actually not necessary even for most quant trading

         firms (very few of them worry about sub 0.001 second latency). Most

         quant hedge fund startups will find IBKR's API accessible platform very

         convenient; actually it's the only game in town.

     c2. Traditional investing is placing large bets for things you know a lot

         about; on the other hand, quant investing is placing numerous small

         bets on things you know a little better than random guess and rely on

         "law of large numbers" to work its magic. Being value investors we are,

         we must admit that quant funds are taking shares in the investment

         space over the past two decades. This is unavoidable because most

         active managers have zero skill and people are gradually realizing

         that. Of course most quant firms also have no market beating abilities,

         but they have PhDs in computer science, finance, mathematics, physics,

         etc, which makes them look more capable.

     c3. Therefore, although not that relevant for the short term, having

         flexible, API accessible platform is a huge advantage as the investing

         world becomes more tech driven going forward.

IBKR has a huge growth runaway ahead

Interactive Brokers, as of Feb 2022, only has 1.7M accounts; of which 34% is in

North America, 27% in Europe and 39% in Asia Pacific. Its international growth

is higher because it faces less competition. The TAM is huge, for example,

fidelity has more than 30M accounts. Why do I think IBKR will take larger market

share in the future?

a. One growth area is people switching from other brokerage services to IBKR

   due to its tech or lower cost. Admittedly, the switching cost is very high.

   But to counter balance that, the switching benefit is also huge; you can save

   at least 300bps on margin rate. Besides, you will also have less problems

   with missing cost basis, missing transaction history for transactions related

   to foreign securities, etc.

   Another tailwind for people switching for lower trading cost is inflation.

   At 7% inflation, you need to make at least 11.5% if it's all short term gain,

   or 9.2% if it's all long term gain, to just break even; and that's assume

   you live in a state with no state income tax. People will become more anxious

   and use margin loan more to just beat inflation; this makes IBKR's lower

   margin rate a lot more attractive.

b. First time young investors don't have switching cost. Most high paying jobs

   for young people nowadays (and going forward) are related to technology.

   These tech savvy first time investors are more likely to choose IBKR over

   competitors because its advantage is very clear.

c. Zero commission is only a US thing; it's illegal elsewhere. IBKR has less

   competition in the international market.

Cheap valuation; earnings growth catalysts

IBKR net income for 2021 was $1.636B compared with the current mkt cap $25.8B.

This is very cheap for a company with dominating technical moat, low cost,

very high margin, zero debt, a long growth runaway ahead. IBKR makes its money

not from commissions, but mostly from interest income from margin loan, and

idle client balance. I don't want to waste time analyzing its income breakup,

but want to point out that IBKR earning is likely to benefit from rate hikes

this year. See this page for how IBKR pays interest for client balance:

    https://www.interactivebrokers.com/en/accounts/fees/pricing-interest-rates.php

a. For European countries with negative rate, IBKR passes the negative rate to

   clients with a mark up; so rate change there won't affect things too much.

b. In the US, IBKR is paying clients max(BM - 50bps, 0) where BM is the

   benchmark rate, which right now is at 8bps. Therefore, IBKR is pocketing

   for itself this: BM - max(BM - 50bps, 0) = min(BM, 50bps). This is 8bps now

   and could become 50bps after two 25bps hikes. During the Q4 earnings call,

   management said the estimated income benefit from rate hikes are:

       first  25bps -> $165M annually

       second 25bps -> $120M annually

   So two hikes translate to $0.68 EPS, or 17% of 2021 earnings. Given the

   current inflation print, this has a decent chance of happenning. Of course

   rate hikes could cause equities to trade down which is bad for IBKR; but I

   think for moderate hikes like 25bps or 50bps the net effect to IBKR is likely

   very positive.

SUMMARY

1. Competitive advantage: technology & automation -> low cost

2. Huge growth runaway ahead

3. Cheap valuation; rate hikes is a potential near term catalyst

Catalyst

young people with high paying jobs start gambling their money for real for the first time

inflation force people to care more about lower margin rate when gambling stocks

hiking rates by 50bps is 0.68 EPS gain