Interactive Brokers: A Stock Pitch
I have written about Interactive Brokers (NASDAQ:IBKR) before, most notably in Xinja’s Pivot. During the Covid Crash I purchased it on valuation grounds, but I think there are a lot of fundamental merits to, and opportunity in, the business. I recently pitched the stock and I’ve tidied up my notes to publish here:
Stockbroking is a dying business. My hypothesis is the industry will branch out into value-added services like financial data & investing tools as a way of generating revenue. Interactive Brokers has a good opportunity to expand its business outside traditional brokerage. Traditionally, there were three main ways to make money in stockbroking:
- Charge fees on trades
- Earn interest on customer cash balances
- Earn interest on margin loans which customers take out with you
- (For completeness we must add a fourth leg to this three-legged stool; start a free trading app with someone else’s money.)
These three methods have been almost entirely eroded. Free trades are now the norm. Charging interest on cash balances only works if interest rates are above zero. Margin loans are still viable (and IBKR is good at this) but rates are very low. While free trading is an interesting innovation the question is always: How much value does it add to the customer?
How IBKR adds value:
Interactive Brokers has been for a long time the market leader in creating value for its users.
- Pre-Robinhood, IBKR’s trades were the cheapest in the market
- IBKR now has free trading for those that want it; customers that pay get better
execution - IBKR has the best execution in the industry; paid trades through IBKR get measurably
better prices. This supports the current fee structure & makes it less likely to erode. - IBKR’s margin loan rates are the lowest in the market
- IBKR is regularly rated 5 stars/best broker/cheapest broker in the industry by a wide
variety of sources - IBKR also pays interest on short positions if someone borrows your stock to short sell
IBKR is a well capitalised, securely operated broker. I believe it is the best-managed broker in the world and it has never had anything close to a “blow up” since its founding in 1977. The founder, Thomas Peterffy, remains a large shareholder and is well regarded in the industry. Some competitors like Robinhood are new to running a secure operation (as recent emergency capital raise and customer hacks suggest) and have damaged brand and goodwill by costing customers money. When people store large amounts of money with you, they need to know your brokerage will not implode.
Brokerage operations like Schwab and TD face pressure on brokerage earnings as most of these fee streams are disappearing. There will need to be new revenue streams created. IBKR is well positioned because it already passes on most of the benefits of its services to its customers in the form of lower prices, interest on cash balances, better execution, and so on. Compared to competitors, there is a lot less to be eroded.
What I think will happen:
- Brokers will turn to value-added services like financial data to generate revenue. You can see this playing out already with Robinhood and Stake’s paid tiers.
- Erosion of traditional businesses & failure of new entrants may cause the industry to consolidate. IBKR is already the leader here in many respects and has been investing heavily in tech to provide a better user experience and acquire more customers.
- IBKR already adds a massive amount of value for every account holder (sophisticated portfolio management & performance attribution, wide range of markets, best execution, monitoring, news & notifications). This is a large hurdle for other providers to compete with and there is still a lot of room for IBKR to add additional features & services that it can charge for.
- IBKR will be able to take more share from incumbent providers like TD and Merrill Lynch which are far behind the curve (albeit making an attempt to modernise). IBKR already has among the best access to data in the industry and is one of the most sophisticated & secure brokers with the widest product offering.
I see IBKR emerging as one of the winners over the next 5-10 years. The strengthening of the industry structure & addition of higher margin software & services revenue from the sale of value-added products should be very positive for IBKR’s total customer count, ARPU, margins, and market share. The washing out and failure of free trading platforms will also be favourable to industry structure and competition.
Brokerage as a Destination (BaaD):
One thing that is particularly interesting about this business is that a broker is always a destination for a market participant. Regardless of who you are or what tool you use, you always need to return to a broker to transact. It is both a toll gate and a place to keep things. There is a strong case for having a suite of tools that can automatically sync with your portfolio because they both live in the same place (i.e. within IBKR). Over time I think that brokerages will attract some of the data & tools industry revenues precisely because of this anchoring. (Look at the value of businesses like Plaid that were created to help customers sync their finances across multiple services; this is a real problem).
Having said that, I also think that investing tools will stratify further; there will be a tool for all kinds of investors (momentum/growth/small cap/chartists etc) and IBKR won’t be able to serve all equally. Nonetheless, there is a large opportunity to create more value by producing tools for a target audience.
Customer acquisition:
Interactive Brokers is willing to spend over a thousand dollars in incentives (excluding marketing!!) to acquire new customers. It can reinvest more than any of the free trading apps and enjoys (I estimate) a shorter payback period. This is a very, very hard business to compete with if money is the primary driver of customer acquisition (it isn’t, but it does matter). Offsetting this is the deep pockets of the investors in free trading apps; dollar for dollar, Robinhood can probably match IBKR, at least for a while. Additionally, competitors are currently better at distributing their product. Content is effective and on that topic – there are no reddit memes about IBKR.
Risks:
- Valuation is tricky.
- IBKR is very poor at onboarding customers, despite offering $200 referral bonuses and 1% of your portfolio value in IBKR stock to new clients. (This is the downside of having excellent KYC & compliance).
- Selling value-added services as a broker is hard, especially when these services have traditionally been bundled into brokers (mostly) for free.
- Parts of the organisation may require a transition in mindset from running a brokerage company to running a data-led investing tools business with all that entails.
- The industry fragments further instead of consolidating. The free trading apps build better tools and a better experience with better distribution & marketing ROI, and divide up IBKR’s business between them. IBKR is currently a relatively small player (a million accounts – Schwab has >10m) which is something of a shield in this scenario (it is not the incumbent), but not much of one.
The bottom line:
Essentially, I view this as Interactive Brokers claiming a fixed or growing percentage of a static to declining revenue pool (brokerage) and owning a small and growing share of a large and growing market in value added services in financial data and investing tools. Brokerage is procyclical (business is booming) but IBKR has very steady customers and strong retention. Margin loans and minimum account fees result in fairly consistent revenues even in the down periods. Moving into investing tools should help alleviate some of the risk in the business, but this will always be a pro-cyclical industry. What you need to watch for is a) IBKR improving its onboarding (this is the most obvious & easiest area for improvement), followed by b) improving its ability to acquire customers, and in parallel, c) the creation of new products and ability to monetise.
Food for thought.
I own shares in Interactive Brokers. A few weeks ago I sold a small number of shares above $70. This is a disclosure and not a recommendation.
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