1 Growth Stock I Like Better Than Robinhood

As a stock broker known for catering to young people, Robinhood Markets (HOOD 0.73%) has faced pressure to innovate because its customers demand a platform that's in tune with their needs -- one that's cheap and simple and yet offers a broad selection of tradable products. 

But giving these new investors what they want is not necessarily what's good for them. Robinhood has found itself on the wrong side of lawmakers and the Securities and Exchange Commission on occasion for the way it generates revenue and encourages risk-taking among its client base. 

Interactive Brokers (IBKR 1.18%) -- a key competitor to Robinhood-- has a time-tested business model spanning four decades, and its stock has recently outperformed Robinhood's by a wide margin. Here's why it's a better long-term investment.

Image source: Getty Images.

A traditional revenue model

Brokering stocks is a practice as old as the market itself. The traditional fee model is simple: a customer wants to buy shares in a company, the broker connects them to a willing seller and earns a commission for doing so. It's the way Interactive Brokers still does things today.

Robinhood has tried to reinvent the wheel with a zero-commission model. Its customers can trade on its platform for free -- at least, that's how it appears. The company uses a business model known as payment for order flow, where it sells its customers' market orders to third parties called market makers. 

These market makers execute the orders and make their money from the spread, which is generally a small difference between what they pay for a stock and what they sell it to the Robinhood user for. Part of that spread is then paid to Robinhood for its part in the transaction. Markets makers generating fees from spreads is common to the industry and there isn't necessarily anything wrong with it.

The problem is, the amount of spread is often determined by the market maker, which can create a conflict of interest. These third-party firms are typically meant to compete with each other for Robinhood customers' orders, which incentivizes them to charge a lower spread and therefore give the customer better pricing, but it appears that doesn't always happen.

In December 2020, the SEC determined that Robinhood was in breach of its duty of best execution because it provided inferior order execution compared to other brokers. Some Robinhood customers were actually paying more in fees than a traditional broker would charge, even after accounting for the savings from the zero-commission model.

Payment for order flow is banned in almost every major market except the U.S. But recently, the chairman of the SEC made comments suggesting a ban was on the table here, too. A ban could potentially place 80% of Robinhood's total revenue at risk.

A disparity in customer assets

Given the fact Robinhood targets younger investors, 50% of which are trading in financial markets for the very first time, it's understandable that these customers would maintain smaller balances in their accounts than seasoned investors would.

Data sources: Interactive Brokers and Robinhood.

Despite Robinhood having almost 15 times more client accounts, its customers have less than a third of the assets that Interactive Brokers' customers do. To put it in perspective, it works out to $4,533 in assets per customer for Robinhood, and a whopping $230,718 per customer for Interactive Brokers. 

That matters because whether fees are charged the traditional way or through payment for order flow, a broker's revenue is mostly about volume. While it's clear Robinhood charges its customers more (as per the SEC's findings) and that they likely transact more frequently, Interactive Brokers probably has the business model with longer-term staying power.

Interactive Brokers is just better value

Sometimes deciding between two companies simply comes down to price, and if that's the case, Interactive Brokers wins there, too. Over the last month, its stock price has risen by 15% compared to Robinhood's decline of under 1%. 

Yet even still, Interactive Brokers is technically the cheaper stock on a price-to-sales basis.

Data sources: Interactive Brokers and Robinhood. TTM = trailing 12 months. P/S = price-to-sales.

Robinhood is growing faster, although there's a caveat. The majority of its growth comes from its customers trading cryptocurrencies, which are also under heavy scrutiny from lawmakers. It doesn't help Robinhood's case that its clients' cryptocurrency trading is dominated by often-disparaged cryptocurrency token Dogecoin.

As a long-term investor, Interactive Brokers feels like the no-brainer choice between these two stocks. Robinhood may well own the future with its younger client base, but there are numerous hurdles for it to clear first. There's also no guarantee its risky tendencies will morph into responsible investing practices in the future.