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CNBC junkies will immediately recognize the ads: Central bank buildings atop piles of money, spitting out an endless supply. A sonorous voice pleading for you to compare their currency prices to their rivals. If tight currency spreads and low margin loan rates don't grab your attention, don't worry: You're not Interactive Brokers'
But even if you've never heard of IB before, pay attention to this: This low-cost, high-tech broker is shaking up the discount brokerage business, dominating a profitable niche, and today's stock price -- masked by temporary factors -- is as attractive as its tiny commissions.
Fast Facts on Interactive Brokers
Online brokerages and market making
Price to tangible book value
Market Making – Goldman Sachs
Source: Capital IQ, a division of Standard & Poor's. TTM=trailing 12 months.
For more than 30 years, Interactive Brokers' founder, CEO, and 90%-owner Thomas Peterffy has used cutting-edge technology and a strict risk management focus to build a finely tuned market-making and brokerage machine. Today, IB's brokerage customers can trade in 11 base currencies on more than 100 global stock, option, currency, and derivative trading venues around the world, all from a single account. That global and multi-product access, along with low commission and lending rates and rapid trade execution, makes IB the first stop for the highly active professional traders that brokerage businesses covet most. Just take a look at the charts below which show not only its growth, but how frequently its users trade:
Source: Company presentation. Normalized to 100 at Dec. 2007.
Source: Company presentation.
With fewer than 200,000 accounts, IB may look like a small fry. But it's growing faster than the rest, while maintaining its focus on their active trader target niche. Trades per account remain an order of magnitude higher than competitors, driving total trading volumes that rival the largest of their peers, and margins other brokers can't touch.
Interactive Brokers maintains this growth and profitability in two ways:
- Automation: IB's focuses on using technology to keep employee count low and the business highly scalable.
- Low-cost provider: This scale contributes to the low fixed-cost structure and means IB can provide extremely competitive rates on commissions and margin lending, rates that attract ever more clients, creating more scale -- a cycle that all low-cost providers benefit from, which also creates a powerful moat for the company.
Temporary problems masking long-term value
The success in brokerage would normally have Wall Street donning premium valuations on the company's stock. But that growth has been masked by the poor results at Timber Hill, the market making operation that's been a millstone around IB's neck for the past year. After posting over $1 billion in pre-tax profits in 2008, Timber Hill mustered only about $5 million in market making pre-tax profits over the past three quarters combined. Declining volatility and increased competition from high frequency trading hedge funds were the main culprits.
But last quarter marked a turn in the market making business, and few have paid attention. That's because the headline remained ugly, with 5% operating margins and pre-tax profits down 97% year over year for this segment. That result, though, was almost entirely due to the dollar's unusual strength in the quarter: separate out the currency impact, and we see that market-making produced 49% margins and $75 million in pre-tax profits -- well on its way back to form and ample evidence that the last few quarter's results are not the new normal for this piece of the business. Further, given the quick move of the dollar back to weaker levels since June 30, much of that currency translation loss should reverse this quarter, setting up a potential upside surprise for the headline figures that draw so much of Wall Street's attention.
CEO Peterffy will gladly accepting lumpy earnings -- and even leave market share and short term profits on the table -- in exchange for keeping business risk in check. He's shunned counterparty risk since day one, only trading in products listed on an exchange and avoiding the intertwined links between banks across the world that nearly brought them all down like dominos. And his decision to keep the company's net worth not in dollars, but in a diversified basket of currencies they call "the GLOBAL," is another striking example that he's working to insure that Interactive Brokers will survive in the event of "financial collapse, nationalization, repudiation of debts or other economic catastrophic events."
Is there a single other CEO out there treating these very real risks so seriously? Peterffy's focus on these things may have hurt earnings this quarter, but his efforts should provide benefit in the long run, particularly if you are concerned about the long-term health of the dollar.
This highlights both an opportunity and a risk for shareholders. Peterffy simply doesn't play the Wall Street earnings game, meaning IBKR is perennially treated as the brokerage industry's Rodney Dangerfield, getting limited attention and even less respect. That gives us a cheap stock to buy , at 1.1 times tangible book value, but means we probably can't rely on Wall Street "selling the story" for our returns. That's fine if you're thinking like a long term owner of the business – you can rely on earnings and book value growth to take care of your investment returns.
I think a more relevant concern is the potential for a cultural shift away from investing in stocks. The Great Depression (and to a lesser extent the 1970s bear market) produced an entire generation of risk-averse savers who swore off investing in stocks. A long-term deflationary environment globally, similar to Japan's experience in the last generation could create a similar emotional shift today. If that happens, IB's business might not grow as I expect.
About 14 months ago, Tom Gardner and I first made Stock Advisor members aware of this fast-growing and profitable online broker catering to high-volume traders across the globe. Its market-making and brokerage businesses combine to provide big scale advantages, and its highly automated operations further give this low-cost provider a natural moat, one that should deepen as global financial markets increasingly automate and intertwine. As the market-making business returns to normal profitability, the market won't overlook this growing gem forever. And at $16, you still have the chance to buy near book value, with ample margin of safety.
In our world of intertwined global economies and too big to fail banking institutions, we'd all be better off with a few more Thomas Peterffys running Citigroup, AIG, and the bankrupt financial firms that so obviously lost sight of prudent risk management. The financial landscape still seems scary -- but as we all know, fear can bring out the best investment opportunities.
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Alex Scherer owns AIG debt, but no companies listed above. Interactive Brokers Group, optionsXpress Holdings, and Charles Schwab are Motley Fool Stock Advisor picks. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.