Description

Interactive Brokers Group, Inc. (IBKR)

***Take advantage of recent 20% pullback in shares to purchase this high-quality compounder***

In 1951 Warren Buffett wrote up a stock pitch on Government Employees Insurance Co. (GEICO) and titled it “The Security I Like Best”. His pitched was largely based on the fact GEICO had “no agents or branch offices” and was therefore able to offer auto insurance to customers at “discounts running as high as 30%”. More impressively, GEICO was able to offer these discounts while maintaining a sizeable profit margin advantage over competitors (27.5% vs. 6.7% industry average). Legendary value investor Benjamin Graham served as Chairman at the time and “the 10 members of the Board of Directors owned approximately one – third of the outstanding stock”. Buffett also added that “In GEICO’s case, there is reason to believe the major portion of growth lies ahead”. Sounds like a pretty good pitch to me, and in hindsight his thesis played out with Berkshire earning a ~50x return on the stock before acquiring complete control in 1995.

I consider Interactive Brokers (IBKR) the “Security I Like Best” and think it shares many attributes with GEICO from 60 years ago. Starting with the most important aspect, I believe IBKR has a structural advantage in their low cost, automated brokerage operation. While competitors such as Schwab and Fidelity spend large sums on high-touch customer service, brick and mortar branches, and massive marketing campaigns, IBKR instead focuses on delivering the absolute lowest cost platform. How do they do this? CEO and Founder Thomas Peterffy explains it best:

“When I entered into this business some forty years ago, I was a computer programmer and ever since that time I have remained a computer programmer and surrounded myself with other computer programmers. So, unlike other businesses, we do not, as much, focus on sales ... which may be a problem ... but we focus on building technology. Our forte is to automate everything and everybody we can automate. That gives us the opportunity to service our customers at a much, much lower cost than our competitors do and for that reason we can charge very low commissions. So, it's magic. The magic is called automation.” – Thomas Peterffy, May 2014 interview

Automation is ingrained in the cultural DNA of Interactive Brokers. From the online application to the computer-entered trades, technology does the heavy lifting rather than people sitting on a trading floor. The composition of the company reflects this operating model:

“I’m a computer programmer, and so are all of the most important people in my company” and “Programmers outnumber other Interactive Brokers employees by a ratio of 5-to-1.” – Thomas Peterffy, November 2006 interview

The end result of this strategy is brokerage commissions that are significantly lower than competitors. Barron’s conducted a price comparison as part of their 2015 independent survey, which named IBKR the Best Online Broker for the 4th year in a row:

While claiming to be “discount brokers”, Schwab, TD and others operate a totally different model and are not capable of competing directly with IBKR. While targeting the “mass affluent”, these large brokers tout heat maps, buy signals, and other gimmicks in their constant stream of ads on TV. They each operate hundreds of branches with thousands of employees. The end result is commissions and fees that add up to total costs 2x – 3x more expensive than IBKR.

A natural follow-up question may be “why don’t Schwab and other automate as well?” This is of course a question Peterffy has faced many times, and his answer is succinct:

“They cannot do it the way we can do it because, as I said, we're computer programmers. They are businessmen.” – Peterffy, May 2014

It would probably be a better bet to start from scratch rather than attempt to mold a company like Schwab into IBKR, but even then they are 38 years behind when the fanatical Peterffy started.

“My idea is to create a platform that is so superior to anything else out there, so much more valuable and so much less expensive to use, that it will just sell itself” – Peterffy, 2006

While businesses can have many forms of competitive advantage, I consider the low-cost / scale advantage to be the strongest. This is because it is one of the few competitive edges that can actually widen over time. If I created a luxury brand that consumers find desirable, I can use that edge to charge an unusually high price on the item and earn excess returns on capital. However as my sales grow, I will be forced to water down the product to reach new markets, and my competitive edge will slowly narrow as my brand becomes generic (see Coach, Michael Kors, others). Conversely companies such as Amazon, GEICO, and Interactive Brokers are able to create a positive cycle or “flywheel” in which the benefits of serving as the low-cost provider only strengthen the moat over time:

Jeff Bezos Sketch of Amazon’s “Flywheel”:

IBKR “Flywheel” from recent advertisement:

IBKR certainly provides a very low-cost service through an intense focus on automation, but is the product any good and does it actually lead to picking up more customers? As part of their review of online brokers, Barron’s ranked IBKR 4.5 / 5.0 in usability, 4.7 / 5.0 for the mobile app, 5.0 / 5.0 on reporting, and 4.8 / 5.0 on trading experience. Despite their relentless focus on automation, IBKR scored 4.6 / 5.0 on customer service. Add it all up and IBKR came out on top for the 4th straight year in the ranking, despite Cost only accounting for one out of the eight metrics.

As an Interactive Brokers user personally for 4 years, and someone who recently signed up for an institutional account, I can say as a pure consumer I thoroughly enjoy the product. Additionally nearly all small funds I’ve spoken with use IBKR for Prime Brokerage and speak highly of the product. It’s no frills, transparent, offers great execution and a wide range of security options which is exactly what an investor is looking for. No they do not provide colorful tutorials or an army of helpers, but at the end of the day a strategy entails tradeoffs and IBKR is not trying to be all things to all people.

More importantly than my personal anecdote, clients are signing up like clockwork with customer account growth averaging 17% per year over the last seven years. Since January of 2008 (as far back as their latest statistics go), IBKR has grown total accounts each and every month, from 97,200 accounts in January 2008 to 331,100 accounts in December 2015.  Over that stretch, aided by a strong stock market, client equity grew from $8.8B to $67.4B.

Historical growth is great, but as Buffett mentioned in his 1951 pitch “of course the investor of today does not profit from yesterday’s growth. In GEICO’s case, there is reason to believe the major portion of growth lies ahead”. I feel similarly about IBKR as they currently have less than 1% of total brokerage accounts in the U.S. By comparison Schwab has ~35x more accounts than IBKR, TD Ameritrade has ~23x as many, and E*TRADE has ~12x more accounts. While I cannot predict IBKR’s growth rate precisely, I feel confident that they have a long runway ahead of them and over time their structural competitive advantages will prevail. CEO Peterffy agrees:

“I think in 10 years we could be the biggest broker in the world, and I am not kidding, because our technology is way ahead.” – Thomas Peterffy, Q3 2014 earnings call

Just like GEICO, IBKR earns unusually high profit margins despite offering a significant savings to end customers. The brokerage segment currently earns pre-tax margins of 62%, over double the industry average. IBKR’s brokerage margins have steadily risen from the low 30% range a decade ago, and Peterffy believes they can reach 70% in the near future as operating leverage on incremental volume continues to flow through.

While the focus for IBKR is on the business and the enduring platform, I believe that behind every great moat is a management team that built it. CEO, Chairman, and Founder Thomas Peterffy is exactly the kind of owner/operator I like to be in business with. Arriving in the U.S. as a penniless defector from communist Hungary, the 21 year old Peterffy struggled with the language barrier but found the language of computer programming to come naturally to him. Using his programming skills Peterffy bounced around various jobs on Wall Street, building tools to automate complex calculations for options traders. In 1977 Peterffy used $200,000 in saving to purchase a seat on the American Stock Exchange, aiming to put his computer driven trading models into practice. Peterffy admits that in the beginning “the other guys looked at me as if I was absolutely mad.” However as time passed peers began to take notice of the unusual success his market making firm Timber Hill experienced. In the early 90’s Peterffy began building a brokerage platform based off the same philosophy of automation, launching Interactive Brokers in 1993.

Today Peterffy owns ~75% of IBKR, giving him a stake in the company valued at over $11 billion. Peterffy runs the company like a man who owns billions of dollars in stock, keeping $2.5B of excess capital on the balance sheet to survive the “once in a hundred year flood” that tends to pop up every few years in the global financial markets. He is also steadfastly focused on long-term results, and provides candid and clear communication to shareholders. Each month detailed brokerage statistics are published for shareholders, providing investors the key metrics they need to evaluate the business.

A logical concern is then “What happens when Peterffy is no longer running IBKR?” Currently Peterffy is 70 years old, in good health, and despite his ability to do anything he desires, he continues to enjoy working. Evidence of this is his large beach-front estate on Antigua, one he “rarely visits” because he finds it “boring” and which contains the “exact same office set up” he has at IBKR’s headquarters. As for succession, Milan Galik has already been named President and successor, and Peterffy answers the common question with “I have a number of computer programmers here that have been with us for 20 or 30 years. They are intimately familiar with our systems and several of them would be capable of running the firm – nowadays probably better than I do.” One of the benefits of IBKR’s model is that Peterffy will leave behind a platform and culture that were created by the founder, but are not reliant on him for continued success.

Of course an exceptional business, with a long runway of growth ahead of it, led by an extraordinary CEO typically is not available for purchase at an attractive price in the public markets. I believe there are a handful of factors currently contributing to the mispricing of this opportunity:

Low Float:

• Less than 15% of IBKR is publicly traded, as Peterffy and other key employees own the remaining 84.3% in a privately-held LLC. As a result, this ~$15B market cap company only has a public float of ~$2.3B. As a controlled company with low float and volume, IBKR is not available as a sizeable purchase for most asset managers and large funds. Other key shareholders include value-oriented hedge funds Arlington Value Capital and Teton Capital, both known as savvy investors but also long-term holders, leaving fewer shares regularly changing hands.

Market-Maker Segment Obscuring Dominant Brokerage:

• While the focus of this pitch is on the brokerage segment of IBKR, the company maintains the Market-Maker (MM) segment that traces back roots to Timber Hill. Peterffy concedes this segment is volatile and not the future of the company, however as long as it generates a fair return on capital IBKR will continue to operate it. In order to shift capital away from the Market-Maker segment, IBKR instituted a $.10 quarterly dividend that comes straight from the MM balance sheet. The MM remains profitable, however pre-tax profits have ranged from a high of $1B in 2008 to a low of $88mm in 2010. While the brokerage segment’s profit continues to march higher, the MM’s volatile earnings obscure the consistent growth and likely prevent IBKR as a whole from screening well.

Complex Currency Fluctuations:

• As a global broker and market-maker, IBKR elects to hold its cash in a diversified basket of 16 currencies they refer to as the “GLOBAL’. IBKR reports in U.S. dollars, so any change in the value of the GLOBAL against the USD will impact earnings. Given the recent strength of the USD, currency headwinds negatively impacted earnings for IBKR by 34% in FY 2014 and 14% through three quarters in 2015. To evaluate the underlying performance of the business an investor must sift through this noise, something not everyone elects to do.

Limited Coverage/Awareness:

• Likely because of the low float, IBKR does not garner much sell-side attention and generally flies under the radar in the investment community. While coverage is picking up, it is common to talk with other investors about Interactive Brokers and hear “I didn’t know they were publicly traded” even if they are enthusiastic users of the platform. As the company continues to grow and market itself more effectively, I think general awareness of the stock will increase.

IBKR today trades for a total valuation of $14.8B, comprising both the market-maker and the brokerage business. I think the MM business is a solid, if not spectacular operation that at least merits a valuation equal to book value. Applying a 1x P/BV multiple to the market maker’s equity and excess capital results in a ~$11.3B valuation for the remaining brokerage segment. This works out to ~17x pre-tax profits or ~25x after-tax net income. Certainly not a screaming bargain, but compared to the 30x+ P/E multiples garnered by Schwab and E*Trade, and given IBKR’s considerably higher growth rate, I think the valuation is reasonable. While not a “classic” value investment, I think anyone waiting around for IBKR to trade for 8x earnings will be waiting for a long time as those earnings continue to compound. With the recent volatility to start the year IBKR shares are off ~20% from a recent high, creating a compelling entry point for this long-term investment.

Disclaimer: The company I work for currently owns shares in IBKR but may buy, sell, cover, or otherwise change the form of investment for any or no reason. 

Catalyst

- Increase in publicly-traded float

- Increased Street coverage / awareness

- Spin-off of Market Maker (Peterffy has said this is highly unlikely, but its possible and a move that would be cheered by many investors)