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The wild market conditions of 2008 have created unprecedented trading volumes in equities, futures and options. I think it’s time to own one of the healthy ‘transactional’ brokers - the computer-based firms that cater to the trading crowd. They don’t hold inventory of questionable securities and they don’t employ financial consultants to make recommendations to clients.

They do provide traders with direct market access to worldwide markets. My most favored selection in this group is Interactive Brokers Group (NASDAQ:IBKR).

The company has a healthy balance sheet with low debt, plenty of cash, solid profits and very low capital spending. Its stock is near its all-time low price despite record or near-record sales, earnings and book value. Here’s why I like it right now.

This ultra-low commission firm offers what appear to be the lowest commission costs of any on-line trading firm while providing an outstanding trading platform suitable for professionals and experienced non-professional investors. They came public in a Dutch auction during spring 2007 at $30.01 per share. They’ve been making money in every quarter since then and posted great year-over-year comparisons in each of the three quarters this year versus 2007. Trailing 12-month EPS are now $2.21 making the current P/E a very low 7x.

Total debt is just 33% of capitalization with almost nothing coming due in the next five years. Book value is over $12/share making the price/book value a quite reasonable 1.2x. When the markets were hot, IBKR shares traded as high as 17x earnings and 3.4x book value.

IBKR holds no questionable paper on its books and earnings are growing in a poor market environment. I predict a big rebound in share price just on a decrease in investors’ flight from risk. Consensus estimates for 2009 now are running at $2.30 - $2.35 so a move back to even 10 times earnings should result in a 12-month share price of at least $23 or up 48% from yesterday’s close. Is that crazy? Hardly. IBKR shares hit highs of $34.25 and $35.93 in 2007 and 2008 and perhaps more importantly, they hadn’t traded below $21 ever until the panic sell-off of the past few months.

At $15.46/share I see very little downside and substantial upside that may be available very quickly once the mood brightens even a little bit.

Here’s a great < 7 month play on IBKR for those of you who are option savvy:

…………………………………………...Cash Outlay ……….. Cash Inflow

Buy 1000 IBKR @ 15.46 ………………. $15,460

Sell 10 June $20 calls @ 1.35 ………………………………….. $1,350

Sell 10 June $15 puts @ 2.45 ……………………………………$2,450

Net Out-of-Pocket Cash ………………… $11,660

Maximum profit would be achieved if IBKR finishes > $20 on Jun 19, 2009.

If IBKR is at least $20 on expiration date (+ 29.4% from today):

  • Your $20 calls will be exercised and your shares sold for $20,000.
  • Your $15 puts will expire worthless (a good thing for you as a seller).
  • You will have no further option obligations.
  • You will have $20,000 cash for your $11,660 outlay.

That’s an $8340 gain on $11,660 or + 71.5% on a 29.4% move in the stock.

Suppose the shares are unchanged on expiration date?

  • Your $20 calls will expire worthless.
  • Your $15 puts will expire worthless.
  • You will have no further option obligations.
  • Your will still own 1000 shares of IBKR with a value of $15,460.

That’s a $3,800 gain on your $11,660 net outlay or + 32.5% on shares that did not go up.

If IBKR shares are < $15 on expiration date you would be forced to buy an additional 1000 shares due to the $15 puts being exercised.

Here’s a summary of that worst case scenario:

…………………………………………...Cash Outlay ……….. Cash Inflow

Buy 1000 IBKR @ 15.46 ………………. $15,460

Sell 10 June $20 calls @ 1.35 ………………………………….. $1,350

Sell 10 June $15 puts @ 2.45 ……………………………………$2,450

Buy 1000 shares via put exercise ………..$15,000

Net Out-of-Pocket Cash ………………… $26,660

In this case your $20 calls would expire worthless.

Your $15 puts were exercised.

You now would own 2000 shares for a total net outlay of $26,660 or an average price of $13.33/share. That’s $2.13 below the original price point or a drop of 13.7%.

At $13.33 your P/E would be just 6.03x today’s trailing earnings and very close to one times tangible book value.

This combination play offers very good total return potential if the shares go up, or even if they stay unchanged. You are protected against loss even if the shares drop almost 14%.

Disclosure: Author is long IBKR shares and short IBKR options.

Source: Interactive Brokers: Getting Richer by Getting 'Broker'