by David Sterman
Here's a fairly simple investment premise: if the stock market rises +10% or 15% in the next six months, one sector will rise +30% or even +50%. That's because a rising stock market tends to bring out increased interest from individual investors. And they bring lots more business to online brokers. Indeed, I just wrote how individual investor sentiment is now at its highest level in nearly four years, and these folks are getting bullish simply because the market has been on the rebound since late August.
Need more proof? The major online brokers just reported an impressive sequential spike in trading volume, as measured by Daily Average Revenue Trading (DART). E*Trade (Nasdaq: EFTC) and TD Ameritrade (Nasdaq: AMTD) just saw +14% to +15% sequential spikes in October, while Charles Schwab (Nasdaq: SCHW), Interactive Brokers (Nasdaq: IBKR) and TradeStation (Nasdaq: TRAD) saw mid single-digit sequential increases.
Then and now
Two major changes have taken place in the decade since individual investors were a major force in the market. On the one hand, DARTs are well below previous levels, despite the recent monthly uptick. But all of the firms have many more accounts than they once did -- in fact, all of the online brokers have at least +30% more clients than they did at the end of 2007. So, if individual investors start to become more active (though still below the levels of the dot-com boom), then DARTs would soar, and so would sales and profits for these firms.
It's too soon to call October's DARTs the start of a trend. The metric surged in the spring but had been on the wane thanks to the market swoon this summer. And though October trading activity was higher than September's, it's still well down from the spring peak.
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But if the recent bullish individual investor sentiment continues to stay aloft (which you can track here), then DARTs are likely to rebound in tandem, perhaps back to levels seen last May. Yet the analysts that follow the industry are unlikely to report on such bullishness until the data come out. That's why you should track the investor sentiment by the week instead of waiting until the middle of the month to find out how the previous month fared.
And you need to ignore industry analysts completely if you are really to see the big picture, which as noted earlier, is all about a bulked-up client base at each of these firms. Let's take Charles Schwab as an example. The company picked up roughly 350,000 net new client accounts in 2008 and another 300,000 in 2009. Yet Schwab's revenue is barely growing, thanks to a combination of relatively light trading volume this year and smaller interest spreads on its fixed income products. But if you assume that Schwab's revenue per customer will rebound in 2011 to 2008 levels, then Schwab's sales would spike roughly +30%, and per share profits would likely rise a lot more than that.
The forecasts don't incorporate such an outlook just yet. Schwab is expected to generate $4.7 billion in revenue next year, roughly -7% below 2008 levels, even though Schwab's client base is now roughly +20% to +25% larger. Looked at another way, analysts think Schwab can earn roughly $0.80 a share this year, but if DARTs rebound in 2011 and interest rates rise in 2012 (which boosts Schwab's profit margins), then you're probably looking at EPS much closer to $2.
For long-term investors, it pays to see how Schwab's shares have responded to previous upturns in trading. Shares fell -45% in 2001 and another -30% in 2002 before the company saw a rebound in operating trends. At the time, Schwab saw net income, which had surpassed $700 million in 2000, fall to around $100 million in 2002. By 2007, net income had surged all the way to $2.4 billion. Although it took a while for shares to respond, they finally rose more than +20% in 2005, more than +30% in 2006 and more than +40% in 2007.
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A similarly bullish long-term case can be made for E*Trade. Right now, E*Trade is barely profitable, expected to eke out a few pennies in profit this year. Per share profit should exceed $0.50 next year simply because the company's ill-fated move into mortgages will no longer be a drag on the company by next year. The company has also seen a solid rebound in the size of its client base. And by math, if those clients boost their trading levels by +15% to +20% next year -- not inconceivable in light of rising investor sentiment -- then E*Trade's earnings per share (EPS) could come in closer to $1. The outlook for 2012 and 2013 would be brighter still if the bull market continues.
If individual investors get off the sidelines and back into the market, these companies could become profit powerhouses. If weekly investor sentiment stays high in coming weeks, you may want to get in on these names before the analysts start to upgrade their ratings.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.