Sam Subramanian's  Instablog

The third quarter was a favorable one for the longs. Except for a few short-lived, minor pullbacks stock prices moved higher through the quarter. Stock price volatility declined, takeover activity rose, and risk appetite improved to help the S&P gain 15%.

Recently I commented on the seemingly unfathomable transactions of large financial services firms divesting their asset management businesses to investment management firms in such a favorable market environment. In the same vein, one would expect discount brokers to roll in dough under such favorable market conditions. Financial reports from discount brokers like Charles Schwab (SCHW), TD Ameritrade (AMTD), and E*Trade Financial (ETFC) however portray a different story.

During the third quarter, trading activity increased at AMTD and ETFC but declined at SCHW. Adverse impact from low short-term interest rates, bite from charges taken to shore up capital, and expenses related to acquisitions combined to offset the benefit brokers derived from an up-tick in retail stock trading activity. 

Here are the specifics: 

Charles Schwab: A 9% decline in daily average revenue trades combined with waiver of $78 million in money market mutual funds fees caused SCHW’s quarterly revenue to decline 19% from the year-ago period to $1.0 billion.

TD Ameritrade: AMTD’s acquisition of options-trading specialist thinkorswim helped trading activity increase 35%. However, AMTD’s overall revenue grew just 1% to $658 million as low interest rates reduced income.

E*Trade Financial: ETFC’s daily average revenue trades increased 7% from the year-ago period helping quarterly revenue to increase 52% to $575 million. A massive $773 million charge taken for the $1.74 debt exchange thrashed ETFC’s income statement.

Are discount brokerage shares a buy, sell, or hold?

The prospects for discount brokers are getting brighter. GDP data for the third quarter suggest that the recession has ended.  Although there are concerns over the pace of economic recovery, following the lead taken by some countries like Australia and Norway, the Federal Reserve may increase short-term interest rates in 2010.  The profitability of discount brokers stands to benefit from a rise in short-term interest rates. Additionally, discount brokers earnings could receive a further boost if revenue trade volumes hold steady or rise. 

Among discount brokers, AMTD and SCHW are better positioned to prosper from an improved economy and a favorable market environment. Shares of AMTD and SCHW are suitable for most retail investors. E*Trade may break even in 2010 and enhance its takeover appeal. However, the discount broker is saddled with quite a chunk of toxic assets. As such, ETFC shares are suited only for venturesome investors. 

Disclosure: I do not have long or short positions in any of the securities discussed.