Interactive Brokers Group And Global Deep Value Stocks

Summary

• Instead of looking for high-conviction picks, one can also look for statistically favorable stocks.
• While I invest in high-conviction picks as well, this can actually be dangerous. For most people, selecting stocks on a statistical basis gives higher returns.
• On a statistical basis, the cheapest stocks are those with high NCAV/Market cap or with low EV/EBIT combined with a strong balance sheet. In the US, these are very rare.
• When investing globally, there are plenty of opportunities for building a diversified deep value portfolio. These deep value stocks can be alternatives for similar well-known stocks in the US.
• Sometimes, a pair trade with such a US stock makes sense. In this article, I discuss such a pair trade with Interactive Brokers is the other (short) leg.

The first part of this article is based on the Welcome article of my premium service on Seeking Alpha. In addition, I have added the description of Aizawa Securities discussed in my last low EV/EBIT premium research article. The comparison with Interactive Brokers is new content.

On sites like Seeking Alpha, you find many so-called high-conviction picks. These are stocks and investments that the SA contributor expects to fly high. But life is random, unknown and unpredictable risks exist and stock markets are reasonably efficient. So often, these fly-high predictions don't work out.

Stock market researchers have noticed this decades ago and found all kinds of explanations for why stocks with good stories often don't have great returns. Some researchers even found that doing more in-depth research into a specific stock increases people's confidence, but doesn't increase the accuracy of their investment predictions. See also here.

Useful stock statistics

So, other stock market researchers have worked backwards and tried to find common characteristics in stocks that have performed very well. To do this, they have computed the returns of US and foreign stocks for decades. They did this in great detail. For example, did you know that stocks of companies that don't respond to a question in a conference call perform worse, on average? I regret that I didn't act on the silence when an analyst asked a question about a possible new offering of common or preferred Crossroads (CRDS) stock.

More importantly, they have found that stocks with low P/E and low P/B do much better than the average stock. In addition, they found that stocks with more current assets than liabilities plus the market cap (so-called net-nets) do even better.

How did they come up with the net-net strategy? Well, the great Benjamin Graham already mentioned that net-nets with a large discount to NCAV do very well in his book Security Analysis in 1934. Later, he also recommended low P/E stocks with strong balance sheets. Instead of the wording strong balance sheets, he mentioned stocks that have total assets less than twice the equity. So what I do here is trying to find net-nets and stocks similar to stocks with a low P/E and a strong balance sheet. I use the same criterion as Graham with one exception. Instead of just "total assets" and "equity", I use "total tangible assets" and "tangible common equity". This excludes certain stocks of companies that have made many big acquisitions and are therefore less safe bets.

In an interview in 1976, Graham said that his low P/E stocks return about 15% per year. Such a statement shouldn't be taken for granted. I am not a blind follower of Graham, but also use the results of others who verified and improved his strategies during his life and after. For example, there is research showing that dividend-paying net-nets have smaller returns than other net-nets. They are less volatile, though. Similarly, there is research showing that non-profitable net-nets do better than profitable net-nets. Graham preferred profitable and dividend-paying net-nets. Therefore, the returns he reported were lower than the statistical returns of all net-nets.

Most people think that what Graham did still makes sense. Unfortunately, it doesn't. As a general rule: What almost all other people like is more expensive, and hence, has statistically worse returns.

EV/EBIT

Graham recommended stocks with low P/E or P/B or a high dividend yield, combined with a strong balance sheet as alternatives for net-nets. Among these, he preferred stocks with a low P/E and a strong balance sheet. However, several researchers have found that Enterprise Value-based valuations are statistically better than Price-based valuations. See, for instance, table 7.1 on page 136 of the book Quantitative Value of Wesley Gray and Tobias Carlisle. By the way, I can recommend this book to everybody. In my opinion, this table shows that the multiple EV/EBIT is statistically the best predictor of future returns. An almost equally good predictor is EV/EBITDA, and another good predictor is P/B. To me, this table shows that the worst predictor of future returns is free cash flow yield. Using free cash flow as a predictor makes so much sense that too many people are using it.

Statistically, in the US, the 10% stocks with the lowest EV/EBIT multiples have a geometric return of 14.55%, according to Gray and Carlisle. Similarly, the 10% lowest EV/EBITDA stocks statistically return 13.72% and the 10% lowest P/E stocks return 12.44% per year. Also, James O'Shaughnessy found that the cheapest P/E stocks have lower returns than the cheapest EV/EBITDA stocks. In his book What Works On Wall Street, the low EV/EBITDA stocks are among the best bets based on just a single multiple. Unfortunately, he didn't present results for the EV/EBIT multiple.

But what kind of return would Graham's low P/E combined with strong balance sheets generate? The answer is 17.8% per year, again from Gray and Carlisle's book. They also applied Graham's trading rules. So, they sold the stocks in the virtual portfolio always as soon as 50% profit was achieved or had been held for 2 years. Unfortunately, in the US, these stocks are very rare. So in practice, it is very difficult to stick to such an undiversified portfolio. But when searching in many countries, it turns out that there are enough such stocks, so that's what I do.

Also, it turns out that low-P/E stocks with strong balance sheets perform a lot better than just low-P/E stocks. The difference is about 5% per year. Indeed, many value investors know how important it is for your return to avoid stocks of companies with leveraged balance sheets. Famous examples are Buffett, Schloss and, of course, Graham himself.

The returns

Because research has shown that EV-based strategies have better returns than P/E strategies, I use EV/EBIT combined with a strong balance sheet to find other stocks than net-nets. With Graham's trading rules, I expect that these stocks return about 20% per year: about 2% more than Graham's low P/E strategy. This statistical return is less than the statistical return of net-nets by between 20% and 30% per year. Diversification has always a price.

For example, I restrict my EV/EBIT stocks to stocks with P/B below 0.65. I think this makes sense, since P/B is a robust predictor of future returns. Sometimes, low-P/B stocks have lower returns because they have too many debts. Such stocks are excluded by screening for strong balance sheets as I do. My experience is that with this extra criterion, the results shift to smaller market capitalizations. On average, small caps perform better than large caps. This makes it likelier that adding a low P/B criterion to the screening criteria will increase the expected returns.

How I find these stocks and what I do with them

I find these stocks with screener.co. IT products rarely deliver more than they promise. This website is one of the exceptions. In fact, it delivers much more than I had expected. It provides screening using all kinds of complex and programmable combinations of criteria. In addition, it provides a number of very handy features that I really need but before subscribing I didn't know I would need.

As I mentioned above, both net-net and low EV/EBIT stocks with strong balance sheets are very rare. So rare that most of them can only be found abroad. Of course, these stocks also exist in the US, but then they are usually so small that such ideas are not really actionable. For example, try to buy the net-net Dac Technologies (OTC:DAAT) with market cap of only $1 million. DAAT is marginally profitable and has about 70 cents per share in current assets net of liabilities.

While these stocks are scarce in the US, globally there can be too many low-EV/EBIT or even net-net stocks for me to research. For example, at the moment, a low-EV/EBIT list with strong balance sheets and low-P/B returns about 90 stocks. It takes me usually a couple of hours to research one stock. So I make a selection. Such a selection always includes the very cheapest among the cheapest stocks from the screener. In addition, it includes stocks with other favorable statistical features and stocks that are interesting for diversification.

Why are there so many Asian stocks in these lists?

If you start screening for yourself, you will notice that most of these deep value stocks are listed in Japan or Hong Kong. Some people don't like some of these stocks. Some people even exclude certain stocks, for example, stocks listed in Hong Kong. Don't you like them either? That's why they are so cheap! Even I don't like them, and neither do I like the other deep value stocks.

Again, we all like and dislike the same type of stocks. Unfortunately, consensus doesn't pay on the stock market.

Since each of these deep value stocks is so much disliked, it doesn't make sense to exclude certain stocks. And if you exclude a certain category of stocks, there is always the next disliked category of stocks to exclude. Consider, for example, excluding Asian stocks. Then what's left? Many oil and mining stocks! There are many people excluding these stocks as well, and that's why they are so cheap.

Accounting practices

There is no fundamental reason why Asian deep value stocks have worse returns than European or American deep value stocks. Oh yeah, their accounting practices! I agree that their accounting and shareholder-friendliness is not as great as that of some US-listed large caps. But don't forget that almost any US small cap pays their managers way too much. Especially when compared to the book value and market cap. And how bad is the corporate governance of Asian companies really? Graham had to deal with much worse corporate governance when he invested in net-nets in the '30s and the '40s of the last century. That didn't stop him from investing.

Market timing with US-based net-nets

In bull markets, there are not so many net-nets. For most of the '80s and '90s, there were less than a handful of net-nets with market cap above $35 million in the US. That's simply not enough for this news service. And now, our markets are in bubble mode. But trust me, there will be a time (probably soon) when there are much more US and European net-nets.

In the mean time, if investing in foreign net-nets is not an option for you, then you can still invest in US net-nets only. Use at most 10% of your portfolio per stock. And keep the remainder as cash or US Treasuries with maturity within 1 year. That way, you are timing the market based on the number of net-nets available. Research shows that your results will still be very good in the long run. For details, see Victor J. Wendl's book.

Interactive Brokers Group

Investing in global deep value stocks often gives cheaper alternatives for US-listed value stocks. See also my last article, where I mentioned 2 cheap foreign large cap alternatives for Micron (MU). Many people know that Micron stock is cheap, but fewer people know that its competitors' stock look at least just as cheap. Similarly, my previous article shows that the cheapest resource companies (oil, iron ore) with strong balance sheets are foreign companies.

Consider, as another example, Interactive Brokers Group (NASDAQ:IBKR). This is a great online broker and market maker. In assets and revenue, the electronic brokerage segment is about 4 times as large as the market-making business.

The stock is certainly not cheap. The P/B is 3. On Yahoo, the consensus forward P/E for 2016 is about 25. And look how leveraged this company is. Total Assets are over 50 times common equity. And the company doesn't pay out much, at least not significantly compared to the market cap. Also, based on discounted cash flow analysis, the company is expensive. To get to the current market price, you first have to believe in an over-50% earnings increase until 2017. Second, you have to believe in an annual EPS growth percentage of in the mid-tens for at least 10 more years. A look at the numbers of TDAmeritrade (AMTD) and ETrade (ETFC) shows that these stocks are expensive as well. However, in terms of P/E, both companies are much cheaper. But P/E is much affected by leverage. Even when treating IB's noncontrolling interest as common equity leverage at the other 2 companies is not much higher. More on IB's non controlling interest below.

The screener comes up with an EV/EBIT multiple of almost 10. This a low multiple. But I think this is a screener anomaly. The company has a large cash balance. But for this company, the cash balance doesn't completely consist of excess cash. A large part of it might be cash in brokerage accounts. A brokerage company can't use this cash for other things in unlimited amounts. Again, even when treating the noncontrolling interest as common equity, the leverage isn't exactly low. So, the enterprise value is, in reality, (much) larger than it is according to the screener. Therefore, the screener shows a multiple EV/EBIT that is too high.

Does Interactive Brokers have durable competitive advantages? While it offers great services I don't see why other companies can't offer the same services. Of course, Interactive Brokers benefits from economies of scale. But that is something different from a real competitive advantage. While it is not convenient to switch from one broker to another, it can be done. Actually, it is pretty easy. I don't think the company can create value from things like brand loyalty as much as, for instance, The Coca-Cola Company (KO) can.

IB can't be acquired easily, since the public has only 14.5% of the votes. The other votes are controlled by the CEO. Apart from the overly leveraged balance sheet and the shareholder structure, there is one other sign of bad corporate governance. The company buys back shares that have been created from employee options. At these prices, IMO, a company should never buy back any shares. Here, investors are pleased at the cost of the financial future of the company by spending too much of their own money.

Don't get me wrong, Interactive Brokers has a leveraged balance sheet, but the company is in no way comparable with certain highly leveraged European banks or bankrupted banks like Lehman Brothers. I suppose your money is safe with Interactive Brokers. Unlike these banks, Interactive Brokers has hardly any debts. Instead, most of the equity is noncontrolling interest. This noncontrolling interest, or minority interest, consists of the shares of minority shareholders in subsidiaries. I categorize it as a liability. The value of this liability can be worth more or less than its book value.

Often, I see that certain insiders keep the best part of the company for themselves by keeping a minority stake in the best subsidiaries. This seems to be the case with Interactive Brokers, since the CEO, Thomas Peterffy, is the minority shareholder of 2 subsidiaries. See also here. The book value of the noncontrolling interest is less than 10 times the common equity, but about 90% of the net profits are attributed to it. So my guess it that the noncontrolling interest is worth more than its book value, making Interactive Brokers even more leveraged. In addition, I see this company structure as another corporate governance issue. Another sign that there are more issues. So I checked the ISS Corporate Governance Quickscore. I wasn't surprised to see that the company got the worst score available.

How does a company get rid of this noncontrolling interest? It buys the other shareholders out for cash or for its own shares. Since Interactive Brokers needs money to grow, I suppose such a buyout would be using new shares. Then, public shareholders will get diluted a lot. The CEO and minority shareholder is about 70 years old. A buyout of his noncontrolling interest may not happen soon, but I think it will happen sometime for sure.

Of course, you could look at the company through the eyes of the CEO instead. He basically owns 90% of the company already, and could decide to take it private by buying out the public shareholders. However, I don't think he will do this anytime soon, since, IMO, the stock is much too expensive. Secondly, let's not forget he is about 70 years old. At that age, most people think it's time for reducing responsibilities instead of increasing them. But the possibility of being taken private could provide a floor for the stock price. Instead, I think the company went public in 2007 for the usual reasons. These are providing cash for the original shareholders, raising cash for the company to grow, the possibility of paying managers in stock and the possibility of acquiring other companies with stock deals.

Aizawa Securities

As I mentioned above, there are many extremely cheap companies listed in Japan and Hong Kong. Often, they are cheap for unknown reasons. One of them is the Japanese company Aizawa Securities (8708:JP). The screener said that the EV/EBIT is 1.4 and the P/B is 0.56. The dividend yield is about 4%. Due to the language barrier, it is difficult to find information on this company. Here is what I found.

This is an online broker and specialty banker with local offices as well as allowing Japanese clients to trade in 11 Asian markets and in Israel. Great business to be in, with good chances of long-term growth. There are no shareholders with a really big stake. The company also provides other investment services, such as recruiting investors to sell specific stock to. Because of the treasury shares, the market cap is about 14.5% lower than Bloomberg and FT tell us. This is almost a net-net. When taking into account the real estate of 3.7 billion JPY and 23 billion JPY of investment securities categorized under fixed assets, the Liquidation Value/Market cap is 1.7. The reason that people don't like this company is probably because the trading commission revenue and profit significantly decreased, according to the last annual report. But during the last quarter, revenue and operating profit were up again. On July 10, 2015, the company announced that it is acquiring Yawata, aka Hachiman Securities, which has about 10% of the book value of Aizawa Securities. The consideration for the acquisition was not disclosed.

Aizawa Securities seems to offer trading in many markets Interactive Brokers doesn't offer trading in. So, with a small acquisition, Interactive Brokers might be able to extend its offering to these markets. At least any investments for this extension could be paid off with revenues from existing customers of Aizawa Securities. The acquisition would be even cheaper for Interactive Brokers if it didn't pay in US dollars, but in Chinese dollars. With its overvalued shares, at current share prices, this seems the only logical thing to do. Moreover, such an acquisition could provide extra liquidity for Interactive Brokers. After such an acquisition, it can simply liquidate certain assets or use the new equity to add debt to its balance sheet.

When looking back, the chances of such an acquisition look remote. My impression is that Interactive Brokers has always been a fantastic autonomous growth story. But of course, it isn't the only broker which this acquisition would be attractive for. There are many brokers in Europe and the US that may want to offer trading in more markets. In general, betting on the global consolidation of internet brokers could be an attractive play for global investors.

A Pair Trade

Pair trades reduce risks compared to simple shorts or longs. In this case, remember that the stock markets are highly correlated. So when revenue and profit are down at Aizawa, chances are high that Interactive Brokers experiences a similar decline. The CEO said in the company's last conference call that 25% of the accounts and 25% of the commissions are from Asia. Given the extreme valuation difference between these two similar stocks, I consider them a good pair: short Interactive Brokers, long Aizawa Securities. The stock prices of very highly valued companies like Interactive Brokers usually react strongly to headwinds. Positive news is usually already priced in. The stock prices of companies at the bottom of the valuation spectrum, like Aizawa, often don't react much to headwinds. These stocks usually respond favorably to good news, since only negative news is already priced in.

Interactive Brokers seems to be overvalued and Aizawa Securities undervalued. I expect that Interactive Brokers will need new equity to finance growth. This new equity would be printed when the company acquires cheaper companies. In fact, at such an event, existing shareholders implicitly sell a little bit of their stock, which makes sense for an overvalued stock. But the new owners will sell as well, and that will decrease the stock price. In addition, shareholders might get diluted when the company buys out the noncontrolling interest of the CEO. On the other hand, Aizawa Securities is so cheap that even a liquidation can create value. But that is not the only way value can be created. This is a good business that could be interesting for a competitor or a new entrant. And unlike with Interactive Brokers, I don't think there are any obstacles for acquiring this company.

Concluding remarks

Good statistical picks are net-nets and stocks with low EV/EBIT and a strong balance sheet. I do research on these stocks for my premium articles on Seeking Alpha. The statistical returns of the first group of stocks have been very thoroughly researched and are between 20% and 30% per year. However, most investors feel uncomfortable with these stocks. Fortunately, companies with low EV/EBIT, combined with strong balance sheets are of higher quality than the average net-net.

In addition, global statistical investing offers compelling alternatives for story-based, high-conviction picks. For many well-known companies, there is usually a better statistical pick. As I have shown when discussing Interactive Brokers Group and Aizawa Securities, clever pair trades can sometimes reduce risk and increase returns when investing in very cheap stocks.

As you can see from the disclosure, I still own at least one well-known story stock instead of owning the less well-known but great statistical alternatives. Shame on me. I'm an investor like anyone else. And just like other investors, I learn. So currently, a large part of my portfolio consists of these great statistical picks, but not all of my portfolio. While I might not have chosen these other stocks if I had to buy them now, I think these stocks are good longs right now. So I watch the developments around these stocks. And when I find a good time to sell, I will replace these stocks with more great statistical picks.

Analyst’s Disclosure: I am/we are long DAAT, CRDS, MU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.