Interactive Brokers (NASDAQ: IBKR) is a unique broker with great business prospects. In my view, its valuation is also attractive and gives investors a comfortable margin of safety. In this article, I’ll explore why you should consider owning IBKR in your portfolio as I do.
Video: I decided to provide the reader with a supplementary video for the article with additional insights on IBKR, its product, and valuation.
Overview and background
IBKR is a broker that focuses mostly on retail investors. Its main differentiator is the fact that they concentrate on delivering the lowest commission structures for their clients. IBKR’s value proposition hinges on helping investors improve their profits through lower commissions and fees, but also through better technology. This is why I think that IBKR’s main competitive advantage is that they genuinely seem to care about delivering value to their customers.
Create technology to provide liquidity on better terms. Compete on price, speed, size, diversity of global products, and advanced trading tools.
– IBKR's mission statement.
In my view, you can’t truly understand IBKR without first knowing its founder: Thomas Peterffy (currently serving as IBKR’s chairman). Mr. Peterffy is an immigrant from 1965’s socialist Hungary. When he arrived at the US, he first worked as an architectural draftsman, but eventually learned to code, and purchased a seat in the AMEX where he traded options. To this end, Mr. Peterffy developed his first proprietary handheld computers for the trading floor. His constant focus on cutting edge technology helped him stand out as an options trader and a broker. Over time, his AMEX operation evolved into the IBKR we know of today.
Source: Interactive Brokers’ 2018 10-K.
If you look at Mr. Peterffy's track record, it's easy to conclude that he's an entrepreneur by heart. After all, migrating from one's home country to the US without even knowing the language is a testament of this. Moreover, he once aired a commercial (self-funded) where he touted the benefits of liberty, individualism, fairness, and capitalism. In such an ad, he warned against policies that could stifle entrepreneurs.
Why does this backstory matter? Well, it gives us an insight into Mr. Peterffy’s character, which in turn helps us better understand IBKR’s core foundation. I think it's fair to say that he believes in capitalism, transparency, fairness, and hard work. In my view, these values are reflected in IBKR’s focus on delivering low-cost fees and commissions to its customers, while also providing them with one of the best trading platforms available.
Interactive Brokers’ competitive advantage
Over the years, IBKR has focused on maintaining its technological edge over its competitors on order execution, while also making sure that they offer the best value at the lowest price. This echoes Mr. Peterffy’s days in the AMEX, where he focused on developing proprietary technology to increase the efficiency of his brokerage.
Naturally, Mr. Peterffy could have decided to profit from the cost efficiencies derived from better clearing and execution, but instead opted to lower the transaction costs of IBKR's clients. This was a bold move, but it allowed IBKR to cement its base on retail investors, which are mostly drawn to IBKR due to its lower commissions. As a result, IBKR initially competed purely on cost. However, over time, IBKR also improved its trading platform and order execution. Currently, IBKR is often mentioned among the best brokers in terms of order execution, mainly due to its SMART routing and IBALGO algorithms. These tools give IBKR's clients access to the best prices available on the markets, but also rebates. So when you put it all together, IBKR’s value proposition is today among the best (if not the best).
Source: Interactive Brokers’ 2018 10-K.
What about “free” brokerages?
It’s crucial to mention that the latest trend in brokerages is commission free trading. In theory, this would put IBKR at a disadvantage versus those competitors. However, in reality, this would ignore the costs of trading on one of those “free” brokerages (like Robinhood, for example) compared to IBKR. The main difference is that Robinhood makes its money by selling its clients' order flow to High-Frequency Traders (HFTs). HTFs pay for this because they can execute those orders at beneficial prices for themselves, but at the expense of the clients’ interests. In other words, even though clients don't pay commissions, HFTs raise clients’ transaction costs through unfavorable execution prices.
Image: Robinhood app.
Naturally, this fee structure might appeal to the uninformed and unsophisticated retail investor. However, once people wise up to such hidden costs, then it becomes clear that in reality, IBKR’s low fees and commissions are vastly preferable. This is something that Mr. Peterffy is betting on. In fact, he thought that Robinhood’s business model was unsustainable because it was a clearly inferior product. But in any case, Mr. Peterffy also acknowledges that IBKR’s client base is much more sophisticated and realizes that they are getting a better deal with IBKR.
In my view, this essentially validates IBKR’s competitive advantage. After all, it seems that sophisticated investors (those who take investing seriously, and not as a hobby) prefer IBKR's value proposition over "free" alternatives. Moreover, I think that over the long term, IBKR will be able to build upon its inherent advantages and consistently create shareholder value.
Great business with a lot of potential
IBKR produces about $1.8 billion in yearly revenues, which is very little compared to TD Ameritrade’s (AMTD) revenues of roughly $5.35 billion. To me, this shows that IBKR still has a long runway for future growth. However, more importantly, IBKR's revenues have much better margins. For example, IBKR's net margin for 2018 was 59.52%, while AMTD's margins were 27.52% for the same period. This proves that IBKR's revenues are much more profitable, and further growth should quickly translate into much higher profits.
Source: Interactive Brokers’ 2018 10-K. The electronic brokerage segment includes commissions and trading gains.
Furthermore, IBKR has clear intentions of international expansion, which is something that its other peers seem to be neglecting (For example, AMTD and E-trade (ETFC) focus on the US). However, on the other hand, IBKR is available in almost 210 countries. This dynamic allows IBKR to differentiate on cost, technology, and also availability.
Finally, I think that IBKR’s valuation is very compelling at these levels. My model suggests that IBKR offers an excellent required rate of return under conservative inputs of future growth. This gives investors a comfortable margin of safety in case IBKR grows any faster. In the model below, I’ve used the company’s ROIC of 15.61% as the discount rate, which I believe is a very conservative assumption.
As you can see, IBKR appears to be fairly valued if we use very conservative inputs. However, if we employ more reasonable/optimistic inputs, then IBKR’s valuation can go as high as $148.69 per share. In my view, the company’s fair value is likely somewhere in between. But the key takeaway is that the stock is trading at a reasonable price, and its valuation leaves ample room for upside surprises.
It’s also worth mentioning that IBKR has a high ROIC and strong FCF. After all, its electronic brokerage business requires minimal capital expenditures and produces substantial CFOs. In my view, this is typically a trait of a wonderful business. Also, IBKR’s low P/FCF multiple is exceedingly compelling at these levels. Plus, the company has no long-term debt whatsoever, which makes it a remarkably robust financial entity.
As much as I like the stock, it's worth keeping in mind that it's not without its risks. The following are the most important, in my opinion.
- IBKR depends on trading volume. If volume decreases (due to lower volatility, for example), then its revenues would suffer as a result.
- IBKR, like most of its peers, is exposed to systemic risks. If counterparties default due to being over-levered, it could have a catastrophic effect on IBKR itself. However, the company is in sound financial condition and often goes the extra mile beyond regulatory compliance.
- In my view, one of IBKR's principal assets is its founder. As of recently, Mr. Peterffy has decided to step down from the CEO position. However, he’ll continue to serve as IBKR’s chairman. It remains to be seen whether or not IBKR will be able to sustain its growth after it loses its visionary founder in the future.
- Financial services are becoming increasingly commoditized. For now, IBKR has been able to distinguish itself from the rest of the pack due to its unique value proposition (price, technology, and availability). However, disruption could potentially harm IBKR.
- Other typical risks of financial firms like security, increasing regulations, sufficient redundant infrastructure in case of disasters, proprietary information, to name a few.
In my view, Interactive Brokers is a unique type of broker. It has a technological competitive advantage and grows its client base by offering the best value. I believe that going forward this will continue to be a successful business model that will reward shareholders over the long term.
Furthermore, IBRK appears to trade at a reasonable valuation. Even after discounting its future cash flows under conservative-to-reasonable assumptions, it looks undervalued. In my view, stocks like IBKR should actually trade at a premium due to its strong business prospects. Not to mention that the current price tag gives investors a good enough margin of safety. Thus, I believe that IBKR is what Warren Buffett would call a “wonderful business, at a fair price.”
Thank you for reading, and good luck.
Disclosure: I am/we are long IBKR. 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.
Additional disclosure: The video is meant as a supplement to the article. I'm still experimenting with the format, as I'd like to deliver financial content to my readers in the best way possible. Feedback would be welcome.