The notorious bank robber Willie Sutton said he robbed banks “because that’s where the money is.”
His words came to mind while I was thinking about which companies might benefit from rising interest rates. Certainly, banks have large cash balances, and for that reason, along with others — many of which were laid out recently by my colleague David Sterman — those institutions could be among the prime beneficiaries of soon-to-come higher interest rates.
I realized there are other pockets of hidden cash, less obvious than banks, that might benefit as much or more than banks when it comes to profiting from rising interest rates.
What other businesses have been sitting on huge sums of cash they can’t spend? Which companies have been forced to earn next to nothing in the form of interest — but should see a significant boost in their income streams as rates rise?
Two came to mind. The first category you probably do business with often — broker-dealers. They clear customer transactions, carry customer accounts and hold customers’ cash and securities.
The second below-the-radar group: payroll processors. These companies handle all paperwork, taxes and withholdings on paychecks, among other services. They hold the funds until the checks clear or are deposited in employees’ accounts.
In addition to fees for services, brokerages and payroll processors both earn interest on the float from client funds. Typically, these funds are invested to maximize interest income and minimize volatility, which means the majority of funds are invested in Treasurys and other government securities with a maximum maturity of 10 years. Most use a laddering strategy to extend the maturities of the investment portfolio and employ short-term financing to handle short-term funding requirements. This allows the companies to average their way through an interest rate cycle and reduce fluctuations in yield.
Laddering exposes the companies to interest rate risk as proceeds from maturing securities are reinvested. While higher yields translate directly to higher income, higher rates increase interest costs on short-term debt.
Overall, both industry sectors are cyclical — and both depend upon a healthy, improving economy to keep growing. If you believe a recovery in the U.S. is indeed underway and will continue for several years, then both these industry sectors should do well — brokerages as do-it-yourselfers join the ranks of investors, and payroll companies as companies start adding new jobs.
In addition to huge piles of cash, there needs to be a few other things to recommend a company. So I consider price-to-earnings (P/E) ratios, dividend yield and a few other metrics to compare among peers in search of bargains.
In looking at brokerages, it’s my opinion that Interactive Brokers Group, Inc. (NASDAQ:IBKR) is significantly undervalued compared to its peers, TD Ameritrade Holding Corp. (NYSE:AMTD), E TRADE Financial Corporation (NASDAQ:ETFC) and Charles Schwab Corp (NYSE:SCHW). Its share value is on the lower end of this range, although it was comparable a year ago. In addition, its P/E is low, and it has one of the lowest debt-to-equity ratios but the highest operating margin and dividend yield.
Interactive Brokers Group, Inc. (NASDAQ:IBKR)’s brokerage segment recently scored a record-breaking quarter with $123 million in pre-tax profit, a 37% increase from a year ago. The company’s pre-tax profit margin climbed to a new high of 58%, but this performance may have been obscured by the lackluster performance of Interactive’s market-making unit, which earned only $7.6 million.
Interactive Brokers Group, Inc. (NASDAQ:IBKR) has a unique growth strategy as it focuses on savvy active traders and investors. It is doing well in that respect, as its average monthly account growth for the first six months of this year is 2,400, outpacing last year’s monthly average of 1,700. No less an authority than Barron’s has rated Interactive at the top of its field two years in a row.
In contrast to the splashy world of online brokerages, payroll processing can be an overlooked industry. But with the labor market improving, companies need to process more employee data and paychecks than before.