Forget Interactive Brokers, Charles Schwab Is a Better Growth Stock

Hayden Capital recently released its Q1 2020 Investor Letter, a copy of which you can download below. The fund posted a return of 4.10% for the quarter, outperforming their benchmark, the S&P 500 Index which returned -20.00% in the same quarter. You should check out Hayden Capital’s top 5 stock picks which helped them beat the market by nearly 24 percentage points. There weren’t a lot of funds who could deliver these kinds of returns without shorting the market or using aggressive put options.

In the said letter, Hayden Capital highlighted a few stocks and Interactive Brokers Group Inc. (NASDAQ:IBKR) is one of them. Interactive Brokers operates as an investment holding company. Year-to-date, IBKR stock lost 15.6% and on May 11th it had a closing price of $40.23. Its market cap is of $16.38 billion. Here is what Hayden Capital said:

“Interactive Brokers (IBKR): We sold Interactive Brokers this quarter. I originally made the investment, based upon the thesis of continued impressive account growth (it had been adding new accounts at a highteens CAGR), and were encouraged by signs that the company was addressing long-held friction points around the platform’s usability. Additionally, these efforts seemed to accelerate the adoption by sophisticated hedge funds, who are larger accounts and use more margin (and thus accrue higher revenues), and new features were launched to entice retail investors as well.

The thesis was largely correct, as the number of accounts had doubled at Interactive Brokers during our ownership period, from ~360K accounts to ~720K (a 100% increase). However, in the last year, Interactive has faced several industry-wide headwinds that hindered some of these positive developments.

Interactive Brokers makes ~60% of its gross profits from “net interest income”. This is the spread between what Interactive makes on client cash balances, margin loans, borrowed securities, and the rate they pay their customers on these assets.

As this segment is dependent upon global benchmark interest rates (the benchmark depends upon the currency denomination of the assets), it has come under pressure from global interest rates that have only gone down over the last few years. For example, net interest margins have declined 15% from a peak of ~1.7% a year ago, to most recently ~1.45%. This means even as accounts have grown, Interactive will make a less money per account, going forward.

Industry-wide commissions have also been under pressure, as many retail-focused competitors started offering $0 trading commissions last fall. Interactive was one of the original low-price leaders, and was also one of the first to initiate the $0 commission price war via its new IBKR Lite platform, once it was clear the industry would inevitably move in this direction.

On the margins, this move was more defensive than offensive. Given that Interactive Broker’s competitive advantage has historically been in its low-pricing (back when the value proposition was ~$1 – 2 per trade, vs. competitors at $5 – 7), this industry shift will have some negative impact (although not as much, as if Interactive didn’t take any action). So far this price war hasn’t had a big impact on existing customers, since only 2.6% of Interactive customers have converted to a Lite account7 .

Now that all the major players have a free option, I suspect the incremental new retail accounts who may have chosen Interactive before, will gravitate towards the likes of Fidelity and Charles Schwab, who offer better customer support and a friendlier user interface8 . Individual customers make up 52% of Interactive’s accounts and 36% of client equity. These clients likely don’t require all the sophisticated features and worldwide trading that Interactive provides, so the primary attraction for this customer segment has been eroded.

I still think Interactive Brokers will do just fine going forward, and our sale is by no means a signal that I’ve lost confidence in the product 9 . Rather, I just think the market has gotten incrementally more competitive for the individual customers segment, who might not find as much value in the plethora of features Interactive offers, or needs to trade futures on obscure commodities. Additionally, it’s hard to make a call on the direction of interest rates, which Interactive depends so heavily on for the bulk of its earnings.

Interactive Brokers will likely continue to grow more valuable over the years. However the rate of this value creation will likely be lower than our other opportunities, so I took the occasion to deploy the proceeds elsewhere. We sold the shares at an average price of ~$51.

We had originally purchased the shares in mid-2016, at an initial price of ~$35, which implies an IRR of ~10% on our investment in a little under 4 years.”

As you can see Hayden Capital believes that going forward retail customers will shift from Interactive Brokers to Schwab Charles Corp (NYSE:SCHW). In Q4 2019, the number of bullish hedge fund positions on IBKR stock increased by about 16% from the previous quarter (see the chart here).

Disclosure: None. This article is originally published at Insider Monkey.