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Interactive Brokers: Margin Masters - [Business Breakdowns_ EP_216]
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[Music]
This is Business
Breakdowns. Business Breakdowns is a
series of conversations with investors
and operators diving deep into a single
business. For each business, we explore
its history, its business model, its
competitive advantages, and what makes
it tick.
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forformational purposes only and should
not be relied upon as a basis for
investment decisions.
I'm Zach Fuss and today we are breaking
down Interactive Brokers, widely
recognized as
IBKR. Founded in 1978, Interactive
Brokers evolved from a market maker on
the American Stock Exchange to a global
cuttingedge electronic brokerage firm.
Its founder, Thomas Pedrey, remains far
and away its largest shareholder and has
earned his place as one of the
wealthiest people in the world. Pedifrey
came to the US from Hungary as an
immigrant who spoke no English and
taught himself computer programming in
the 70s. Eventually, he pioneered
automated trading and played a crucial
role in the digitization of financial
markets. Today, we'll explore the
journey of IBKR from its early days as
Timber Hill to its current status as a
publicly traded company with a market
cap of nearly $80 billion. We'll dig
into how Interactive Brokers makes money
beyond just commissions, including their
net interest income and other market
making activities. And we'll explore
their reputation for offering lowcost
access to a vast variety of global
markets and sophisticated trading tools,
which has made them a favorite amongst
traders and institutional investors.
Additionally, we'll discuss their
differentiated tech stack, their global
reach, and again, their famously low
fees. We'll explore their competitive
landscape, the risks they face, and what
the future may hold for this brokerage
giant. To break down IBKR, I am joined
by Freddy Le and Yakobo Dinardo of
Latitude Investment. We hope you enjoy
this breakdown of
IBKR. So today we got a two for one
special. We're joined again for the
third time by Freddy Le and his partner
Ayakapo to discuss interactive brokers
which has been quietly covered business
despite the fact that its growth has
been so pronounced and it's integral in
kind of the way that we interact with
the markets today and its growing
presence. I think Freddy Yakapo just to
set the stage about the brokerage
business, discount brokerages and the
broader landscape. Maybe we kick it off
there and then we can dive deeper into
this particular business and why it's so
special. Yeah, sure. No, it's great to
be back on the show. Thanks for having
us. Interactive is a really interesting
business. It's one we've owned for about
18 months, but been following for a
number of years. It's a digital broker,
so you can trade stocks and bonds and
currencies and options, pretty much
anything you like through it. And it
started out 50 years ago as a by far and
a way the most technologically led
business in the space. And there's lots
of history we can get into. But what
they've done through investing in
technology and investing in automation
and a couple of other strategic
advantages is develop by far and away
the lowest cost model, the lowest cost
to serve with the highest quality
output. And this is what's driving the
flywheel effect. They're making the
highest profitability at the lowest
costs, driving huge growth in their
customer base. And that compounding is
coming without advertising, without
marketing. And individual investors are
increasingly choosing interactive over
all of their competitors. But what's
most exciting in this business model in
the last 5 or 10 years has been the
doubling up of that compounding effect
through the growth in other channels. So
they're growing from other brokers
introducing business. They're growing
from hedge funds. They're growing
through RAAS or what we call IFAS in the
UK. And they're really growing
internationally. They're a truly global
business with a huge market potential.
and a lot of exciting things to talk
about today. I guess a nice place to
start when talking about brokerage
businesses. Just take us through the key
revenue streams and how these businesses
fundamentally make money. It's
relatively simple. There's a lot of
complexity when you really dig into it,
but at a headline level, they make money
in two ways. They make money through
charging commissions on trading, and
they make margin through net interest
margin. So, a spread on cash held on
account or margin loans that they make.
And it's reasonably straightforward to
model this through. They have three and
a half million accounts. The average
account does about 200 trades per year
and the average commission is about $3.
When you times that through, you get to
the sort of roughly $600 per account in
trading commissions per year or around
$2 billion a year. On the net interest
margin, they pay very good rates on
cash. It's a real strategic advantage.
They own quite a narrow spread on their
funding, but effectively their sort of
securities lending and margin business,
which is about 11% of client assets, is
financed with customer deposits. And the
spread between what they pay on those
two equates to a net interest margin of
about $800 per account or about $3
billion. And those are relatively stable
per account numbers. And so the real
driver for this business over time has
been and will be account growth. And
when we started looking at the business,
it had around a million accounts. It's
got around three and a half million now
5 years later and they have various
different targets to get to 10 20 or
maybe 80 million accounts as time goes
by. And so then when I consider
Interactive Brokers and the broader
landscape, you've got Charles Schwab,
Fidelity, obviously Robin Hood, what are
the key differentiating factors about
this particular business as opposed to
its peer set? When you look at
interactive, it was born out of a person
who is first and foremost an engineer
and a technologist. And that type of
culture has reverberated throughout the
firm day one. So when you look at
interactive, it's by far the most
automated of all brokers. So when you go
on to the app, most of the functions
you'll hit on it, including actually
eliminating accounts because they
exceeded the margin loan is done
automatically by a bot. This doesn't
tend to be the case for the competitors.
And this has also morphed the broker
into being really one that is liked and
used first and foremost by experienced
traders. The first days uh the business
was really only used by individuals and
what today we call prop traders. These
are individuals with account balances
that tend to vary between let's say
200,000 up to a couple million dollars
per account of client equity. And this
compares broadly speaking quite
favorably versus other online
brokerages. So you'd think someone like
Robin Hood or E Toro would have account
balances averaging maybe 5 to 10,000. So
it would be the first brokerage you go
to when you learn about trading. And
places like Schwab would have higher
account balances, but they would be used
in a much less frenetic way. As Freddy
mentioned, you make about 200 trades a
year per account on an interactive and
that number might be tens of times even
lower if you're using your Fidelity or
Schwab account which tend to be used for
slightly different purposes. So
obviously 401ks being one of those in
the US. So I think it's impossible to
really appreciate how
differentiated IBKR Interactive Brokers
is without spending some time discussing
its founder. Thomas Pedy came here with
effectively nothing I believe in the
1960s and is now one of the wealthiest
and relatively unknown Americans. Can
you just tell a little bit about his
story, how this business came to be, how
it's evolved over time, and then how
much of the business and how involved
Thomas is today? As you said, he was
born in Hungary during basically the
periods of war in Europe and he migrated
with nothing to the US pursuing the
classic American dream. And the business
started out actually as a market making
business for options when Thomas bought
a seat on the Chicago Merkantile or
Board of Option Exchange. And initially
his broad idea was that of pioneering a
way of pricing options. It was at the
time when the formulas were coming out
from black and shores and when option
trading was nothing compared to today
and the company was called Timber Hill
and it was really an option market
maker. But if you think about that, the
way Thomas approached the business was
completely different in the sense that
he wanted to automatize everything that
could be automatized. And this still
permeates the culture of a business
today. Interactive doesn't want to be in
businesses that eventually cannot be
automatized in the future. On top of it,
if you think about the role of the
option maker, risk management is at the
center of everything you have to do. So
you're taking obviously both sides of a
trade most of the times and you're just
creating a market for participants. So
up to these days obviously risk
management is one of the most important
point that differentiates interactive
compared to other brokerages. There's
couple of examples, but the only time
they really actually lost some money in
a significant way, which is not
significant compared to the total amount
of equity they have, was when the Swiss
central bank let the Swiss Frank
appreciate freely and the company lost
about 1% of their capital at the time.
And recent examples include when
interest rates were zero in 2021 and a
lot of other online brokers decided that
it was the time to take some duration
risk to make some more money on net
interest income the company refrained
from doing that. So I think when one
thinks about the two vectors on why this
business is so well managed and managed
to succeed but I think his starts as
someone who is fundamentally an engineer
and focused on risk management are two
very important aspects of the business
and it's worth saying that he's also
very hard-nosed and smart businessman.
So whenever he saw that the option
market making business due to changes in
regulation and the market environment
after the great financial crisis was not
a business that would earn excess roe
anymore he decided actually to close
that down to focus entirely on the
online brokerage and so when you
consider the business of online
brokerage there was a pretty big
evolution I'd say over the course of the
last decade primarily focused on payment
for order flow or poff and so what you
went from is a world where commissions
were 510 $25 per trade to a competitive
landscape where many of their peers
offered zero commissions and so I'm
curious despite that IBKR while still
being a business that charges
commissions has seen its growth explode
what is going on what is the debate
around PIFO which I believe is actually
not even a legal business proposition
outside of the US how do you think about
that backdrop as it relates to
Interactive Brokers ability to continue
to take share. We think this is one of
their key competitive advantages that
since day one they've always chosen to
have direct market access. So imagine
like a kind of Costco model. They're
cutting out the wholesaler. They don't
have someone else. They don't have to go
to a broker. And so when they have
linked their system up to every exchange
in the world, give or take directly. And
so they execute directly at the best
price on your behalf. Whereas payment
for order flow, which is pretty much
just a US phenomenon, these businesses
who buy that order flow clearly make a
large amount of profit. And so that has
to come out of someone's wallet and
implicitly that has to come out of the
customer's execution price. And so you
can listen to the CEO Thomas Pepy
talking quite viciferously about this
practice and other banking practices
that have yet to be regulated, but it's
something that they've always avoided.
And it does save them a huge amount and
allow them to move much faster than a
lot of competitors as well. So, it's no
higher cost. They don't get the payment
for order flow into their revenues like
some other businesses do, but they don't
need it because they can prove best
execution. They still have lower
commissions across the marketplace. They
charge far less than others in most
cases. And their other draws are their
much cheaper margin loans and their much
more generous payment for cash on
deposit. They basically pay 50 basis
points less the local base rate on any
cash deposits over a certain threshold.
So they're seen correctly as giving back
everything they can to customers with a
small margin and then it's just that's
their principal competitive advantage.
The second as Yakapo's already touched
on is the automation of the trading
itself of the risk management and of the
management of the business and all the
opex which means that their cost base is
just so much thinner than the others. So
they're able to continuously reinvest in
price. I think one of the things that's
interesting is if you look at the
headcount of IBKR relative to its peers,
it obviously speaks to their interest in
making sure that everything is tech
enabled. I will say amongst some
investors who use the platform, they do
complain about the lack of customer
service at times, but it's what allows
them to offer such incredible lowcost
execution. And then the other aspects of
it being really your ability to use
leverage at a very low cost of capital.
Can we just talk about how they use
their balance sheet in a way that
provides such a structural cost
advantage relative to their peer set?
Fundamentally, there's a couple of
points here to be made. The first one is
a bit like Jamie Diamond at JP Morgan
talks about having a fortress balance
sheet in financials is of paramount
importance to succeed over time. It
allows to obviously survive crisises if
they happen. Interactive has a similar
approach. If you look at the balance
sheet today at the end of 2025, there's
probably going to be about $18 billion
of excess capital, which is about 95% of
the total capital they have. That allows
them obviously to grow the business in a
fairly serene way without necessarily
participating in the ups and downs of
the market. And the second point being
when offering lowcost margin loans, it
stems partly from that and partly from
again going back to the automation
point. The big risk when offering margin
loans is that eventually those accounts
will need to be basically closed because
with a market draw down the fall in
value is superior to that of a margin
loan. And there's plenty of examples
around the latest one actually coming
from Archigos where even at investment
banks which one would think are fairly
well invested in technology still
require quite a lot of human involvement
and personal calls in order to make that
decisions. That never happens at
interactive because everything is
automatized and the account if it
doesn't post the required collateral
within a very short period of time is
automatically liquidated and eliminated.
And if you think about that dynamic,
that is exactly what allows interactive
two things. One is to underpric
competition in terms of cost for the
margin loan. It's about half the cost of
Fidelity or Schwab or whoever else
competes in the US. And it also allows
them to offer slightly more leverage
than competition without really
affecting the total risk if you're able
to cancel that account or to close down
that account fairly quickly and you're
also able to mitigate the risk of loss
from that account in a better way than
competitors. That allows again to foster
that competitive advantage coming from
lower cost and obviously higher
automation.
And so I think it would be helpful to
illustrate how this manifests by
demonstrating what an account looks like
and how a customer uses the business.
For example, let's say you have someone
that's a professional trader that has a
million-doll account and maybe is
running at$2 or $3 million of gross long
and short. They're obviously borrowing
and lending securities. What does it
look like? And then how does that
translate into the different revenue
line items? So the commission revenue,
the net interest income, the fees and
services that they provide just to
really drive home how people interact
with this business and its ability to be
differentiated on every service that it
provides to its key customers. The
difficulty here is that one does need to
disagregate a little bit. We've been
discussing this as an online broker,
which makes it feel very much like it's
aimed entirely at individuals logging
onto a website or an app. The truth is
more than 50% of the business and a
large portion of the growth in the
business although individuals are still
growing very nicely is the other three
main cohorts which are white labeling
the platform and service for raas
advisers around the world prop traders
and hedge funds. They're now the fifth
largest prime broker in the world. So
they're larger than many of the big
banks you could name from a standing
start about 10 years ago. They're
growing far faster than the market for
prime because they are seen as more
attractive to the hedge fund groups in
general. And then the final one which is
just worth touching on is what they call
introducing brokers. And you can think
about this as another bank or another
brokerage business who is outsourcing
and cancelling their own internal
technology investments. As an example,
they just brought on HSBC globally and
then they're going to plug in the
underlying trading capability of
Interactives. And I would think about
this in the same way that a lot of
people have become comfortable with
outsourcing admin or custody to JP
Morgan or these large custody banks like
Northern Trust. A large number of these
huge global institutions as opposed to
investing in the technology are renting
it implicitly from interactive and that
is where a lot of the growth's coming
from. So what we see at an account level
is slightly averages of those things. We
can make some assumptions about where
the margin skews towards the hedge funds
and the prop traders and obviously away
from a lot of the RAIA business. But
what you see is an average account
balance that even when it was
individualled was much higher than most
other firms and very normal typical to
have 100 $150 $200,000 as the average
account balance. Against that there are
two other interesting assets which are
the margin loans which we've discussed
which used to be far higher actually and
have come down as a percentage of equity
over the last sort of 10 years but are
ticking up again at the moment in the
short term at about 10 to 12% of assets.
So, if you've got a $200,000 account,
you might have $20 of margin loans
against some securities in there on
leverage. What's also been very popular
with all of the brokerage platforms,
including Interactive, has been
securities lending. And again, as we've
probably become boring saying, this is
fully automated. So, you can sign in if
you want to. Your securities, your
stocks can be lent out to people who
wish to borrow them and to short them.
They're still fully tradable. They're
fully collateralized from our
perspective as shareholders by cash and
the client earns most of that lending
fee and again there's a small but very
honest spread which is all transparent.
So they have a similar amount of
securities lending about that sort of
for a $200,000 account about $20,000 of
lending so 10% of the base. So that's
the kind of average, but we do believe
it skews a lot. A lot of the introducing
business and a lot of the RAAS we think
are probably using less, probably
trading less as well under that sort of
200 trades per year. And then really the
majority of this stock lending, margin
loan, and even the turnover, the number
of trades or darts as they call them,
daily average revenue trades, if
anyone's reading the annual report after
this, that skews towards the hedge fund
business. So, it's a variety of
different clients all benefiting from
the same lowcost platform, but they're
using it in different ways. When you
look at this business's P&L, and I'm
looking at 2024 as a reference, you have
about $1.7 billion in commissions, which
results in around $2 billion of
non-interest related income. And then
the rest, $3 billion is that net
interest income, that NIM, resulting in
about $5 billion of revenue. How do you
think about how that should evolve over
time, the mix in quality as it relates
to the evolution of their customer base,
which you just mentioned? And then a
second question related to that, when
you see a business that's as significant
an earner on net interest margin, you
beg the question as it relates to
interest rates and how they impact the
business and what would happen in an
environment where rates were going down
versus going up. Just curious on those
two items really revenue mix and nim as
the business evolves over time. There's
quite a few ways to cut it. This is
clearly a cyclical business. It grows
very rapidly and account growth that had
been around 25% per year is inflecting
up towards 30 and 35% per year at the
moment as the flywheel gathers ahead of
steam. The most important thing that I
want to compel you to understand from
our perspective is that it's account
growths that matter. And if you need to
believe account growths are what matter
then one needs to believe the sort of
stability in the other things like the
amount of trading and the revenue per
account. And so when we've interrogated
the sort of the number of trades that's
been going on as the mix has changed and
the accounts have been growing the
trades per year have been falling and
again one would expect hedge funds are
trading many times a day but ra
introducing brokers in particular are
probably trading less than the 200
average trades per year. And so we
expect and we've observed over the last
5 or 10 years a kind of 5 to 10% decline
in trades per year. So if the growth is
similarly skewed between the different
cohorts over the next few years
obviously in periods of volatility one
trades more in periods of low volatility
one trades less but as a trend we put a
deflation if you like in the number of
trades per year and I think there's
probably a small amount of potential
deflation to come through from
commissions but the management team have
talked about flat average commission
levels from here and it really does
depend on mix again a crypto trade is a
very different commission level or an
option compared to trading Google
shares. The way it's worked is you have
that kind of average $500 $600 per
account of commission. It'll probably
trade a little bit lower, maybe 5% down
per year on an average basis and then be
cyclical with client equity. But if
account growth is 35% or anything along
those lines, that will dwarf any
reinvestment backing price. That's the
easier one is the commissions. And
obviously, you can take your own view on
average client equity and average equity
market performance over the long term.
When you factor those things in too,
they offset that reduction normally on
the NIM. And I think this is probably
one of the greatest misunderstandings in
the business and it was certainly what
gave us the opportunity to invest in it
18 months ago is the actual sensitivity.
If you think about the alternative, if
you think about a business like Schwab,
which only a couple of years ago almost
needed effectively a wholesale rights
issue because it had what was
effectively a run on its funding source
because they weren't paying anything on
their customers cash and customers when
interest rates went up started saying
we'd better go to a bank or we better go
to a money market fund and they robbed
Schwab of that source of cash and
funding. The arrangement between
Interactive Brokers and their customers
is just far more honest and it's very
transparent and it's as I said on any
large balance more than $10,000 which is
about 2/3 of their entire customer cash.
They just pay the local market base rate
less 50 basis points. That results in a
far lower risk firstly to the point
about Thomas Pepy's risk conservation.
Clients are probably not going to leave
because they get 50 bits more elsewhere
even if they could. But secondarily,
it's actually less interest rate
sensitive than you think because if
rates go down by 50 basis points, they
still just take 50 basis points on a
spread. And so they do disclose that
overall interest rate sensitivity. And
for a 100 basis point move down in
interest rates around the globe, and
again this is a global business,
probably 40% US. Yakapo is nodding at
me, but it's global in nature. If global
interest rates fell 100 basis points,
NIM would fall by 10%. And again, that's
NIM per account. So if you're growing
your accounts at 30 35% it will more
than offset a multiple of times that a
net interest sensitivity. So that's why
we focus so obsessively on the business
model and the potential for account
growth. From a NIM perspective, Zach,
what's also pretty interesting is
obviously margin loans tend to be higher
yielding products, maybe pay 100 basis
points more than what they get on cash
on the asset side. And these tend to be
cyclical but move in the opposite way of
interest rates. So for example, if
interest rates were to go back down to
levels that we observed in 2019 or 2020
or 2021, the amount of leverage that
investors are usually willing to take on
is slightly higher. So the margin loan
per account was materially higher back
then. And so in the mix as interest
rates fall, we would also expect margin
loans to pick back up. helping a little
bit with a nimfall. If you go back in
time, 2019, 2020 were pretty difficult
years for whoever was exposed to rising
interest rates and the company was still
making maybe 30 basis points less than
today net interest income. They have
proven themselves in a way through cycle
to be able to earn a fairly attractive
spread on assets and liabilities. And so
you guys had mentioned the international
opportunity here and where some of the
growth is coming from. Obviously we've
seen through the co backdrop
participation in capital markets and
investing exploding perhaps the advent
of Robin Hood as an on-ramp for that but
also just the financialization of
western economies. What are the growth
opportunities for this business? And I
asked that in the context of on their
earnings calls, they're very often asked
if there's any M&A opportunities. And
because they operate at such low costs
and they provide such attractive margin
loans to customers, the pro-former
earnings of acquisitions make the math
very difficult for them. And so I guess
weighing organic versus acquisitive
growth where they're going to see their
business continue to expand. interested
you picked up on that comment too
because it's one we've discussed in the
past which is this idea that if we buy a
business but then we take it to our
spreads and our offering the underlying
revenue and profits would collapse in
that business. So they're not able to
pay what the owner thinks they can pay
because if they give back to customers
as much as they give back in their main
business it would be a very different
profit level. And so that to us is
incredibly telling. They are open to
acquisitions. They have done them in the
past but there's nothing out there which
would make sense. And so they're going
to grow organically. They have one of
the lowest advertising budgets of all of
the online brokers and despite that have
outgrown anyone we look at. They're
growing organically. They're growing
because their rates are just better than
everybody else's. And if you are trading
any meaningful amount of capital, I'm
not here to sell it, but I'm sure some
people listening to this will be trading
their own shares. And it's worth a look
because it's a meaningful saving to go
to a business like this. And I think at
the moment what they're getting asked
more about is this sort of potential for
growth in the more B2B channels that
we've discussed the RAAS the hedge funds
and the introducing brokers. But
notwithstanding that individual accounts
are growing very rapidly too. So the mix
isn't changing very quickly. And when we
think about growth potential I mentioned
earlier a few different sort of big
hairy audacious sort of goals for the
management team. Schwab have I think 25
million accounts principally in the US.
I think Fidelity is something around
that level. They are smaller on average.
So there's a tale of those accounts
which would be less profitable for this
business but 3 12 or 4 million accounts
that we have today is still a fraction
of that domestically. And they talk
about 20 million globally as a sort of
first stop in their growth story. And
then at a sort of later stage they talk
about this 80 million number because in
a couple of countries where they operate
they are already at sort of 1% of the
population. And that would be that sort
of level of penetration. And the key
thing to that potential is people will
still continue to trade a lot. Whatever
happens with markets becoming more
digital and outsourcing within the B2B
channel will probably continue for the
next 5, 10 and 20 years. Big question is
can someone compete with this? Can
someone come away to stop them
organically growing share? And given the
counterpositioning and that first
comment about acquisitions and the
competitors to reinvest to try to build
the direct market access and to invest
in prices and costs and automation like
this business has, everyone's folding
and using this business instead of
trying to compete with it. to your
comment of more participation into
financial markets by all sorts of
individuals especially after COVID. We
believe that to be a pretty good
tailwind, too, because as we said at the
beginning, someone who is inexperienced
and might have a smaller account
balance, he might start a Robin Hood
account or E Toro or whatever else he
can get his hands off depending on the
jurisdiction. But after a certain period
of time, after becoming more accustomed
to trading and honestly after having
increased his own disposable income, we
do believe the proposition of joining
interactive, especially as an active
trader is so much better than anything
that's around there that we do see a lot
of these customers eventually dropping
to interactive over time as soon as the
account balances reach $100,000 or
$200,000. And if I can just add one more
thing, you mentioned earlier some people
are upset with the customer service. We
see a lot of analogies between this
business and other lowcost businesses
that we look at. One would be sort of
Ryionaire. And I think it's really
compelling to see that business, another
business we like where Michael said, "I
didn't realize looking after customers
would make me so much profit." And he
started making the customer experience
more pleasant. I think they're doing
that at Interactive, too. They've had
this obsessive focus on costs and
automation for 50 years, including in
their prime brokerage business, but
they've just rolled out what they call
the sort of white glove service, which
is a very manual, independent director
looking after your account as a hedge
fund. And I expect a bit more of that
over time, coming back into the business
on the customer service, too, which
slightly opens up their market. One
final thing they're doing as well is
really relaunching their app, which will
come in and help that customer
acquisition that Yakapo said of those
who are out there learning the ropes in
apps like E Toro and Robin Hood, but may
want to grow up into interactive later.
And so we touched upon it in relation to
M&A, but clearly a business that's
generating as much excess free cash flow
as this one, capital allocation becomes
increasingly important. What is their
demonstrated strategy as it relates to
redeploying the cash that they're
generating on an ongoing basis if M&A is
not available to them? This is a very
important question especially as the
business will eventually mature and in
fact at the moment the only capital
return we are receiving is a dividend
yield that's usually targeted to be
about.5 to 1% of the total market
capitalization. And there's a couple of
things though to keep in mind. And I
think the company wants to keep a
balance sheet that's as strong as it can
be mostly to develop the prime brokerage
and hedge funds business. And one of the
reasons being that the companies they do
compete against BMOs like Goldman,
Morgan Stanley, UBS and Bank of America
are materially larger financial
institutions. So to win over customers
and hedge funds that manage 1 to5
billion of assets, they do need
potentially stronger balance sheet than
what we actually could imagine
ourselves. The second point comes
actually with a company structure. It is
a publicly listed company but still
today insiders own roughly 80% of the
stock of which most of it 75% is still
Thomas but the CEO and CFOs or have a
significant stake in the business and
therefore launching extremely big
special dividends or share a purchase
programs is not necessarily doable until
the float of a business is increased. So
we like many other external investors we
are looking at the topic. We do believe
over time as Thomas as he rightly says
he's not immortal and he's approaching
or above 80 years of age. We will see
how that evolves. But it is something
that we do like to an extent because if
you think about ways of maturing as a
business the final phase when growth
slows down and is not what it used to be
20 years ago. any business has a choice
to make which can be growing again
through M&A whenever it is possible or
returning excess cash to shareholders
and we are not even close to there as
Freddy has discussed there's a potential
over time to probably 20x the number of
customers on the platform but once that
is done having excess capital to return
to shareholders as the structure has
probably changed by then is an option
that as investors we do like to have
there's other businesses that are in
that situation I Berkshire Haway being
an enormous one which is in a similar
position with an incredible amount of
cash and treasuries sitting on the
balance sheet. And so when you're
evaluating financial businesses, there's
always a debate about how to properly
value them. And without asking you guys
to appine upon the valuation itself,
what do you think are the most important
metrics here in it being return on
equity, price to book, PE? How do you go
about valuing a business like this? It's
really a combination of everything
you've mentioned. I think to an extent
today the RO of a business we can look
at it in two ways. One is obviously
including the excess capital and one is
excluding it. One thing you realize
quite quickly is actually how capital
light it is compared to normal
financials especially when you back out
the excess capital. So it might make 15
to 20% ROE including the 19 billions of
excess capital but it might make 10 15
times as much excluding that earnings is
and price to earnings normalized
earnings are also another way we look at
it. So sticking in our own assumptions
obviously of accounts growth and trades
per account and commissions and then
looking at what a normalized and average
net interest income could be given the
prevailing rates of interest around the
world. But as you say it is not one of
the simplest businesses to value on
either of two metrics. So we do focus
really on both and see how both interact
with each other. At the same time, we do
not feel yet confident enough to assume
a significant capital return of the
excess capital. So, we let it build in
our model with our mind going 5, 10, 15,
20 years from now, what will that
capital eventually earn. But so far, I
think they've proven to be fairly good
stewards of it. One other way to think
about it is to invert it. Given the
competitive advantages, given the
demonstrable success across these
verticals which are all very nent, given
the arguments we've made around the sort
of the limited reduction in revenue per
account either from NIM sensitivity
which will bob around or from the
commissions and trading per account.
You're making roughly $1,500 an account
in revenues at the moment. What's the
probability they can get to 10 or they
can get to 20 thus making 15 or 30
billion dollar in revenues and they make
a 75% operating margin. I think they
make 75% net margin. It'll probably be
around there. It could go up a little
higher, but that's with their generous
offering back. You're talking about a
very profitable, rapidly growing
business. And the question one really
needs to ask is who's going to stop that
happening? Is there a competitor in the
marketplace that will stop that? If not,
how fast or how slow will it happen is
the bigger question. And something
Thomas has said is we can grow at 30%
with no advertising. We can probably
grow at 40 50% if we do more targeted
advertising, but they're not looking to
do that right now. But I do think they
could accelerate the account growth if
they wanted to cuz there's a lever they
haven't pulled yet. Obviously, much of
what has been said about this business
has been overwhelmingly positive. But
when you're dealing with a business that
interacts with leverage, margin, long
and short side of the investment
industry, there's inherent risks. I
would love to hear about how you guys
assess those risks and maybe some of the
stress tests the business has faced.
Even as recent as a few weeks ago, we
saw the broader market sell off 10, 15,
20% and what that meant for their
business. I think would show kind of the
resilience and durability of the model
that they have here. Yeah, I think one
of the key things to remember if anyone
else goes away from this and analyzes
the business is that this was a market
making business in a large part as well
in the past. So it's very different to
2009 and 2014 was the day where they
really exited most of that business. So
this is now a middleman a broker in a
far more than the sort of asset risk. So
the risk as you say slightly lies in
that margin loan piece and their ability
to risk manage and collateralize against
those loans because obviously when they
make these loans or they do the
securities lending they take and hold
collateral and something Yakapo
mentioned earlier these accounts are
stopped out automatically now as if and
whenever they get too close to that
margin limit and so it's all an
automated process they claim to have
very good risk management systems but
I've never met a financial business that
doesn't claim to have good risk
management systems so your question
again is right How have they fared
through the last decade of quite a lot
of stress tests I'd argue whether COVID
or big draw downs in 2022 in the very
popular stocks or the recent hit their
largest loss was really from a very
strange sort of move in the Swiss Frank
10 or 12 years ago maybe even 14 years
ago where they lost about 1% of their
equity capital today so a very bearable
amount for a business that is multiple
times over capitalized and through the
recent turmoil of the last 3 to four or
5 years it's dimminimous the risks from
margin, the losses, the bad account
balances, it's not been an issue for the
business. So the risk management system
exposed has clearly been working. If you
think about how financials businesses
run into trouble is some sort of
liquidity mismatch that exists between
assets and liabilities. And I think in
that in new investors to the company
should take quite a bit of comfort that
most of the assets are really 30 days in
duration. Now some of that is a function
of how the yield curve has been looking
for the past four or five years which is
flat to inverted. So there was no point
in taking interest rate risk and
duration risk the capital of a business.
But in general I think the company has
always taken a prudent approach to risk
management. I think that again stems
from probably Thomas's beginning as a
market making risk manager. And if you
think about the mother of all stress
tests, which was the great financial
crisis, when the business still owned a
market making business, one of the
leading market making business in
options, the company decided quite early
on in 2007 to stop making prices to
customers in longdated options, which
eventually ended up being part of a
market that not a lot of people talk
about today that was entirely in liquid
and where losses just piled up. So I
think analyzing the liquidity of a
balance sheet and in general risk
management choices is where one can get
comfortable that downside risks are
fairly well managed in terms of
long-term risks. Freddy mentioned a
little bit about competitive landscape
and how it might evolve. I would add one
to it which is as you mentioned before
Zach there has been a huge increase in
participation in financial markets. Some
of it is very healthy. New generations
are learning earlier how to invest and
some of it is more akin to really
gambling. And if you think about that
and the ramification it might have in
terms of regulations in the future or if
losses actually pile up for retail
investors, this is an area that is worth
bearing in mind. You might have noticed
that in the past 18 months, they've been
talking a little bit more about their
new product called Forecast X, which
basically allows, it's almost like a
sports betting platform on economic
events that allows customers to really
express an opinion that is a yes or no
on individual outcomes. It might be
about inflation, about payrolls. And the
simple fact that the CFTC initially
didn't allow those products to go out
because they were too akin to sports
betting tells you that there is a
component in financial markets today
that goes through online brokerages.
That is more similar to gambling rather
than what we would normally consider
investing. And so a correlary to that
last question is one that we always
conclude with lessons learned when you
guys evaluate this business that can be
applied to others and from an
operational perspective the way that
management runs this business that you
think can be applied to other businesses
to help drive better shareholder
returns. When we're looking at what
gives our businesses a competitive and
strategic advantage over their industry
and that will endure for the long term.
One of the really best ones, and we've
only got a handful of these that have
this competitive advantage, is this
lowcost, high service model, and service
in this case means better access to
markets, quicker trading, neater
valuations. Not yet. Someone on the end
of the phone, but we'll wait and see on
that. But so this low cost to serve,
highquality product, it's brilliant
because it's so hard to compete with.
This is one of the best examples that we
have found. And obviously others being
things like Ryionaire, Costco and a few
other businesses on our lists. And I
think it leads to 10, 20, 30 years of
potential advantage which will come
through in this case through account
growth. And so that's been the primary
one. And I think when you've dug back as
long as you can in the history, and
there's quite a bit written about this
business over the last 48 years, this
obsession with technology, automation,
and costs has been there from day one.
And so that's a softer point, but it's
around the culture of a business. It
doesn't have to be founderled, but it's
often founderled, but it's certainly got
to be someone with skin in the game, and
it's got to be someone who's
intrinsically demands that of a
business. I don't think it's something
that you can come through with an MBA
and just say, "Oh, I'm going to go for a
lowcost model." I think it's got to be
something that's really in you. And I
think the final thing that this business
helped teach us is just how cheap very
high-quality cyclical businesses can
become because people misunderstand or
fear cyclicality in what is otherwise a
very strong growth business. This was
trading on 12 or 13 times earnings,
delivered earnings only 18 months ago.
It's a little more expensive now, but
it's still inexpensive. The way we look
at these things, which is with all
cyclicals, you'll always get a good
chance. You can find the great cyclical.
You might have to wait three or five
years, but you'll always get a great
chance. And the great ones are worth
waiting for. Well, Freddy Yako, I
appreciate you guys coming on so much to
discuss IBKR. Around 50 years ago,
Thomas Pedy came here with effectively
nothing and has built what is today, I
believe, a $75 billion plus business of
which he owns the vast majority of. It's
a really interesting story from both a
business history, but also business
performance perspective. I really
appreciate you guys coming on to help
tell it. Great speak to you. To find
more episodes of breakdowns ranging from
Costco to Visa to Madna or to sign up
for our weekly summary, check out join
colossus.com. That's join nsus.com.
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