Why we Won’t be Getting Broker with this Stock
Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
I’m willing to bet that the last thing that you consider when making an investment is the price you need to pay your broker to get the deal done. If you’re like me, you probably don’t even want to think about what you pay them each year. It is just a cost of taking control of your financial future.
Other than shopping around for the best deal, there is a way that average investors can take even more control over their financial future. If you can't beat them, then buy them! That’s exactly what I’m recommending today to those who are following my virtual “No Drip, No Mess” Portfolio. In this case we’re going after one of the best small online brokers, Interactive Brokers (NASDAQ: IBKR).
Why Interactive Brokers?
I like IB over their slew of competitors for two reasons -- they target higher-volume traders over long-term investors and they have something most of their peers don’t, a market-making business. In addition to these key differentiators, they have a rock solid balance sheet and generate more than enough cash to pay a very respectable 3% dividend. While I think that they have a couple of short-term issues to overcome, long term I think they’ll make investors much richer, not broker.
The allure of making a quick buck has led many investors to cash out of a trade for a quick profit. I can certainly remember more than one company that’s risen in value many multiples of my last sale price. Still, this allure for fast money, momentum trading and technical analysis is not going to go away no matter how many trades get away from us. By offering ultra-low commissions IB gives these traders a platform, and they make their money on volume instead of margins.
While I think we all understand how IB makes money on the commission side of things, it’s the market-making business that might leave some of us scratching our heads. When I go to the store a buy soda, I hand over my cash to the clerk and go on my merry way. When I log into my broker to buy a stock, behind the scenes a market-maker acts as an intermediary to make sure I can get my shares without having to find someone to sell them to me. The market maker will sell me their shares and then go find someone else that’s selling and collect a little bit on the spread between the price I bought and someone else sold. It is a very lucrative business but not without its risks -- just ask Knight Capital Group (NYSE: KCG). In the case of Knight it was a software bug that cost them an astounding $440 million after 45 minutes of trades gone wild.
I know what you’re thinking -- we’re combining a low-margin volume-based business on one side with a high-risk market-making business on the other and you want me to buy it? Isn’t that the same recipe for another Wall Street disaster? Didn’t you watch MF Global or Lehman Brothers collapse?
Well, in the case of IB, it’s quite a bit different. Take their latest earnings call where CFO Paul Brody had this to say: “Turning to the balance sheet, it remains highly liquid with low leverage, we actively managed our excess liquidity and we maintained significant borrowing facilities through securities lending markets and with banks. As a general practice, we hold an amount of cash on hand that provides us with a buffer should we need immediately available funds for any reasons. We also continue to maintain over $2 billion in excess regulatory capital in our broker dealer companies around the world. Long-term debt-to-capitalization at March 31 was 0.6%, which was down from 2.1% at year-end 2011 due to the gradual slinging down of our senior notes program. We expected debt to be entirely retired by June 2012. Our consolidated equity capital at March 31, 2012 was $4.82 billion.” Not exactly an over-leveraged situation that has taken down so many firms.
Still, I’m sure you’re wondering why I didn’t go with one of the more well-known discount online brokers such as E*TRADE Financial (NASDAQ: ETFC) or TD Ameritrade (NYSE: AMTD), or a more diversified financial like of Capital One (NYSE: COF), which recently purchased ING Direct and their subsidiary ShareBuilder. I like the growth potential of Interactive Brokers as they begin to attract more retail customers who are attracted to their ultra-low commissions, especially on options trades, as well as their wider availability of shares to short. Retail investors are becoming more sophisticated and more concerned with volatility. IB’s platform gives more options to the average investor.
Not only does IB have a lot of room to grow as they attract more savvy investors, they’re also not going make you cry by starting a mortgage business like E*Trade, nor will their lower end credit card unit savagely beat down your investment like Capital One’s credit card portfolio has the potential to do. While their market-making business is a risk, and it lost money last quarter, over the long term I see them continuing to grow customer accounts just as they did last quarter to the tune of 16%.
For the portfolio we’ll be writing two December $13 puts to start and this will give us an initial allocation of 2.6%. At around current prices we should be able to get about a 4% yield on our cash used to hold open the trade. If we’re successful in nabbing these shares we’ll most likely look to write two more $12 puts to fill out a full 5% allocation. From there we’ll combine those puts with some written calls forming a covered strangle to increase our income, which we’ll use to combine with our dividend eventual capital appreciation for some nice gains over the long term.
Do puts, calls and strangles all sound like foreign language to you? Would you like to become a savvier investor like those flocking to Interactive Brokers? Make sure you check out Motley Fool’s Options Whiz, which is free this month.
latimerburned has no positions in the stocks mentioned above but is a customer of Interactive Brokers. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Interactive Brokers and TD AMERITRADE Holding. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.