Which Brokerage Is The Best Investment?

Marshall is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Editor's Note: The previous version referred to Fidelity National Informational Services as Fidelity Brokerage. They are not the same, this version has been corrected. 

E*TRADE Financial (NASDAQ: ETFC)took a big hit last week when its largest shareholder, billionaire Ken Griffin, announced it would be selling off its entire stake of the brokerage company. Is it still worth your investment, or do other online brokerage stocks make better bets?

Sold short 

Griffin had initially set up a team in 2011 to look into strategic alternatives for the brokerage company, but investors now fear that E*TRADE may not be acquired anytime soon. 

The big pressure for E*TRADE has been its poor management of the low interest rate environment, seeing its net interest spread dwindle. The brokerage now expects its net interest spread to decline another 10 basis points in 2013 and 15 basis points in 2014, along with a number of other risks.

With that in mind, let's review E*TRADE's major competitors, to see whether any of them have a more 

Which brokerage should you buy?

TD Ameritrade (NYSE: AMTD) might be the best bet in my opinion. It has a majority of its operations concentrated in the U.S., leaving a lot of room for international expansion. The company also has potential to increase its market share in the U.S.

However, a tough macroeconomic environment has pressured this stock as well. Trading volumes at the brokerage remained low, and the average client trades per day for the first quarter of 2013 decreased 9% year over year. However, the company has robust market share and a compelling valuation, making it a a top pick in the industry. 

Charles Schwab(NYSE: SCHW) is looking to strengthen its client-advisor relationships, but faces pressure on daily average revenue, as its retail customers place fewer trades.
 
For 2012, Schwab saw daily average revenue trades fall 7%. Schwab also has more exposure to fee-based revenues than other companies, generating some 40% of its revenues from this area. Its acquisition of optionsXpress will add to trading revenues, but not significantly boost overall revenue, since trading revenue is only 18% of Schwab's total top line.
 
Schwab's results are heavily dependent on short-term interest rates, given that 35% of its top line came from net interest income in 2012. That means earnings growth might remain weak, since the Fed plans to keep interest rates historically low through mid-2015.
 
Interactive Brokers Group (NASDAQ: IBKR) gets 50% of its revenue from market making activities, and 50% from electronic brokerage. Its market-making involves profiting from the difference between the buying and selling prices of securities. Yet competition usually forces the company to match the quotes of other market makers, leaving little room for large profits.
 
The brokerage has also seen pressure across the board of late. This includes its market making revenues being down 25% last quarter on a year over year basis, as well, electronic brokerage revenues fell 12%. Much like Schwab's issues with daily average revenue trades, Interactive Brokers saw a decline of 21% year over year for cleared and execution-only customers. 

The devil's in the details

From a valuation standpoint, E*TRADE is rather expensive, while notable competitor and better buy TD Ameritrade is in the midrange of the industry:
 
Price to earnings (forward earnings estimates)

<table> <tbody> <tr> <td>E*TRADE</td> <td>22 </td> </tr> <tr> <td>TD Ameritrade</td> <td>19 </td> </tr> <tr> <td>Interactive Brokers </td> <td>14</td> </tr> <tr> <td>Charles Schwab</td> <td> <p>24</p> </td> </tr> </tbody> </table>
 
TD Ameritrade should trade at a premium valuation based on a number of factors, including its earnings-generating capabilities and superior margins. E*TRADE has seen earnings decline some 59% annually over the last five years, while TD Ameritrade has managed to keep earnings relatively flat despite a poor economic backdrop: 

Earnings growth (historical 5-year average)

<table> <tbody> <tr> <td>E*TRADE</td> <td>-59%</td> </tr> <tr> <td>TD Ameritrade </td> <td>0%</td> </tr> <tr> <td>Interactive Brokers</td> <td>-6%</td> </tr> <tr> <td>Charles Schwab</td> <td>-6%</td> </tr> </tbody> </table>

Operating margin (historical 5-year average)

<table> <tbody> <tr> <td>E*TRADE</td> <td>11%</td> </tr> <tr> <td>TD Ameritrade</td> <td>41%</td> </tr> <tr> <td>Interactive Brokers</td> <td>63%</td> </tr> <tr> <td>Charles Schwab </td> <td>33%</td> </tr> </tbody> </table>

Don't be fooled

TD Ameritrade has managed to average an operating margin that's in excess of 40%, compared to E*TRADE's mere 11% (the lowest in the industry). I believe that TD Ameritrade is best positioned to capitalize on the rising trend in do-it-yourself investors.


Marshall Hargrave has no position in any stocks mentioned. The Motley Fool recommends Interactive Brokers and TD Ameritrade. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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