Chit Chat Stocks - Can Interactive Brokers Thrive With High Interest Rates? A Deep Dive with Luis V. Sanchez (Ticker: IBKR)

Episode Date: January 12, 2023

Interactive Brokers operates as an automated electronic broker worldwide. The company serves institutional and individual customers through approximately 150 electronic exchanges. Listen as Brett and Ryan ask questions about the company, its business model, and valuation. Enjoy the show! ***************************** This episode is sponsored by Stratosphere.io, a web-based terminal for financial data, KPIs, and more. Try it out for FREE or use code “CCM” for 15% off any paid plan. Sign up here: https://www.stratosphere.io/ ***************************** Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney  Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Interested to see more of Luis's work? Check out their Twitter here: https://twitter.com/LuisVSanchez777?s=20&t=zeqXC9VqTUE5El6YtUUE9g Contact us: [e-mail] Timestamps Interactive Brokers | (2:28) What is "Net Interest Margin"? | (25:03) 0% Interest Rates are Done | (46:54) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. My name is Ryan Henderson, and I'm joined by my co-host, Brett Schaefer. Today is our Thursday deep dive episode where we interview an analyst to discuss a single stock. And today we have on Luis Sanchez to talk about interactive brokers. Luis is the manager at LVS Advisory, and he's an investor that we personally admire and try to emulate in a lot of ways. He's been on the show multiple times. I think you'll see from today's episode just how thorough his research is on the companies he owns. But before we get to that, today's episode is presented by Stratosphere. Stratosphere is the best web-based research terminal for company-specific metrics like KPIs and segment revenues.

Stratosphere has clean data for KPIs, segment data that is triple-checked for accuracy and beautiful data visualizations, helping you save time and the frustration of digging through SEC filings. We use Stratosphere for our own home screen. We used it today to research interactive brokers in preparation for this episode. you can use it too for free by going to stratosphere.io. That is stratosphere.io, and the link is in our show notes. If you're more interested in Stratosphere, stick around after the episode. We did a three-minute interview with the Stratosphere founder, Brayden Dennis. It's worth sticking around just to check out. But without further

ado, here's our interview with Luis Sanchez. Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or recommendation. Now, please enjoy this episode. okay today we are joined by i want to say four-time guests now is the third okay uh third time guest louis sanchez uh if you're a regular listener you are probably familiar with louise's

work um if not he is the managing partner at lvs advisory we're going to link to the website in the show notes and there's plenty of good reading there he just released his q4 letter if you want to get a better glimpse at his overall portfolio and everything that he does. But today, we are talking about interactive brokers, which is probably a business that a lot of people are familiar with on the customer side, but maybe haven't looked at it as an investment. So why don't we just start with the basics? How does IBKR make money and what's enabled them to achieve operating margins that are almost 50% or higher in some years? Yeah. Well, first, Ryan and Brett, thanks for having me again. It was fun to do these.

And yeah, I guess I'll start with the elevator pitch. And perhaps I should also offer a disclaimer, which is that I am long IVKR. So just as a disclosure and that, you know, obviously I'm not providing investment advice here. I'm just giving my opinions on what I think, but everyone should obviously do their own research and consult a financial advisor. With that out the way i i do like interactive brokerage quite a bit as a as a stock and as a long-term holding um i actually purchased it in this past year 2022 over the summer when the the shares were quite depressed along with the rest of the market although that being said it's funny that i purchased it last year for the first time because i've been a customer for over 10 years

and i never really thought about buying the stock until recently and i guess i'll get into why what yeah what was sort of the genesis for that what what inspired you to go all right you know what i've been using this for 10 years and never thought about it maybe i'll take a look at it yeah well at the at the at the core of what i'm looking for are high quality businesses with long-term reinvestment opportunities that are available at attractive valuations and i think you know if you can combine those three basic building blocks and you're right about those three basic building blocks it tends to make good investment opportunities and on top of that you know i really really like

to find situation when where there's a lot of insider ownership and and i have a high opinion of the insiders which i i do in this case right um i guess why i never why i was never really that interested in ibk before is because i don't i've never really thought of myself as like a financial specialist um and i always kind of perceived ib as more of a specialist stock because it can be a little bit complicated when you want to look under the hood of, okay, well, how does like a net interest margin work and like what are the mechanics of that?

And there's obviously complex regulatory, there's a complex regulatory environment in the banking space and in the brokerage space. And also, I guess I just never really looked at the financials. I never really understood or I never realized how fast the company is growing in terms of the customer base, how profitable it is, and it actually doesn't screen very well.

And I can get into that too, but if you just look at it like a Bloomberg terminal or a Capital IQ over like a 10 or 15 year time period of financials, it doesn't screen well. And that's actually very misleading because the company has significantly transformed its business model since about 2007 2008 to today so it actually does take a little bit of work it took me a little bit of work to get comfortable with it and to understand it and to understand the drivers and to be able to model it but once i did i just kind of realizing oh okay this actually is a very durable business with a lot of nice competitive advantages and good unit economics that i think has a really long runway um and you know it has a very interesting catalyst too so part of what

got me interested in 2022 is um first of all the stock was was down a lot right historically this has also been on the more expensive side it historically has always traded for like 25 30 times plus i think it's traded as high as 40 times eps in the past but last summer it got as cheap as 12 times it got, you know, which is where I think I started buying it when it was 12 times EPS stock. So I think part of it was like, oh, okay, the valuation here is actually really cheap, which is interesting. The second thing was, if you think about why the valuation was so cheap, a big part of it is just that, well, this is kind of correlated to the market cycle. so um i think like if you think about who makes up the customer base for a company like ibqr which

uh i don't want to get too far ahead but it's an electronic brokerage so they have a really diverse customer base but a lot of their customers are are retail investors like individual traders are the largest constituent and retail trading activity is somewhat cyclical right When stocks are going to the moon, like we had in 2021, trading activity was crazy. And we had GameStop and Mania, you know, we had Memestop Mania, we had the COVID traders in 2020. So the trading activity was really hot. And part of the reason why this was cheap is because basically they were comping the

really crazy trading activity of 2020 2021 a lot of people viewed ibkr as a code beneficiary to a degree um but uh and and when stocks are down people just don't trade as much right and you know if you look at the financial model here um when interest rates are low about two-thirds of the earnings power is trading commissions however what what i kind of observed is that okay interest rates are not low and i looked at the financials over the past you know 10 15 years and you know we did have similar level of interest rates 2006 2007. we did have rising interest rates in 2019 or 2018 2019 so you could actually see what happens when interest rates are rising when they're elevated and the dynamic switches so now in 2023 interest

income net interest income is actually going to be two-thirds of earnings or it's actually going to be a majority but we'll see how high it goes but it will be a majority of earnings and what What got me excited in 2022 is like, OK, training activity, obviously training activity is going to be down, but they're going to more than offset that by the amount of money they're going to make with higher interest rates. and then this really interesting dynamic basically the why now pitch is okay it's kind of a heads

I win tails I don't lose because if interest rates stay high IBKR just prints money but if interest rates start to fall or just stop rising well that's going to support trading activity because then stocks are probably going to have valuation support

if interest rates actually start to decline uh you should expect stocks to probably start to increase or start to appreciate again and then you have this kind of changing dynamic where you know they're they're two they're two lines of business are somewhat counter-cyclical to each other but we could actually be in a sweet spot where interest rates kind of stay elevated um but trading activity actually remains robust and that's you that's really skipping ahead but that's kind of what really piqued my interest in 2022 when i started looking at it um and now like maybe just going back to the elevator pitch like why ibkr

like why do i like this business well i like this business because it has a really clear competitive advantage as a electronic broker because it is the lowest cost provider in the industry it's the it not only has the lowest expenses uh relative to all its competitors but it also passes along the the lower expenses to its customers so it charges much lower commissions but it's not just about commissions it's also about charging lower interest rates for like margin loans it offers the most attractive interest rates for cash deposits so that's all part of i guess the cost of ownership or the benefit of being an account holder and i think that's a really powerful dynamic um it's also it's also a very fast growing business in terms

of the number of accounts so today it has about two million accounts and that it actually has 10 exits accounts over the last 10 years and at two million accounts it's still it's still at a very small fraction. I mean, it has less than 10% of the account base of its larger competitors like Schwab and Robin. So I actually think there's a credible path to 5x-ing or 10x-ing its account base over the next 10 years. And there's a lot of reasons why I'm happy to get into that, why I think that's going to happen, or at least it'll move in that direction. And as I mentioned, it benefits from higher interest rates. So I view that as a pretty nice catalyst for earnings. And it benefits

from higher interest rates for a few reasons. But primarily the reason it benefits from a high interest rate is because IVKR holds all of its liquidity and all the liquidity of its customers and T-bills. Right. So what does that mean? That means that they have very, very low duration and they immediately benefit from higher rates in a way that none of their competitors benefit from higher rates. If you start to look at the duration of a company like Schwab or a bank like Merrill, they have a much longer duration,

which actually gives IBQR a really, really interesting competitive advantage in this landscape. And then the last thing that I'll just say is that it's attractively priced. So on consensus earnings for 2023, I just checked this morning, it's about 14 times EPS. So it's a discount to the broader market. On my own estimates, I believe that my numbers are a bit, I believe there could actually be higher earnings than the street has. I think it could be as cheap as 10 times this year's EPS. And that's more like a bull case. and yeah it's a it's a it's run it's really really well it's a really well run company

the founders still control business the the ceo is really good and also has a lot of skin in the game and yeah and i i basically think if you put it all together it's a it's an attractively priced well-run company that has a long-term potential to continue to compound. Well, let's talk a little bit about the mechanics there. Because as you kind of mentioned, it does take some work and there's a lot of moving parts, I think, when you first look at it. So for listeners that don't know, and you briefly mentioned it there, what are the big revenue drivers?

So like mechanically, um, you, you mentioned that they take the customer's liquidity invested in T-bills. That's, that's one avenue. Then obviously there's commission trades. Why is like, why is the, why do they get to invest in shorter duration assets than other exchanges? Right. Um, well, okay.

So the, the business model is it's an electronic brokerage. So it doesn't have physical locations. It's all online. And there's basically three types of customers or three types of ways they make money or three different business models within it. So the flagship is what's called IBKR Pro, and that is they charge a $1 per trade commission and they offer really competitive rates on interest earned and margin rates. So I believe roughly 95% of their account base is on the IBKR Pro plan. okay um they have this other product which they launched i believe in 2019 called ibk light ibk light is a zero uh commission model where it's it's basically they made it after robin hood kind of gained traction um and effectively if you're a customer

of ibecare light you don't pay for you don't pay for trades that you make in like u.s listed stocks but you may still pay commissions for like foreign stocks or like some more obscure stuff or like derivatives um but in order to compensate for not charging the commission ibecare does receive some payment for order flow but they also charge uh more aggressive they don't offer as attractive margin rates or interest rates on them. So a lot of the difference between like an IBKR Pro plan and an IBKR Lite plan is that IBKR Lite is more monetized with like the net interest margin. And then the last thing I'll mention is something called introducing brokers.

So what this is, in addition to having its own direct customers that IBKR manages accounts for. IBKR has opened up its platform for third-party brokers to build on top of the IBKR platform and manage their own front end. So for example, if you and I wanted to start a new brokerage company and all we wanted to do was handle the marketing and customer service, we can get onto the IBKR introducing broker platform. They'll handle all the backend first. They'll handle the regulatory aspects. They'll handle the trading, the clearing. They can even handle the customer service.

We don't want to do that. And the way they monetize that is the same way they monetize everything else. They charge the same IBKR Pro rates to the introducing brokers. But because IBKR Pro is so much cheaper than the other options in the market, An introducing broker, like a third-party broker, can build on top the IBKR Pro platform, mark up the commissions, mark up the interest rates, and they're still cost-competitive. So that's how much cheaper IB is relative to the competitors. And those are the three big drivers. And really, the biggest driver is the IBKR Pro.

But the introducing broker platform does represent about 20% of accounts today. And it is an interesting way that IBTR or that Interactive Brokers is growing, especially in international markets. So how does IB make money? I mean, they basically make money from two ways. It's charging trading commissions and the net interest margin. Maybe I'll start with the trading commission, which I think is a really interesting topic in this industry. So the industry has definitely evolved over the past 10 years or so

with the zero commission trading model being present. So basically, the entire industry went from charging high commissions. So if you remember in like, well, I'm old enough to remember Scott Trade. in like the early 2000s charging like $7 per trade and that being considered a bargain, right? So there's just been this really long arc of like fee pressure on the commission side. That being said,

IB has always had a $1 commission. It's never really changed. It's always offered basically the cheapest commission that it could and it stuck there and it's never had to adjust it lower. it's never increased uh that commission but it's it's just kind of continued to as as companies continue to scale and um add technology you know it's it's levered it's it's lower commission rate

to drive uh there's a lot of fixed expenses in this in this business model so it's levered that that consistent commission rate to drive much higher um pre-tax margins over time they have in the past charged other fees so i'd be used to charge some like minor service fees here and there for various things if you needed to set up a special type of account or if you needed to make a certain type of trade so maybe the commission rates might vary a little vary a little bit depending on which market or or um exactly what you're trying to do with your account But if you look at, I've done this analysis, and over time, they've pretty much eliminated all the other fees. So a few years ago, they used to charge some minor service fees here and there.

Today, they don't charge any of those. So they actually have driven more value to the customer over time. um so and i guess i should talk about the value prop like what is the ivcar value prop um the the first the first value prop is obviously what we mentioned it's it's cheaper to trade and and you earn more on your cash deposits you pay a significantly lower interest rate on margin You also pay lower rates on derivatives trading and other types of trading, which customers clearly value, right? But in addition to being cheaper, I'd also argue it's better.

So what I mean by that is they have more asset classes to trade. So you can trade FX, you can trade commodities, you can trade OTC, over-the-counter stocks. you can trade in over 90 countries now that's actually crazy because at Robinhood you could only trade well last I checked Robinhood you could only trade U.S. stocks at Schwab who is pretty much their largest competitor and Schwab bills itself as you know an electronic low-cost broker that's trying to kind of fit some aspects of the same customer segments. Schwab is only letting you trade in about 27 countries. So IBKR has 3x the number of countries covered in Schwab.

IBKR lets you trade in 30 currencies. You can only trade in 7 currencies at Schwab. I don't think you can trade a lot of the more esoteric. Well, I know for a fact that you can't trade a lot of the OTC stocks at Schwab because I use Schwab professionally as well. Effectively, what IBQR is, it's an institutional grade trading platform that is offered to the masses.

And it's even more than that because a lot of institutional trading platforms that are offered by large banks like Goldman Sachs and Bank of America, they don't have, in a lot of cases, they don't have the same coverage as IB. So there's a lot of things that you can trade on IB that you can't trade even at Goldman Sachs. So there's a lot of professional hedge funds and professional traders actually prefer IB for various reasons.

IBKR also provides a lot of really great tools that are value add. So they have all these cool trading algorithms out of the box. So if you want to run like a VWAP algorithm or some other kind of more sophisticated algorithm, you could do that with IB. You're not going to be able to do that with most other kind of retail trading platforms. They have an institutional grade API. So if you want to stand up an algorithmic trading, like a fully systematic trading solution, you could do that with IBQR. You can't really do that with a lot of other funds. I've spoken to quant funds who really like institutional quant funds who use IVPR's API

and they say it's much better than APIs that are offered by some of their other front brokers so IVPR has a very very powerful platform so it's not only cheaper but I would say it's also better right um I'll stop there but I can maybe talk about some other things I think are really cool about the platform too. No, I think that covers a lot of it. I guess just the only other spot where I think listeners would maybe not understand would be on the net interest margin.

Could you maybe go into that a little bit more and just talk about why? Because you mentioned that they are able to invest the customer liquidity in short duration assets, which is unique. What kind of allows them to do that versus- Or is it just a choice? It's just a choice.

Yeah. Oh, okay. And it's just a basic spread like at a bank, right? Yeah, exactly. So, right. So what is a net interest margin? Net interest margin is effectively, it's the classic business model of most financial institutions. You charge a higher interest rate than you're paying on your liabilities, right?

your customers are paying you a higher rate like your customers pay you five and then you pay your creditors too right so then you can lock in a three percent net interest margin right that that's as simple as that so um this is kind of this is where it gets kind of interesting because i think here doesn't really have too many pure play competitors if you really look at the landscape it's changed a lot over the years there's been a lot of consolidation so i would i would have argued that td ameritrade would have been the best comparable company to ibkr but td was actually acquired by schwab schwab isn't actually schwab is probably the best comp to ibkr today but there are some key differences namely that schwab is also a bank so schwab has

a lot of, first of all, it has a different regulatory status, but it also has a loan portfolio, right? Because Schraub is making loans to businesses. They take banking deposits. They have a very different capital structure if you look at it. So there actually are pretty good reasons why IBKR's balance sheet and net interest margin profile differs from who would view as its competitors and then obviously if you're looking at like a merrill lynch um or um you know whatever these other like an e-trade which is owned by morgan stanley um they're they're they're within larger uh financial institutions that do have more complicated balance sheets. IBKR, yes, it's a choice, but it's also maybe a structural

advantage. IBKR has zero corporate debt, so they have no liabilities. They have full flexibility on how much risk they want to take with their cash. It just so happens that the company itself is very very conservative they don't want to take credit risk you know they'll say this they'll say this often on conference cups they don't want to take credit risk they don't want to take duration risk and i understand it you know i understand why they don't want to take um corporate credit risk like that's definitely a choice but the reason why they don't want to take duration restoration risk meaning that instead of holding a three-month uh t-bill you know you could you could own a 10-year or a 30-year bond that theoretically should pay you a higher rate

of interest, but then when the interest rate structure changes, you're not going to be able to adjust to that as quickly. So why does IVPR choose to hold short-duration T-bills? So that they can more quickly adjust the amount of interest they can pay to their clients. faster so you know kind of skipping ahead of it but i think a reason why i think one of the reasons why ibkr is uh going to take market share in the cycle is because in a high inflation environment um the end customer cares a lot more about how much interest they're earning on their accounts and you know if you look at the interest rates that ib is uh lend is offering on its cash

Cash is competitive with high interest banks like Ally and Marcus. It's right there, toe to toe. So you can argue that just putting your cash in IB and not even trading is already a win if you're a retail depositor. So I think that there's a practical reason why they do that, because they always want to have the best rates. And I think if rates start to fall, they could make the decision to extend duration, although I think they'd really like to have the flexibility to control pricing, right?

So maybe to take a counter example, Schwab has a longer duration. If you look at Schwab's portfolio, they own some mortgage-backed securities. They give them a higher yield, right? So Schwab's portfolio is earning them a higher yield. It's earning them like 5%, 6%, 7%. But if rates, now that we're in a higher rate cycle, you know those same things that Schwab is investing in they could actually be earning a higher yield if they bought them today right so Schwab has less flexibility and if you actually

look at the rate that IB is giving out and compare it to Schwab it's much more attractive it's because structurally IBPR has more flexibility to offer more attractive rate than Schwab which has to kind of more slowly more gradually adjust to the changing rate environment because if you look at the net interest margin equation, it's two parts. One part of Schwab's equation is more locked in, so it takes longer for them to adjust to the change in the market. All right. That's a great overview of the pitch and how the business works, but there's going to be some smaller things we want to hit

that I think listeners might be interested in. One unique thing about IBKR is, and I don't have the exact numbers in front of me, but the founder, and I think I'm pronouncing this right, Pederfy, is it Pederfy? You might know who he is. Pederfy. He owns the majority of the shares outstanding right now.

I guess the question I have is what enabled this to happen? Did he already have a lot of wealth before starting IBKR? And is there any relevant history to him and the company that you didn't already hit on that listeners should understand for this business? Yeah, absolutely. I'll set the context. Thomas Pederphy, the founder, he's currently the chairman. He's a Hungarian immigrant. He came to the US in the 70s. His background is he was a computer programmer. So he has an engineering education, which very much actually is reflected on the culture of IB and how the company operates.

I think in the 70s, he bought a seat on an exchange, and he just became a really successful trader in his own right. In the 80s, he set up the predecessor company to IBKR, which was effectively an electronic market maker. So, you know, using his ability, his sophisticated ability to trade, and then combining that with his ability to program, he created one of the first, you know, electronic market makers in the 80s. And he, I believe his firm was the largest electronic market maker of derivatives in the U.S. in the 80s and early 90s. And then eventually, and he basically built a technology infrastructure around that. And he realized in the early 90s that there was a lot of synergies between market making and offering electronic brokerage. He saw the opportunity in brokerage, and I believe they launched, IBTR launched its brokerage operation in the early 90s, around 93 or 94,

and it was really small, right? So, and they rebranded the company, I believe, to Traffic Brokers when they launched that electronic brokerage company. So when he launched the company, he owned 100% of it, right? And because he was already wealthy and the market making, was effectively making a ton of money for the company, he really didn't need to raise money for the business. So when he took the company public,

it was really about liquidity, right? So he IPO-ed a small piece of it. And he's effectively, he's just been, he's actually been selling just a little bit every year. And he's a very consistent seller. I think he even sells a little bit every day. It's just, to him, it's just, it's programmatic. he just sells a little bit every day. And so one of the reasons why the stock screens really weird

is because the share count has gone up a lot over time. And it's purely a function of the fact that Peter P has been selling his shares a little bit every year, right? So it's not because Ivy hasn't been issuing a bunch of stock. And actually, as the share count goes up, the percentage that's owned by the public also goes up so nothing it hasn't really been a bad thing for shareholders and actually it's been a good thing because it's provided more liquidity to the stock over time but he still owns about 75 percent of it and over time i mean he's in his 80s now over time that's going to continue to float lower he has a son who's on the board who will probably inherit um whatever shares pedrophy doesn't sell in the public market

but that's kind of that's kind of how um how we got here with with the public float dynamic and the corporate ownership i guess i do want to hit on one thing which is pretty important which is that legacy of being an electronic broker and you know pedrophy being an engineer the company has always maintained a really really heavy investment in technology and also because of its legacy as being a very sophisticated market maker, the company has a very, very sophisticated knowledge of the market structure of exchanges and how they work. And these are all things that have really driven

IBQR's low cost advantage over time because the company philosophically, they've always wanted to invest in technology before they just hire more people. They've always opted for automation as opposed to inefficiency and that's really just the culture of the company and the person that pedrophy hired to be his successor in 2019 milan galic worked with pedrophy in the 90s and also started off as a programmer um and if you look at you know if you want to be successful at ib

it seems like the culture is they promote the engineers they promote the product people and they're obsessed with technology and if you think about what interactive brokers is at the end of the day it is kind of an e-commerce company right because offering offering trading and connecting to exchanges all around the world is largely a technology problem right and it's a technology problem that you you know you set the rules you set the parameters based on regulatory rules. You set the parameters based on different exchanges. And it's a technology problem. And that's a very, very different founding story to its competitors. I mean, I think E-Trade aside, most of its competitors, if you look at one of the things that I found really, really fascinating

about IBKR is if you look at the revenue per employee at IB and you compare that to any of its competitors is off the charts. IB is just so much more efficient. And that's because of like its legacy and its founding story. Let's kind of talk through, I guess, the evolution since you become a shareholder. So you sent us your research note in September. At the time, I believe you had a cost basis, I think around like 58. Today, the stocks trades around 75. So, so far it's done well. What's kind of, how has the story evolved? What's changed since you wrote your thesis? And then what's kind of the state of the business today? Yeah. I mean, I established my position last summer and I quickly made it one of my largest

positions and i just due to my own portfolio construction rules and you know i don't really want to get too much into that but like i haven't really traded it much since i have a view i have a long-term view of the stock which is i think that over the long term it's going to compound and i have a short-term view of the stock which is that the fed hiking interest rates has been a net positive for EPS growth just because of the net interest margin dynamic. And I'd say my views haven't really changed that much since I bought it last summer. The stock has gone up a bit, so that's been nice. The valuation has gone up a little bit, but i think it's still very attractive which is i haven't i don't think i don't think this is the

time for me to be selling it yet um but um yeah i mean effectively so far every like it's and it's been a short time period i mean we're talking it's january 2023 i think i started buying ibkr maybe june of 2022 i mean it's been less than a year um and so far everything is as expected interest rates have gone up ivy has seen their their revenue from interest from interest income go up a lot um maybe the only thing that's been a little disappointing is that the markets have not really recovered. So if you think about what drives the business, part of what drives the business is the underlying clients, like how much equity they have. And IBKR reports this. So it's not just the number of accounts, but it's also how much invested in aggregate the

accounts have so as a result of a down market their client equity is also down right and why why does that matter it matters because well it matters for a few reasons but most mechanically as it relates to earnings power if you think about it the larger your equity base is the larger your ability to uh the larger the ability to offer like loans is like margin loans and other products so if i you know ibkr also reports its its margin loans outstanding which is obviously one of the uh drivers of its interest income and its margin loads are down i mean that shouldn't be surprisingly that shouldn't be surprising because interest rates are up but But in addition to interest rates being up, client equity is down.

So some people may have been forced to close out some of those loans. So and I think that's very well understood by the market. I think that's more or less been priced in, which is why the stock's cheap. I think the market pretty much understood that all things being equal, higher equity values uh correlate to to better uh earnings performance by ib but you know part of my thesis is that over the long run over the long run uh the equity markets will come back and that'll be supportive of earnings growth um i'd say i've been i'm so that's been something that's been a little disappointing is just that um the equity value of the underlying account holders

has actually been hit larger than I would have maybe initially modeled. Although it's not due to IBKR per se, it's just due to the more macroeconomic situation. The account growth has definitely slowed, right? So entering 2022, I believe their accounts are growing at like a 35% year-over-year rate. Exiting 2022, we got the numbers from December.

Their growth rate was about 25% year over year. So it's still very fast account growth, but it has decelerated quite a bit. And if we continue to have an equity market or I'd say financial markets that are not very conducive to investors, I would expect investor appetite to open accounts to not increase. I would probably expect continued deceleration of that. That being said, what I hope for this year and what we will have to wait and see is, okay, clients have already taken the hit in their equity in their equity value right so one of the reasons why i think this is a really good business model is that it's not just about opening new accounts it's about

existing clients adding to their existing accounts over time a lot of people have their 401ks or their roths or their iras or just their trading accounts at ib and most people add to their investments over time so i i really like i think about you know i think about a mental model here when i think about some of the financial financials that i own is that i really think that there's a lot of similarities between some of the financials i own and like software companies right and like a framework that is really common in software is like land and expand and like net revenue retention like what's your net revenue retention growth and if it's you know if it's over 100 that means your existing customers are spending more money and they're more than

offsetting uh churn right so over time in in a brokerage account and also in a bank account in general you know you should expect a positive net revenue retention rate so even if we have kind of a flat to maybe even slightly down market um my expectation is for the underlying customer equity to at the very least be stable and more optimistically to grow and to outpace the growth of uh you know market appreciation right which which i really liked um and there is another dynamic here and i'm kind of on it i'm kind of rambling but i think this is actually a really interesting uh phenomenon which is that if you look at um customer cash like in general like where do people hold their cash right a lot of people hold their cash just

sitting in bank accounts that earn zero percent right now that we have high inflation and high interest rates we've actually already started to see a shift of people just emptying out their zero interest rate bank bank accounts and piling into high interest savings account but also brokerage accounts so i think that there is a and i think this this will will continue to see this in 2023. But I think inflows into brokerage, I believe, and I think this is supported by data, that money is moving from traditional banks into online banks that offer better interest rates and brokerage accounts where they can park it in money market funds that are also yielding attractive rates. So that's actually one of the things that is supportive of, in my opinion,

the near-term earnings power and revenue growth? I forgot the initial question, but hopefully I answered it. No, it definitely covers it. Very comprehensive. One little follow-up I think I have for maybe why you're saying that the business is going to be in a much better place than it was, say, a decade before just earnings-wise, and obviously they're going to grow their account base. But it's one of the ideas here that we may be done, and this is obviously a very, very tough question to answer. We may be done with zero interest rates from the Fed for a while. And that even if equity market, or excuse me, interest rates don't stay at 4% or 5%, they're not going to go back down to 0%.

And if say they're at 2%, 3%, something like that, and the equity markets recover, you could actually be in a much better spot than when, say, there was zero interest rates, And we're in that bubble period where the business can earn that net interest margin and still get those better commissions and have the higher, I'll call it AUM, but just total the dollar amount they have under management. 100%. Okay. So I think this is something I talked about in my memo at length, and it might get a little bit complicated, but I'm going to try to explain it, how I think about this. So, there's a couple of ways to think about IBKR, if you're thinking about it, if you're trying to frame the business, right? Because I think one of the ways that I frame the business is you have a durable brokerage business that has long-term ability to grow its account base and grow its, basically, its commission earnings and all the earnings that are associated with an online brokerage. However, the stock is so cheap. At a low double-digit earnings multiple, the stock is so cheap that I would argue that you kind of have a free call option on interest rates being higher than people expect.

Because effectively, what the market is saying with the current earnings multiple attached to IB is the market basically assumes that rates are going to go back down to zero. And that, you know, if you kind of just, if you just, I guess maybe another way to think about this is if you adjust IB's earnings today for what its earnings would be in a zero interest rate environment, then IB's evaluation multiple would probably be closer to 20 times, right? If you basically just took away all the incremental interest income that they earned last year, or that they're expected to earn this year, you're going to get closer to like, you know, a high teams, you know, 20-ish type earnings multiple, which is probably a fair multiple for, you know, a business that is growing its account base at a double digit rate that is attractive, right? Right. So but then there's this question of, oh, OK, but that logically led me to think, OK, well, what if rates don't just go to zero or what if they go to zero? But it takes a couple of years to get to zero. Or what if they bottom at two percent or three percent? Well, then I would argue that the current frame, the current valuation framework that IB has, that the market has in IB is too cheap because it's not appropriately valuing, you know, the call option that you have on higher rates, right? So hopefully that makes sense.

Maybe I'll just more mechanically explain why I think that's interesting. So in a zero interest rate environment, the net interest margin that IBPR has generated has been about somewhere between one to one and a half percent, right? In a high interest rate environment, so in a 2007 or a 2019, well, in 2019, IBPR, we didn't have high interest rates. And IBKR's net interest margin went from like 1% to like 1.8%. So it definitely went up, right?

And I don't quite remember how high interest rates got in 2018. I think they got up to like the low 2% range. So we're already higher than we were in 2019. So, and the Fed is projecting, and I think interest rate expectations are that the Federal Reserve will set interest rates somewhere between 4% and 5% in 2023. and then they'll peak there and maybe they'll start to decline from there or maybe they'll just stay there. So I think there's a very reasonable path in my modeling. I believe that IB's net interest margin, which is already about what it was in 2019, it's already about

2%. I think you could see IBKR's net interest margin go to 2.5% to 3% at a high end. So the difference in EPS for IBKR between a 2.5% net interest margin and like a one and a half net interest margin is like two and a half dollars at EPS. So I think last year, IBKR only earned like $3 at EPS, right? So you're talking about more than 50%, you know, EPS growth, just on the difference in net interest margin. And of course, net interest income, it just 100% goes to the bottom, right? So now, if you start to think about the reverse of that, let's say we're at a 2.5% net interest rate margin, and market interest rates fall, let's say the Fed lowers them to 2%, because, you know, there's a scenario where inflation is still somewhat persistent,

but it's cool. And maybe the Fed, and maybe we start to get higher unemployment. So the Fed might turn some dials and lower interest rates a little bit to kind of like satisfy its dual mandate. If we have 2% interest rates, IBQR's net interest margin is not going back to one, right? It'll probably still be around 2%, right? So structurally, IBQR is going to be generating a higher margin and a higher return on equity at a 2% net interest margin than it was at a 1% net interest margin. And another really interesting thing about IBKR is if you actually look over time, because we've had a really long period of zero interest rates, IBKR has somehow managed to squeeze a little bit more juice out of NIM over time.

So if you look at the beginning of zero interest rates, the NIM that IBKR was generating was actually a little bit lower than the NIM IBKR was generating at the end of the zero interest rate period. And I believe there's a few reasons for that. I believe that IBKR has gotten a lot more sophisticated about securities lending. I believe that IBPR has found some efficiencies in the way that it manages its liabilities as well. There's a lot of things that it does on the tech side that can squeeze a little bit more juice out of the NIM. So I would even argue that if we go back to a zero interest rate environment, the floor on that interest margin will probably be higher than it was in like 2017 and 2018. So that's part of what leads me to believe that the market, which is relying on basically the market is putting, is laying, is overlaying a 2016, 2016, 2018 framework for IBKR today.

But I actually think laying that framework over IBKR today is actually undervaluing, structurally undervaluing the unit economics that I believe IBKR will generate in various scenarios of interest rates. But I guess at the core, and the reason why I'm bullish on IBQR is I believe that even at a zero interest rate, even if rates go back to zero, I think IBQR is pretty attractively priced. I believe you're basically getting the core brokerage franchise for fair value, maybe a slight discount to what it would be. Remember, IBQR used to trade for 25, 30 times EPS in 2017, 2018. And I believe you can currently get that even if you assume no value to incremental interest earnings at a high teens, low 20s, multiple. And it's still

growing very fast. But then I think you have a lot of upside to the extent that interest rates surprise to the upside. All right. We talked a lot about maybe the dynamics over the next year to. But I think you mentioned before that part of your thesis is the long-term growth in accounts and basically the long-term growth in the assets that are managed. Not managed. I used the term AUM, but I think listeners know what I mean. The assets that are at IBKR. We've seen, and you mentioned this as well, the stagnation over 2022, late 2022 of account growth. And I think that makes sense with the bear market. If they're going to 5X their account base over the next 10 years, where is that going to come from? Yeah, absolutely. So

let's just start with the existing addressable market. So today, IBPR has about 2 million accounts. Now look at who its competitors are. Schwab has over 30 million accounts. Robinhood has over 20 million accounts. E-Trade has over 20 million accounts. eToro has more. I don't know the number, but it has more accounts than IB, I believe. Or maybe it has millions of accounts, right? So within the existing landscape, IBKR can take share.

And who is it competing against? Robinhood could be out of business. ibkr has a better value prop than schwab ibkr has a better value prop than pretty much all the competitors depending on what the customers need right um if if customers care more about earning high higher rates on their cash deposits and trading more markets and saving money on their trades um they may consider ibkr so i think market share is one thing um however the market is growing. The total addressable market is growing. If you look at all of its competitors, I think Schwab has grown its account base at roughly a 5% rate over the long term. And that's

a fairly mature business, right? Given that it already has something like 34, 35 million accounts. IBKR has a couple of really interesting niches, but probably the most interesting niche is the ex-US niche. So 50% of IB's accounts are in North America. One third of their accounts are in Asia and about 20% of their accounts are in Europe. It's a very international business and international side is growing much faster

than the US side. And IBKR uniquely has the ability to open accounts over 200 countries okay and in these 200 countries and off is pretty much offering the best value prop as an electronic broker relative to all the other competitors in those local markets now the us market is a very competitive market and ib is already the leader in the us and it's a very competitive market right if you start looking at really small countries like romania or indonesia or um colombia where i believe ib offers accounts in all those markets and you look at who they're competing against and a lot of those countries you don't

have these large fintech players you don't have an etoro or a schwab you have like a traditional bank that's still offering full like full fee accounts with very limited access to international markets right so if you think ib is a good value prop in in north america or in western europe it completely smokes the value prop in like eastern europe southeast asia parts of africa i mean they're in 200 i think 215 countries last i checked they're basically everywhere where they can be and obviously they're not operating in markets that are blacklisted because they actually you know compliance is really important but um and i've done a lot of work on the compliance side which we could talk about but um so they're getting a lot of new accounts in all these

like little niche countries where they're kind of dominant and i've done a lot i've done calls i've done calls with customers and competitors in various developing markets and have confirmed that ib is very strong competitor now there's another reason why ib is a strong competitor in these local markets. Because if you think about, if you actually ask people in these different countries what stocks they want to invest in,

it's really interesting what they'll say. People in Colombia and Indonesia, they want to own Tesla. They want to own Apple. They want to own Samsung. They don't necessarily only want to own the local companies. They want to own the global leadership companies.

um these are like universal universally desirable securities right and if you think about comparing like let's say ibkr to like a local bank in columbia the local bank or the local brokerage in columbia doesn't have the same ability to trade in north america or in asia as ib so in a lot of cases there is if you want to own tesla and i've had this conversation with local traders in different countries the only way to buy tesla in some countries is to open an account at ibkr right and in addition to that ibkr is offering the most attractive forex rates so if you want to like if you're in if you're in one of these countries and you want to own something in us dollar or euro it's a lot cheaper to do it um with ibkr um so i think that's um i think that is

the biggest tailwind because if you think about the long arc of where we're going you're seeing increased financialization of the world, there's a growing number of publicly traded companies in developing countries there's a growing interest in people

wanting to invest, there's a growing middle class globally that needs to invest and needs a safer retirement so IBKR is riding a lot of these trends and they're uniquely doing it Okay. Last question. And this is the one we try to always end with, which is the pre-mortem. You mentioned this is kind of heads I win, tails I don't lose scenario. And when you look at the

whatever happens to interest rates, you could see how that would play out. There's benefits both ways. Is there any tails I lose scenario? Is there anything that would cause this to be an underperforming investment. Yeah, 100%. And we glossed over a lot of risk, and I could quickly hit what I think are the key risks after I answer this question. But I think what you would have to believe to lose money on IBKR is that both interest rates will fall and trading activity won't recover. So if interest rates decline and people still hate the financial markets, If interest rates go back to zero and stocks don't recover and therefore investor desire to own, to invest in stocks and bonds don't recover, then hard to see that being good for IBQR, right? But I think the Goldilocks is that interest rates don't go to zero.

Maybe the interest rates stay where they are or maybe come down a little bit. Maybe they go down to like 2% or 3%. So you get a little bit of a benefit on the valuation of financial assets, but IBKR still retains the vast majority of its economics on that interest margin. So, you know, those are the two key dynamics, right? If both of those things, you know, if investor interest in the market and interest rates fall, then yeah, IBKR is going to report pretty horrendous numbers. Now, I think the probability of both of those things occurring is pretty low. I think there could be a reasonable probability on one or other of those things happening. I think we could see either an environment where interest rates stay high or stay where they are now,

and the markets kind of stay in, let's call it a trading range you don't appreciate very much. I think IBQR, you know, it's currently, it'll probably retain roughly its current earnings power. And I think it's attractive here and it's printing money and, you know, they could return capital to shareholders, right? And I think if rates fall and the market recovers, who knows, maybe we get a repeat of 2020, 2021 again, you know, commission volumes go crazy. I wouldn't bank on that, but I would certainly expect an increased appetite for investing. And obviously, if rates go to zero, that's going to have valuation support on IBKR's multiple itself, right? So it's a little bit of a double impact there.

So maybe I should quickly hit on what I think the key risks are of IBKR. Maybe these are the things that are keeping other people up at night. I think the first thing, and I think I've kind of addressed this, is that a lot of people view IPPR as a COVID beneficiary because they saw their account growth kind of soar during 2020, 2021. Like, account growth really accelerated. And in addition to account growth accelerating, you saw trading activity per account go up. You know, we're a couple of years removed from COVID now. and I would argue that 25% account growth in 2022, well, we exited 2022 with 25% account growth.

Account growth was actually higher than 25%. It was closer to 30% during the entirety of 2022. But I would argue that exiting at above 20% account growth suggests that there's probably more than just a COVID beneficiary story here. And for all the other things that we talked about on this call, the long-term tellers. Um, you know, interest rates going back to zero, but I think we've covered that corporate

governance and succession risk. I think it's worth mentioning this. So a lot of people say, okay, cutter fee is 80. What's going to happen when he's no longer with us? Uh, and I think there are a lot of people who speculate that Ivy care may be, it may be sold, um, or, you know, there's a question, will the sun take over? The sun doesn't have a lot of operating experience as a board member, but actually I think Ivy care already solved the succession question because the ceo milan was appointed in 2019

and he's basically a carbon copy of pederfy he's like a mini pederfy he's younger he's uh i think in his 50s and um he thinks about the business and very similar life is very similar training this is also his life's work he has a majority of his own personal net worth tied up in the company stock as well um i've done a lot of calls with like former employees of the company and i don't think anything's going to change if pedophilia is i'll just put it that way um and my impression of the internal corporate culture at ib and it's a very mission-driven company people people are very efficient they work really hard and you generally get a lot of satisfaction out of it. I have a very positive impression of what it's like to work at IB based

on my multiple calls with former employees. Okay, there's a couple of more like left tail risks that I think are worth mentioning. Some people view IB as like being vulnerable to a financial crisis. So what I mean by that is like, okay, well, what happens if we just get what happens if all their clients blow up like if there's like a 2008 systemic crisis or you know some other kind of systemic crisis ib does have a liability they do have some counterparty risks to their customers so if all their client accounts just like blow up for whatever reason um there would be some liability so the first thing i would say is that well ib has been around doing electronic brokerage for 30 years, right? So they've lived through the S&L crisis in the 90s.

They lived through the Asian financial crisis. They lived through the dot-com blow-up. They lived through the 2008 crisis. They lived through the 2020 crisis. They've never had a real charge-off. The largest charge-off that IB had was actually in 2020 when the price of WTI went negative. IBKR incurred a $100 million charge-off because their software didn't allow customers to close their positions with a negative oil price. I guess whoever designed the IBKR software didn't think that that would be possible. So that was the largest incident that IB's had, and that was a $100 million hit to IB. IBKR has $10 billion in equity on their balance sheet. So the largest that they've ever been hit by would have hit their equity by 1%. I think that they're very

conservatively capitalized. And as I've mentioned, they have no corporate debt. So I do think that it is worth thinking about, okay, what could really go wrong systemically? Where is IB vulnerable but if you you know the best way to analyze that is you know you have 30 year track record and then obviously as a private market maker for even for another 20 years before that i think they know how like this company has operated very very conservatively and it's not a situation where like you're dealing with a company that pushes its balance sheet or its risk constraints to the to the limit i actually think it's the opposite and then i guess the last risk factor that I'll mention that I think about

and this is probably the one that I think about the most is there is some regulatory risk involved in opening accounts in over 200 countries right namely there's anti-money laundering risk and

they have to be really really careful about who they open accounts for and the information they have on customers so needless to say opening an account in the u.s is lower risk than opening an account in let's say indonesia and there's a couple of reasons why the ids that people have in indonesia the system for

identifying people and the kind of information that you can get from people is not as robust in indonesia as it is in the u.s right just to to speak to that so ib has invested quite a lot in compliance and they've significantly ramped up their compliance investment in the last couple of years they employ local country experts that handle compliance for every single country that they operate in and they have had a couple of minor compliance issues in the past but um i believe this is a country that i believe this is a company that takes compliance and kind of left very seriously. And I have a high degree of confidence that they're handling these kinds of risks well. But it is a situation where it wouldn't be, it is possible for them to make a

compliance mistake in one of these other countries. I guess the only thing I would say to that is the client base here is very diversified. So let's say they have an issue in Indonesia, not to pick on indonesia but let's just say they have an issue in thailand uh okay if they have a really really bad issue maybe they just close that country down right but because their account base is so diversified closing down access to one country isn't really going to be that material you know the the countries that would be material would be like north america and western europe to ivy cares financials but a lot of like the long tail where you really have a higher compliance risk, I think it's pretty well diversified. Makes sense. Okay. I think that's all the

questions we have. Brett, do you have any more? He's shaking his head. Okay. So I guess closing out, where can, I think you've probably said this on shows before, but where can people follow you? I think your research note on IBKR is up on your website as well, correct? It is. So if you want to look me up, you can just Google my name, Luis V. Sanchez. The V is very important. And my website is lvsadvisory.com. And if you go to my communications page, I have a version of my IBQR note there. Perfect. Okay. That's going to do it. I want to throw a disclosure on this. Brett and I are not financial advisors. Anything we say or discuss here on Chit Chat Money.

It's not formal advice or recommendation. We are, however, general partners at Arch Capital, so clients may have positions in the securities discussed in this podcast. Luis also mentioned it as well. Do your own research. This isn't financial advice on his part, but that is going to do it.

Thank you all for listening. Thank you again, Luis, for coming on the show and we'll see you all next time. Okay. I'm welcomed by the founder of our exclusive sponsor, Stratosphere.io, Brayden Dennis. Brayden, welcome. I wanted to basically give listeners that are interested in Stratosphere more context around what the platform is. So let's start there. What is Stratosphere? And then why did you decide to start it? Yeah. Thanks for having me. I appreciate it. And I'm glad to be sponsoring the podcast. As a

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like our costco members or you know if i want to do a comp against like the streaming like Like how many Netflix subs versus, uh, HBO plus discovery plus no Disney plus, like how do I build out proper comps of those? Because those are the metrics that actually move the business. Those are the ones that actually move the needle more than any like gap financial metric you'll find. And so it started off as just purely a passion project. And I figured, let's just make the leap into entrepreneurship and, uh, see where it goes.

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If you use CCM, you get 15% off any of the paid plans. But I think that covers it pretty well. If you're interested, please go ahead and check out stratosphere.io. We'll have a link in the description as well. But thank you, Brayden, for joining us. Ryan, keep it up. I really like what you and Brett are doing and I'll be listening along.