Yet Another Value Podcast - Luis Sanchez lays out the $IBKR thesis

Episode Date: October 17, 2022

Luis Sanchez, founder of LVS Advisory, disses the bull thesis for IBKR, including why the company is a major beneficiary of interest rates rising and how the company's business to business solution can drive major account growth.See Luis's IBKR write up here: https://lvsadvisory.com/wp-content/uploads/2022/09/LVS-Advisory-IBKR-Write-Up-September-2022.pdfChapters0:00 Intro2:45 IBKR overview6:05 What is Luis seeing in IBKR that the market is missing?12:30 IBKR's valuation15:15 Is IBKR more net interest or trading driven?19:00 IBKR's focus on active traders23:30 Does IBKR have one product risk from the bigger asset managers?28:30 Blow up risk38:00 International account risk and opportunity42:45 Business to business growth52:45 Trading account stickiness53:35 IBKR and crypto55:55 IBKR's founder and management team1:00:15 Share buybacks and insider selling

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That's Composer. Dot trade slash value. See important disclaimers at Composer. Trade slash disclaimer. All right. Hello. Welcome to yet another value podcast. I'm your host, Andrew Walker.

If you like this podcast, it mean a lot. If you could rate, subscribe, review it wherever you're getting into. from with me today. I'm happy to have on for the second time. My friend Louise Sanchez, Luis is the founder of LVS advisory. Luis, how's it going? Good, man. Thank you for having me again, Andrew. I always look forward to it. Thanks for coming back on. I'm really excited. I guess I'll do the pitch for the stock in a second, but let me start this podcast the way I do every podcast. First, a disclaimer to remind everyone, nothing on this podcast is investing in advice. You know, on your first appearance, we talked about Endor, which is a very small,

very illiquid German company, if I remember where they're trade correctly. This time, the stock's going to be a little bit bigger, a little bit more liquid. So, you know, probably a little bit less there. But please just remember, do your own diligence, consults financial advice or not financial advice. Second, a pitch for you, my guess, you know, people can go listen to the first one if they want. But it's been great getting to know you. For those who don't know, we kind of share a we work. So we've gotten to know each other and play some games through that.

And as soon as you published the research report on IBKR, I was like, oh, this would be a great podcast. So just really happy to have you on and really happy to have gotten to know you more over the past couple months. But all that out the way, let's turn to the talk we're going to talk about. The company is interactive brokers. A lot of our people might be buying and selling. A lot of our listeners might buy and sell on their platform. Ticker is IBKR. And I'll just pause there. You know, what's so interesting about interactive brokers? Yeah, absolutely. Thanks for that great intro. And I think the fact that last time we covered it indoor and this time we're covering IV is a pretty good reflection of the kinds of stocks that I like, which is basically anything

and everything. So, you know, really, I run two strategies, but the theme of our more growth-oriented strategies, we're looking for high-quality companies with long, you know, competitive. advantages long-term growth runway. So sometimes there's exist in microcaps, but sometimes there's a pretty good example of that in mid-in-large caps. And I think IB is a good example of that. Effectively, the 30-second pitch is that I believe

that IB is a very durable business with a lot of growth runway. The company is an electronic broker, so it's primarily helping people buy and sell securities. It's primarily a retail broker, but it does also have some B2B aspects of its business, which we'll get to. But over the last 10 years, it's 10X, it's client base. It currently has about 2 million accounts. And, you know, 2 million accounts, while that's a fairly scale number, you know, Other players have more than 10x that account base. So over the long term, I see IB continue to rapidly grow its account base.

And it's continuing to do that even in 2022. The company is a low cost leader. It has some interesting competitive advantages and niche areas that it caters to. It has a niche leadership position for more sophisticated retail investors and anyone who's doing international trading. And the reason why I think IVKR is such an interesting stock to look at today is because it has a couple of distinct earnings catalysts, namely the first is just that it's a count base is still growing very rapidly. The second is that it's actually one of the rare companies that uniquely benefits from higher rates. So the way that I think about IBKR is there's

two parts of the pitch, there's the durable long-term, long-term compounding of the business, which I think you're only paying for really that today. And then what I would call as this like interest rate call option, which I think is very mispriced, which is if rates stay elevated for longer or if rates don't immediately go back to zero, this is basically just, straight cash flow that goes down to Ivy's bottom line that the market really isn't ascribing much value to. So that's more or less the 30 second pitch. We'll talk more about interest rates, obviously, because I think that's an interesting story. And they were giving, they gave some numbers on the Q2 call and my notes are so disorganized. I'm having trouble finding. But it's so funny

because on the Q2 call, you know, they were talking to the Fed funds rate was, I don't know, like 1.5 or 2. and here we are three or four months later and the Fed funds rates are going to be approaching 4%. So the numbers they gave as you're going back and reading their most recent earnings call are just, it's so stale and it's so funny just how quickly things have moved just on that interest rate thing. It's been insane. Let me start with the first piece of Bushback. You know, the market here, the market's a very competitive place. And first question I always like to ask is, what are you seeing that the market's missing? So I'm going to ask that. And then I actually have a follow-on that's kind of unique to IBCR that I'll follow up with. Yeah, you know,

it's funny. I have like a list of like five, four or five things that I think the market isn't really, or at least I have maybe a variant view on. The first one is that I'd be clearly benefited from what happened during the pandemic, namely that there was retail stock trading mania. and they had their number of accounts they opened, accelerated significantly, as did the whole industry. And now we're kind of in that hangover portion of the pandemic where for most of the industry, like if you look at Robin, they're actually not growing their accounts anymore. The IB is actually still growing their accounts at a pretty nice clip. but the trading activity per account is significantly down.

There's a couple of like KPI trends that are negative. And I believe the market is over extrapolating the recent negative trends in some of these KPIs where a lot of people will push back to me to say, okay, yeah, well, the trading activity per account is never going to get back to what it was in 2021. one. And what people need to realize is that it doesn't have to. And actually, the current level of trading activity and the current level of KPIs on a per account basis is actually reverted back to 2018 levels. So now we're kind of at a point where people are continuing to extrapolate the unit economics on a per account basis, potentially getting worse, where there now becomes

an increasing probability that some of the KPIs could actually get better, which is, really interesting. The second major area that I think people get wrong is they look at IVCA, if you look at this company on like a 10 or 15 year basis, it screens terribly. Basically, it doesn't look like they've really compounded EPS at an attractive rate. It looks like it looks very volatile. And there's a couple of reasons for that, namely that the business mix is just It's a very different business that it was, you know, 10, 15 years ago. They had a market-making business, which was 80% of its business in 2007. It's now basically not a material.

It basically doesn't exist anymore. You know, in different interest rate regimes, the margins and mix can look different. And effectively, we're at a point where I think the business is at now, if you look at the core business, the core business based on what exists today has actually compounded at a very nice rate. And I think sets it up for future financial characteristics that are going to be very attractive. I think the last two areas that I'll quickly highlight is a lot of people believe that there's a high probability of like a blow up here. For example, iBKR is a broker and you know if it's a if the underlying account holders blow up their account

equity during a financial crisis that you know that creates counterparty risk for a company like iBKR and you know given what i just said about how the financials look really weird if you look back at 2008 2009 i think people have the wrong takeaways from what happened in the last cycle And I actually don't really see a lot of risk of a negative scenario. And I could talk about that a little bit more. And finally, it's just the interest rate call option, I think, is really mispriced. If you look at, we were just talking before the pod, IBKR on street numbers trades for about 14 and a half, 15 times 20, 23 EPS,

which is historically a very cheap multiple for this company. And it's just, it trades at a discount to the market, which I think is interesting, given that I believe this is an above average quality business. Depending on your view of rates, on my numbers, and we can get into this more in detail later, on my numbers, IBCR could be as cheap as 10 times next year's earnings if you actually ascribe some value to interest rates. So the way that I view, the way that I believe this, the stock market is currently looking at this company is it saying, oh, hold on, this is a cyclical, just look at the historical results being, you know, the result, historically it's been more volatile. The metrics don't look that great. It's had a couple of quarters. It's had, it's had the last year and a half that KPIs have turned negative. We don't know when that's going to, when that's going to reverse. This, could blow up if things really, you know, run off the rails here in the next couple of quarters. And then people are just assuming interest rates are going to immediately go back to zero.

Therefore, we shouldn't ascribe any value to their interest rate tailwind. And there's a lot of interesting stuff to kind of dive in there. But I think those are the common areas that I think people may be, I have a different view on. That's great. And those are all areas that I wanted to touch on. But I just want to touch on one more thing on the, you know, kind of markets, a competitive place. How is this going to outperform? Like, look, I've looked at IPKR in the past. This has always been a popular company for kind of value investors, compounders to pitch. And guess what? They've been right. It's done pretty darn well. A lot of the things that we're going to talk about, I think people will see why it's been so popular. The founder led, you know, the guy still owns like 75% of the stock. He's a billionaire. He's a boss. I'll give some quotes. from him later. But just to go back to the alpha thing, right? 19 times this year's earnings, let's call it, 14 or 15 times next year's earnings on the street number, maybe a little bit better than that if, you know, the interest rates come through and all that sort of stuff,

though you do have to start saying, oh, interest rates go up, does trading revenue go? Like, it gets a little, but, you know, those aren't crazy expensive multiples, right? We're not talking 20 times sales or something, but they're also not crazy cheap multiples. You know, I was doing a little work on Facebook yesterday for a post just because a friend posted them and they looked interesting. And that's like 10 times price to earnings on this year's number, which are probably a little cyclically depressed. And that includes a massive investment to into the metaverse, which if it doesn't pay off at some point, it probably stops. And, you know, they've got cash on their balance sheet. So obviously, you don't have to compare interactive

brokers to Facebook, but look, markets are down 25% this year, right? Like there's a lot of stuff that looks cheap, 15 times next year's earnings, not expensive, but not the cheapest out there. And I think a lot of people might look at it and say, hey, how are you really going to drive alpha with something that's fairly to maybe fairly priced, especially for this environment? Yeah. So, okay, to just really, really boil it down into kind of two things here. The first is that I think my view of the business quality is above what the current multiple implies, I actually do believe this should be an above market multiple business long term. And the second is that I believe that the street estimates just need to go up, right?

Yeah. On my numbers, on my numbers, it's like 10, 11 times 2023 EPS. And it could be even cheaper depending on how much value and how much value you want to ascribe to certain moving parts of the business. So I think that multiple could be too cheap, but I I also think that street estimates need to go up. So I think that's where, you know, potentially there could be some alpha if I'm right, which I may not be right. And just I found the number just so people know. So the share is outstanding.

If you do it, they've got this weird structure where, you know, they have a hundred million, about 100 million shares outstanding. But there's another 300 million at like the LLC level that the shareholder control. So I think the right number is about 400 million shares out, if I'm remembering correctly. Is that about right? Oh, that sounds about Ray. Rough math, that's about right. On their Q2 call, they said every 100 basis points increase in Fed funds rate is about $2

million in net income, right? So that's pretty simple. Fed funds rate up another 1% that's over 50 cents per share in earnings. Like that's a pretty meaningful number on a $67.70 stop. Just on the business. So they're going to make money from two places, right? They're going to make money from giving margin loans to people. That's their net interest line.

And they're going to make money from trading commissions, right? People buying and selling a lot of stocks. And then those are their two main lines. So I just want to, when you look at interactive brokers, are they more a trading business? So they're making all their money and then the margins loans are a nice supplemental. Or are they more of a margin loan business, right? They just want traders to come on, take margin. loans and where the real juice is is actually on the net interest income.

Yeah, there are a bit of a balanced play here. And let me actually, so I think historically the mix in the zero rate in the zero interest rate environment has been about two thirds non-interest revenue and about a third interest related income. And in 2019 and when there was a higher interest rate regime in the past, that's been more 50-50, right? And now we're talking about interest rates that are higher than 2019. So I would actually expect that to flip next year, depending on how high rates stay, although it's important to note that the interest earning component of their business is not purely based on the absolute level of interest rates, because even in a zero interest rate

environment, they're earning about a one-and-a-quarter net interest margin. And they do that because they monetize customer cash, they do securities lending, in addition to margin loans, and other forms of credits that they have on their balance sheet. Relative to like a Schwab, Schwab is almost purely a balance sheet-related play. And that's kind of been the direction of the industry over the past five to ten years where we've moved into zero commission trading business model. whereas IB has that product offering more than 90% of their customers use the the model that still charges a low-cost commission.

And yeah, I do want to add one bit of context, though, and maybe we can get into this in a minute. But I actually was surprised about some of the B2B aspects of their business. that I just wasn't aware of even though I've been an IB customer for over 10 years. Do you mind if we go to B2B after? I just want to ask more basic questions on the business, but I did have a lot on the, because I'm guessing they've got the, yeah, we'll talk about those in a second because it almost turns them into a tech business.

But I just want to focus on, you know, on their earnings call, they said, hey, look, there was this really interesting quote. They said, hey, we do things that we think are interesting. And really what we're trying to do is we're trying to make a platform that's really attractive for people to come trade on, right? It doesn't sound like they want people to come and buy and hold. They wanted people to come trade on and they say, look, we want rate execution, low commission rates so that people can trade actively. And they're really pumping like, look, if you're a trader, margins, margin rates, right? Like, we want you to come and

use margin. That's where we're going to make money. And we're also going to incentivize you with, they've got a little, in their September deck, they said, hey, if you're borrowing $300,000 in a margin loan, right? We're going to charge you 3.5% for it. If you go to e-trade, they're going to charge you 10%. Schwab, Fidelity, TD Ameritrade, 9 to 10%, right? So it's so much more economical for you to come into, for you to go to interactive brokers if you're going to use margin. And that's great, but it does strike me as, hey, you're attacking an active trader if you're cutting commission, really focused on getting people trading, really focused on getting margins. And that does present like other risks, right, where markets get super non-volatile, people stop trading as much.

And not just people stop trading, but your active traders really lose interest. There's other risks, too. But I just wanted to ask you about that kind of like active trading focus, if that makes sense. Yeah, okay. I see where you're going with it. There's one important part that you're missing of that piece, though, is not only are they offering. And actually, this is a really common. question I get, which is, okay, IBKR is sell, it's value prop is we're going to offer like

value to, to, to investors by lower cost. Given that there's zero commissions, does, is that value prop still valid? Like, who cares if, you know, if you're charging one dollar per trade when Robin is free and Schwab's free, which is actually, they're not free, but, you know, we can get into that. The important piece, too, is that IB is also offering the highest interest rates on cash, right? So there's the value prop for IB in a zero commission business model has actually shifted more to the value prop of, hey, we're going to offer you the best margin rates. We're also going to offer you the highest interest on your cash balances. We're also going to share with you the proceeds from stock lending, and we're going to also do all sorts of

interesting ways to sweep your cash to give you the best account yield, right? So that starts to, that gets into more of the ethos of the company is, you know, this is really a scale, a scale economy shared business model, right? Where, so it's not, and I would say you are 100% correct. They have a niche where more sophisticated and more active traders will use IB because on a per trade basis, they're effectively offering wholesale rates, right? Half a penny per share, dollar per derivatives, contract, etc. And the net result of that is the revenue per customer for IB is about 10x,

the revenue per customer of like a schwag, right? So that's the net result. And I actually view that as shifting over time as they've been expanding into more, I would call it mass market customer base. And I believe that the value proposition and what actually is going to help them gain market share is the fact that IB is very uniquely positioned because A, it's low costs and B, we'll get to this, but on the balance sheet, it has all of its liquidity and T bills, which means that it can more quickly adjust its interest rates than its competitors that have duration in their portfolio. And that's it. And that's going to allow IB in this cycle where customers are now a lot more focused on interest rates. What is my bank yielding? What is my

margin loan costs? I believe that's actually a new value profit. They're going to be able to really push going into the next couple of years. You mentioned blowup risk earlier and we'll probably talk about blowup risk, but you know, one way they could blow up is, as you kind of said, interest rates rise and they have to pay their clients more on their deposits and they've invested in, you know, it's the classic you borrow short to lend long. They've invested in a lot of long duration stuff to kind of reach for yield, interest rates rise and they get murdered.

And they've been so clear, look, here, and a direct quote. We do not take that risk. We invest in T-vills and repos. Like, that's how we get our interest income, and then we pass a lot of that onto our thing. Just one more thing on the, their focus on more like kind of professionals, active, you know, because the next step is e-trade got bought by Morgan Stanley. You know, like these guys are merging.

And I do worry if your whole value prop is, hey, professional traders, active traders, whatever it is, come to us. We offer better margin loans. We offer wholesale pricing. Like, that can be matched if somebody's, got, you know, interactive brokers is only monetizing that. Like, e-trade, I know that they've got Morgan Stanley is out there trying to pitch wealth management, all this sort of stuff. Could you see an e-trade, J.P. Morgan, all these guys at some point, they just say, look,

we're not making that much money. Let's just give wholesale pricing to anybody who we think is a target client. And then we'll make the money up by getting their client info for wealth management or, you know, all these other stuff, like these baltons. It's the old one product versus to somebody who can turn your product into kind of the lost leader to get you into a bigger ecosystem? Yeah, I don't think so. Just be two reasons why, maybe even three reasons why, but fundamentally, all of IBE's competitors have just much more bloated cost structures.

They've invested a lot more in customer service. They've invested a lot more. Frankly, they're just a lot less efficient. the ethos of IB and the way it was founded, you know, 40 years ago was it was founded as an electronic market maker. Yep. So, you know, the skeleton foundation of this company is, you know, routing orders and not only routing orders, but connecting markets all across the world, right? Which is another thing where IB, like, in order for, like, there's just, there's just like ib has like three or four x the amount of markets and products available to

trade so for a lot of for a lot of um competitors they they can't even match on price they also can't match on product but um so there's a different cost structure um right there's um there's um trying to think um the original i lost i lost a train of thought it's fine the you're saying why can't they just offer wholesale oh okay oh sorry sorry now i i regain the train of thought um so there's a fundamentally different cost structure but secondly like what you're basically saying is uh cross subsidization uh where you know you're using one thing as like a loss leader to to promote another thing and that sounds like exactly the cycle we just went through where Robin Hood was giving free trading and, you know, Schwab was doing free trading.

And what we've actually seen is the opposite. Well, obviously, I don't know what's going to happen with Robin Hood. They're going to have to figure out a way to make money. But we've actually seen the competitors now that the market's consolidated rates prices. So in my business, I use IB for some accounts. I also have a relationship with Schwab for some other accounts. And I can tell you, Schwab has been adding incremental fees in all sorts of sneaky ways over time. IB has actually done the opposite.

IB has actually been reducing fees in all sorts of interesting ways over time. And fundamentally, I think that there's just a different philosophy around what the value profit is, where Schwab, they don't even feel that they need to pay. They don't even feel that they need to pay the same level of interest rate as IB because they're customers value their customer service and value a different user interface and value the brand. Whereas IB's whole value prop is around, no, like, come to us for value, you know, we're going to do the best we can on customer service, but a lot of people don't expect the best customer service from Ivy, which I actually view as potentially a long-term opportunity

for them. But fundamentally, their value props is a bit different. They serve different market niches. They serve that more active trader. They serve the more international trader. They serve an investor who's more of a self-service, more focused on, you know, the numbers and less focused on having, you know, a customer service rep walk them through, how to place an order. Let me ask one more risk on IB, and then I do want to switch the B to B side because it's very interesting and it can drive a lot of growth and it seems like it already has, but it does seem like there could be an inflection point coming up there. Just on blow up risk. There's two ways that these type of firms blow up. I think we already addressed interest rate risk that,

you know, they have been very clear they're doing T-bills and repos. So they're not exposed to dramatic interest rate risk. It's probably a benefit if interest rates go up. So I don't think we need to address that. The other way that trading firms blow up is, right, look, they do margin lending. And if your account, if you have $100,000 in equity and $100,000 in loan and you lose 75% overnight because you were betting on phase three trial and it went to zero and your account goes negative 50,000 equity. Well, guess what? Interactive brokers is going to have to eat that. And that might sound dramatic, but we have seen time after time, you know, once every five years someone blows up. There was a currency trading, right? Like five or six years ago,

I think it was the Swiss dollar or whatever, Swiss franc, broke, broke parity and a couple four FX exchanges blew up. Knight Capital blew up. Robin Hood almost blew up when GameStop was going straight up. Like, these things do happen. So let's just talk, blow up for us. Like, why are you not concerned the interactive brokers is going to have that? Yeah, okay. There's a few, there's like several interesting ways to frame it depending on which aspect

you want to focus on. I mean, the first fundamental thing that I would point to is just that I'd be spent around for 30 plus years. It's already survived, you know, the Asian financial crisis. crisis, the SNL crisis, you know, the 2008 financial crisis, you know, the various crises that we've had over the last two years, whether it's negative oil prices or, you know, retail trading mania. So I'll just point to the fact that IB has proven to be a survivor. The owners of the company, the majority owners of the company are extremely conservative as reflected in the way that they position their balance sheet. I.B. has over $10 billion of equity capital. They have $1 million of cash on hand. They have zero corporate debt.

They have access to financing markets. They have in the past half of the bond markets, but they are debt-free right now. So they're very conservatively capitalized. And obviously, this is like one of the key risk factors and one of the things I've asked the company a lot about. And basically every time there's like a wiggle in the market, I'll ping the company and say,

hey, how does this impact, how does this impact your positioning? And they'll, you know, they'll kind of give me some color on that. But if you, like, maybe let's start with like the retail, like what happened in like Robin Hood Trading Mania. Sure. Robin had to be billed out by its investors.

It, you know, it had an interesting issue where, you know, Just correct me, but one of the issue with Robin Hood was they had extreme customer concentration in GameStop and AMC specifically in meme stock. So their margin requirements for trading and collateralization all the thing went up. I understand it's interesting, but if I cut to the end, I think it would just be, hey, interactive brokers has like 30 years of customers and everything. They don't have massive concentration in any one stock. I don't think you have any worries about the Robin Hood specific. civic issues, but tell me if I'm wrong. Well, okay, I think it is valid, though, just because that a majority of IB's accounts

are retail-oriented. Okay. Yep, perfect. And the way that I would frame it to you is that basically, I, sorry, Robin Hood had to be billed out, I think for a sum of about $3.5 billion. Yeah. And as I, you know, that was a very extreme market environment, and Robin Hood had a very extreme situation in terms of the concentration of positions.

And given what I just said, well, IBE has that cash on hand. They have more than $3 billion on hand. So if that were to somehow replay in the next year, and the company continues to build this equity. So I think they're going to, they've, they've, the company is very focused on this kind of thing and they have this cash for that kind of rainy day. to put it that way. The second thing is that there are,

I have to look at my notes to give you the exact figures, but there is a material segment of IB's accounts that are either CTAs or hedge funds, you know, prop traders effectively. And so there are, there are, it does have exposure to like folks who are trading futures and folks who are trading commodities. And the biggest issue that IB has actually had was in 2020 when the price of oil went negative.

And IB actually ended up paying about $120 million because what effectively happened with IB is that there was a glitch in the software because whoever designed the software didn't think they had to account for negative oil prices, which was clearly a huge oversight. And look, it's a huge oversight, but it's one I can completely understand why you'd be like, yeah, nobody's going to pay people to, but it makes sense. If there's oil, if you're, if you have to take literal physical delivery oil out of pipeline, I'd be like, well, I can't, I can't put it in Penny's kennel. You know, somebody else take it. So what effectively happened was the glitch prevented IBE's customers from closing out their positions when the price of oil went negative. And because IB couldn't allow them to close out their position, I'd be effective.

effectively took care of everyone's losses that were experienced. And that was $120 million, and that was the biggest issue that, the biggest issue that has led to IB paying out of margin debt. And $120 million is, you know, not a lot of money for IV. The next thing I'd point out is that when you really focus on where the risk, like the more systematic risk are in terms of counterparty of this. It's really typically not from retail investors, which is where, aside from what Robin Hood went through, you're typically looking at situations where like a prime broker has a lot of

exposures to hedge funds that have a lot of leverage. You're looking at Archegos, right? Archiegoes from early 2021 where they're levered up five to one. It's in five stocks. It turns out that they were driving. all the five stocks off and the stocks collapse and the brokers look around and say, oh, shit. So there's there's two things here.

The first thing is that relative to IB's prime brokerage competitors, IB does not have the same risk tolerance in terms of allowing its hedge fund clients to take on like six X leverage. Yep. You know, IB's, so that's one thing, it's just in terms of like a gross amount of leverage that allows, institutional customers to take on. The other thing, and, you know, this may be a consideration. You know, the company really wants to be more, one of the reasons why they're building up their equity capital here is they do want to do more business with hedge funds. They do want to be more of a prime broker. I actually, that's actually not part of my investment thesis. I don't actually think they're really a competitive prime broker because of what I just said, you know, hedge funds want

leverage. But the other thing is that IB has very tight risk management systems. And a lot of their risk management systems are algorithmic, where they're running all these algorithms of exposures. And one of the things they do is if a client or a hedge fund has some exposures that they de-risky, they'll start charging them extra fees, like a risk management penalty. And if it's really extreme, they'll just automatically close those positions algorithmically. And that really, really irritates sophisticated funds. But the, so that's on the negative side, that's one of the reasons why I don't think

IB is going to, you know, they're not going to be the custodian, the prime broker to like millennium tomorrow. But on the other side, it kind of shows more on what you're talking about is it reduces is a blowup risk because they have all these very strict, much stricter than, you know, a credit suisse, much stricter than those types of firms, risk management controls. In addition to the really conservative way that the company is capitalized, I'm really not that concern, but it's a valid question. I was just trying to find it.

I can't remember when, but I do remember that the CEO who we should probably talk about him in a second because he's a baller, but he's a baller. but he published a letter that was like, hey, we've got, we looked at our shareholder register and we've got like 5,000 mutual funds and hedge funds that enter stock, but we only have 3,000 hedge funds that trade through us. So we're like, guys, if you own our stock, why don't you trade through us? Like, the opportunities are enormous. I just thought that was a cool sales but you, am I remembering that roughly correctly? Yeah, I believe so. Yeah, I can't find the letter, but I thought that was so cool. Let's talk

about, so I think we covered a lot of the risk cases. We can go into some more risk cases in a second. I want to talk business to business opportunities and I wanted to talk about the CEO a little bit. But any other risk, I think we hit the most of them at least at a high level. Any of the risk people should be aware of or that you're thinking about? Yeah. I think, you know, where I'm really, where I really focused in on and we haven't really discussed this yet is one of IB's key areas where it's really dominant is in opening accounts and all sorts of different international markets. IB is available in nearly 200 countries, and a part of taking that, and the positive side of that

is, you know, North America and Western Europe are the most competitive brokerage markets in the world, yet IB is still doing pretty well here and it has a solid value prop. IB is in places like Indonesia, Romania, you know, these like more niche places where there's basically no competition. Charles Schwab does not exist in Indonesia to my understanding. And it's competing against basically full service offerings. And that's one of the reasons why it's able to just show, have such strong account growth. But the negative side is, you know, that does come with some incremental compliance risk. It's something that I've been really focused on and I've asked the company a lot of questions about and I've done a lot of research in that area. I'm really

comfortable with their, you know, the level of the level of compliance sophistication they have and the level of risk management that they have on that side. But it definitely is one of these things where if there was like an Achilles heel, potentially it could just be some kind of lapse in compliance, just because it's really hard to do like AML, it's really hard to do know your customer outside the U.S. Correct me of them wrong, but it would probably be something along the lines of like one of these emerging markets gets like all of their customers' accounts get nationalized or something would be the big risk.

And I don't think that would be bloke because I don't think they've got. enough equity in any of these accounts where like it would be hit to earnings but it wouldn't be a blow up so yeah i mean that's an interesting that's an interesting point and in addition to that i would say capital controls in some of these other countries too right where if you know ib does have like customers in in hong kong and it has customers in some of these other you know countries that have seen their currencies get hit quite a bit and the government's may view ib as like a conduit that helps people, you know, like aid capital flight. I mean, that's, that's certainly a way, a way that some countries could view brokers. IBM doesn't facilitate money transfer. That's an earnings hit,

not a blow up the business risk, unless the, unless the country's going to go and hit them with like a $500 million, it'd have to be a bigger than that, a $500 million fine for helping to have to evade capital controls or something, right? Yeah, you know, fundamentally, North America is about 60% of their current business. Western Europe is like another, you know, 20, 30%. So 70 plus percent of their business is developed markets where, you know, rule of law is a lot more predictable and understood. They do have, like their business in Asia, their business in Latin, their business in Africa

and Southeast Asia is growing very rapidly. And over time, that's going to increase as part of the mix. Ivy, that is a really interesting, like, long-tail opportunity, right? But, yeah, I think there is, the good thing is that in those other markets, IB is quite diversified from market to market. So if any one of those markets failed, you know, something happened, And it wouldn't, you know, it wouldn't be good for IB. Like Russia is a good example, right?

If like a situation like Ivy had to divest from a market like Russia, you know, that that wouldn't be great, but it wouldn't be something that would cause a stock to collapse. Let's go to one of the upside cases. And I think the biggest upside case, it kind of ties into its new account growth, right? and that ties into business to business, which you started to allude earlier. I am just going to give one quote. So the CEO and chairman was at a conference recently, and he said, hey, somebody asked, hey, you said you want to get to 80 million trading accounts across the world. That's about 1% of the global population.

Isn't that kind of crazy? How confident are you in that prediction? And the CEO just said, my confidence is very high because I always get what I aim for in the long term. And, you know, the man owns 75% of this company. It's worth, I don't know, $15 billion or whatever. Like, just what a boss to be like, look, I'm a 15 billionaire. I built this company up from nothing. And I'm going to get what I wanted a long term.

But part of getting to that 80 million number, you know, it's not 80 million people are going to have an interactive broker branded account. It's this business-to-business partnerships that they've been rolling out that I think are really interesting. So I'm just going to pause my ramble there and ask you, business to business what is it why is there upside all that type of stuff yeah absolutely so um business to business in in the context of iB means um iB has a bunch of retail accounts where people open accounts in their own name um they also service hedge funds they also service

uh registered investment advisors like myself um and like so like the way that i would use iB is I have like a master account and all of my clients open up sub accounts under under my account, right? Or if you're a hedge fund, you know, you have could be dozens or hundreds of LPs who are in a fund and you're dealing with IB. That's a pretty nice chunk of their business. And the important thing to know about that is regardless. Regardless of, and I'm going to get to this other thing they have, which is introducing

brokers, regardless of where the accounts are, what type of account it is, what country it's sent. It's all monetized the same way. All the commission rates are the same. B2B customers don't pay any platform fees. They don't pay anything extra that like a retail account holder is paying. They also don't get anything. They also don't get any discounts, which is, which is nice too. So for like for my like for like for an RAA all the sub accounts they pay their commissions. They IB collects their interests same way as if they all had direct accounts. What's nice for IB for like a B to B relationship is that there's like an intermediate intermediary between IBM and the end customer who's helping them with like customer service

and who's also you know basically adding customers on their behalf. So it's. You are their sales force, right? You've gone on their platform and you're going to go, you're economically motivated to go get people to sign up with you, and that will get new people onto the interactive broker's platform. Right. So they have this other thing called Introducing Brokers, which effectively is a white label version of the entire brokerage platform. So if you think about IB as a really cool technological stack that's connected all the markets across the world and has a really attractive, low-cost. commission and attractive financing rates.

In addition to IB is supplementing back office in terms of helping other brokers run compliance checks and know your customer and, you know, negotiating wholesale rates with other partners, it's a plug and play. So if we wanted, if you and I wanted to start a brokerage company, we could, we could use IB's back-end platform, and then all we would have to do is, well, we'd have to do the front-end, we'd have to do the marketing, customer service. We could choose to white-label the UI and U.S., right, so that customers just, they use an app that's white-label branded. Customers don't even know that they're on the IB platform. And the way it works for an introducing broker

is that they pay IB the regular commissions and they can mark it up. So if IB is charging half a penny per trade or half a penny per share, then the brokerage partner can charge a penny per share in pocket the half a penny difference or it can charge double the margin rate. My interactive broker's personal account, I pay half a penny per share. If somebody goes and gets a white label, they're going to pay half a penny per share. Like, it's truly interactive brokers when they say we give our customers wholesale rates. Like, they're not kidding.

These introducing brokers who might bring hundreds and hundreds of millions of dollars in trades or whatever onto the account are going to pay the same amount, basically, as somebody who has a $100,000 account balance. Absolutely. And it's a really great value prop for introducing brokers because it's not easy to build this infrastructure, obviously. And, you know, one of the really interesting. things about IB. And one of the strongest value props that they have is in international markets

in developing countries, there is a very strong desire to invest in like U.S. and European or even like develop market Asia, high quality companies. Like everyone wants to own. It doesn't matter if you're... Apple, Google, yep, yep. It doesn't matter if you're in Florida or if you're in Bali for somebody, you want to own Tesla, right? Somebody asked them about this, about the international risk on their last earnings call, and they were like, what are you talking about? Like, are international customers, all of them buy Apple, Tesla, whatever, they're loving it because the U.S. dollars up 20% they bought American companies, like, in their home currency, they actually absolutely crushed it. So if you think about it, and this is, this is, um, If your options, so if you're, like, if you're, if you're one of these local brokerage companies in Bali,

it is, it is not easy for you to have to create a system that connects to the U.S. market. And all of Ivy's local competitors, while some of them, some of them don't even offer access to these Western markets, which just makes them a non-starter for a lot of, and customers, but a lot of them that do, don't do it, don't provide good trade execution, charge really high cost to do it. So IB is a really attractive option, not just for the retail and customer, but also for these platforms that just want to connect to IB. And maybe, you know,

IB probably doesn't have the best marketing. I mean, IB doesn't do a whole lot of marketing, period, but it probably doesn't have the best brand in some of these smaller countries. It probably doesn't have the best customer service in some of these countries. But these introducing brokers can kind of step in and fill that void where, you know, And I've spoken to some of these introducing broker customers, and they're basically all about, you know, they're providing a very premium level of customer service. That's actually very, very complimentary to the other aspects of Ivy's platform.

If you are in one of these introducing brokers using the B-Speed platform and a customer takes out margin, right, is interactive brokers, are they only providing the trading platform or is interactive brokers handling the margin as well? They're getting the margin too. Okay. So they're doing the margin. And then if you're the introducing broker and Ivy's charging 3.5, you can mark it up. So you can say, okay, Ivy will have it's 3.5 and we're going to get another two points for us. Which, look, that's a big markup, obviously. But if you remember back to the very start when we talked to margin loans, like interactive brokers, $300,000 margin loan,

they'll charge 3.5, e-trade will charge 10. Like, we're talking U.S. to it's mainly international. But, you know, you could probably charge five or five and a half or six percent and still actually that would be two you're just still matching the market you're still competitive in the market so that's that's ib is so cheap that you can mark up its rates and you're still cost competitive with other other options and that's free money to you right it's literally free money because you're just getting that two percent spread interactive brokers i'm guessing is having the risk of negative equity balance the uh risk management and all that. So you're just getting your 2% for free. Yeah. There's a really, there's another really important aspect to the story that I should probably mention and very

fundamental to why I think this is a durable business. So fundamentally, brokerage accounts, even more so than checking accounts, are very, very sticky deposits, right? So the churn, the turn rates on an IB account are sub 1%. They're minuscule, right? And especially in this environment where we have high rates, nobody really wants to keep their money in banks. They want to deposit their money into IB and try to earn yield off of that or wherever they go to invest their money. Now, when you add the B2B element, now you're also adding a very sticky relationship with the B2B partners. So for me as an RIA with, you know, dozens or hundreds of sub-accounts, it would be a complete nightmare for me to try to switch to another platform. It's possible, but it'd be a total

and complete nightmare. I can understand why as an RIA with multiple customers and everything underneath them, it would be very sick to move this thing, right? Like, not only would it be a massive headache for you, but your customers are used to logging in and checking balances and everything on one end, it's going to, but I am curious, you said brokerages in general are lower turn than banking accounts and just using my own personal thing. Like, yeah, I don't love to switch anything. But if I switch my banking account, like all my credit cards are linked there, my direct deposit is linked there, my bill pays are linked there, like everything. Whereas if I switch my brokerage account, I'm literally just transferring money from one money and maybe some stocks, but that's doable

from one account to another. I'm surprised that brokerage accounts are stickier than checking accounts under that scenario. Am I missing something? Is it a sticky deposit in the sense of the cash that you put in that checking account doesn't stay there. But the cash that you put in your brokerage account not only stays there, but it grows over time. Okay.

Because you're adding value to the account. Okay. And yeah, the relationship that you have with your broker, with your broker, relative to other consumer products is much lower trim. One angle that we haven't talked about, yet, which six months ago might have been what we kind of let off with or went second, is crypto, right? And interactive brokers does have some crypto offerings. You know, in the current crypto market, I don't think people care. I don't know if it's ever going to be anything,

but just wanted to quickly address, you know, how is interactive brokers attacking crypto? Yeah, so they were late to really adding crypto. I think the first thing that they didn't really do anything with crypto until the futures were traded on the exchange, which was a plug-in-play to their existing exchange offerings. Eventually, they realized that they should add it to their platform because there's enough customer demand. But the way that they did it was they partner with Paxos to offer it. So they're doing it through partnership. They don't have a lot of direct exposure, they're not known. Crypto, crypto investors don't really come to IB to do crypto for the most part. So for better or for worse, IB kind of miss the crypto wave, which

they, they are, it kind of goes to their philosophy of like, if customers want to trade something, they're going to eventually find a way to add it to their platform. But crypto was one where they were not the on the leading edge of that wave perfect perfect uh just before we wrap up or talk about any last thoughts i did want to quickly touch on management and the management team here you know look uh petrophy i believe that's how you say his name peter fee he billionaire classic founder owner operator still own 75 percent i find the management teams take refreshing like they're very clear i think they think about risk management well i'm just the q2 call i highlighted in their notes, look, the first thing they do is they come out with all the bad news

that's happened to the business, right? The business is producing near record results, and they come up and they just say, here's the bad news, China cracked down, war in Ukraine, affected mood, new account openings dropped by 40% because equity markets are down. Like, they just hit you with all the bad news. They tell you the risk management. They tell you they're going to be conservative. I rambled a little bit there, but I do just want to address it because he is a founder operator and it's probably a pretty key piece of the bulk of pieces here. Yeah, so Petter Fee transitioned. He started the company in the 70s, originally as a market maker.

In the 90s, they started offering retail brokerage. In the mid-2010s, they exited the market-making business for the most part. And so what I was alluding to earlier was, you know, In 2007, 80% of the business was market making. And today, the mix is very different. Pedrophy has been, and they did that for a number of reasons, but fundamentally to address the question on pedrophy, you know, his background is very technical,

and he started off as a programmer. He's been more keen to hire and promote people who are also technical. So the CEO that was transitioned to in 20, 19, it was Milan Gallic. He also started as a programmer. And my, my read is that Milan is like a carbon copy of pedophie just younger. And, um, and that's on many levels. But these guys have real skin in the game, both Milan and pedophie. This is the vast majority of their net worth. From what I understand, not just them, but also the extension of their management team. They work really hard. They work very long hours.

They're always on. This is their life's work. I would argue that there's some of the most sophisticated market participants out there because they understand the plumbing of the market and also have one of the largest troves of account data. So I think I view them as very sophisticated where I would give them a knock and where I think that the platform has room to improve. is that while they've been extremely, extremely good about keeping cost low

and making really interesting investments on the technology side, they've lacked some of like the product vision to make the UI and the U.S. best in class. Yes. I'm laughing because if you, anybody who has an interactive broker account, you open that thing up and it is, it's weird to get used to, man. It's weird to get used to. Yeah. So, you know, if I had to give them a knock, it's that they've been maybe overly technical and, you know, they've been so focused on like execution and, you know, connectivity. It's come at the expense of ease of use. So there, there's just one thought. A lot of people wonder, okay, what's going to happen to the company after pedophies gone? Like, it's sold. Is something going to magically happen? I, you know, my, my base case. here is I think Milan is very close resemblance to pedrophy. There's definitely been some indications that on the margin, he's tried to do things. If you look at the direction of the platform,

it's definitely gotten a little bit more U.X friendly, more user friendly. We'll see. Maybe they also don't do a lot of marketing. I think the interesting thing that could happen is if the company tries to make a play to be a bit more mass market and be a bit more. bit more user-friendly and to really try to capture, you know, try to close the gap between Schwab, which has 33 million brokerage accounts, interactive, which has 2 million, you know, there is a really big opportunity for IB. And look at Robin Hood. I mean, Robin Hood has 25 million accounts, and it wasn't even a thing 10 years ago. So there is an opportunity for IB to capture, and it's really just a question of like, does Milan kind of lean into the more sophisticated,

the more global niche that they've dominated, or do they kind of steer the ship a little bit differently and go for more of like a mass market play in addition to retaining the existing business that they have? Let me wrap up with one, just kind of switch tax completely and wrap up with one question, which I always like to ask. And that's capital allocation here, right? And the company, unless I'm completely mistaken,

I mean, they bought back the tiniest amount of shares, right? they don't really buy back shares. And I think anybody who looks at the company, inside ownership is not a problem. Again, they own like 75%. But, you know, Thomas has been selling 40,000 shares per day every day for basically the past two years. That's two to three million dollars worth per day. Like, it must be nice to be able to sell that and basically make it not even have a dent

in your share ownership. But I think a lot of people look and say, hey, these guys are very astute. the stock doesn't trade that cheaply, as we talked about the headline price earnings number earlier. You've got the CEO selling 40,000, the chairman's selling 40,000 shares every day, and they're not buying back shares despite a really nice capital position. So, you know, is it that cheap? Just toss it over to you, capital allocation, all that type of stuff. Yeah, it's been an area that I've pressed the company on. Schwab, which just full disclosure, we're also long Schwab,

has recently announced a massive buyback program and that's at the tail end of building capital for a long period of time IB continues to be in capital building mode

and when I've asked the company well why don't you why don't you do buybacks and the first answer is actually pretty logical which is okay well our flow isn't that great so that's always going to be the first response right yeah a lot of our

institutions are outstanding need the flow. Yeah. Right. So then the next question is, well, why don't you buy, why don't you just directly buy Thomas and stock since he's selling it every day? And then the answer is, well, we don't know if that would be, we don't want anything to look like we're doing, we don't want to do anything that wouldn't look above

board. Yeah. And it's like, okay, well, like, there's, there's, there's interesting questions that you had there. And then, but really that the real answer that they seem to be coming back to. And I think actually the answer could change depending on the interest rate environment. But the real answer they keep coming back to is, hey, we are growing our account base at 30% per year. We intend to keep growing our account base at a 20 plus percent rate per year sustainably.

As we grow our account base, we need to keep building our equity. We're earning, you know, in excess, I believe that they're earning in excess of 20 to 30 percent return on equity on accounts, on incremental accounts that they're adding. That's a very good investment for them to make. And they do have this in the back of their head where it's like, you know, we want to make sure we have a very conservative capital structure such that worse comes to worse, we could survive the next financial crisis or we could survive the next run on the bank. So I view it as their view on capital allocation is they're basically investing for growth. by building their equity capital,

simultaneous with the fact that they're very, very conservative. Now, if rates stay high, if rates don't immediately go back to zero, they're gonna, they're gonna be a cash flow machine. They're gonna have weight, they're gonna generate a ton of excess capital. I think that they would probably do a special dividend or do something to return capital.

But yeah, like I, you know, I'm pretty, happy with reinvesting in a business when it has a very attractive long, long runway. So I'm okay with capital allocation here. I think eventually they can eventually Thomas is going to, it's going to transition. He's, you know, approaching his 80s. At some point, I think the story on capital allocation could shift, right, if the float changes. So we've seen what other companies in the industry are doing. I think Schwab is kind of leading the way there. And I'm just going to give everybody a tip.

Obviously, I think this idea is interesting. If anybody goes and does work on it, the first thing that jumped out to me, and I'll short-circuit it for you, if you go back to 2015, you'll say, oh, there were 64 million shares outstanding. And then you come today, you'll see 100 million and be like, this company's, though, compounder their issuing shares left and right. And the answer is, no, they're not. What happens is, again, that LLC structure, as Thomas continues to sell down his state, those shares shift into the public market. So if you look at Bloomberg or something, you're going to see share count increasing, but actual the economic shares outstanding, if that makes sense, have stayed flat or shrunk over that time just to kind of alleviate those concerns.

Do you want to add anything to that or did I miss it? No, I mean, and the net benefit of that is that as the float becomes more widely available, it gives institutional investors more access to the company, which has the potential to help support the stock. Perfect. Hey, I think we've covered a lot. We're a little bit over our hour, but just want to make sure any, any last thoughts here, anything we didn't hit hard enough that you wish we had hit harder or anything I kind of glossed over that. Yeah, there is one thing that I think that I really like about this, which is just the fact that I think, I think the risk reward is very good, regardless of if rates go up or if race go back to zero. So effectively, If rates go back to zero, I think you see a lot of the KPI metrics kind of revert. I think people start trading more again. I think people get more excited about the markets.

I think there's valuation support. If rates stay high, it's a pretty massive, it's a pretty massive bump. And one of the reasons why I think the interest trade call option is fundamentally misprice is because there's a scenario where rates go down, but they don't go to zero. Like, let's say inflation is somewhat sticky, but the economy is still in a recession, do interest rates go to two or do they go to one? Anything above zero is actually a significant tailwind relative to the historical metrics for this company. And I do like just in the context of a portfolio where most of my investments are beneficiaries of lower interest rates. I've been surprised how many of my investments, it turns out, have been so.

interest rate dependent. I absolutely hear you there. I don't mind having something that could actually benefit if rates don't immediately go back to zero. It is an interesting way to think about it, right? Like, look, we're not talking about interest rate. What if interest rates aren't zero anymore? Like, they're not zero anymore. So these guys, this quarter especially, in Q4, you'll see the real full run rate of it. They're going to make a lot more in net interest margin from that. So you get that benefit. And then if you said, oh, what if rates go to back to zero, as you said, okay, they're just going to go back to what they did in net interest last year. But you should be talking about multiples across the board going up. As we've seen, like multiples are really

interest rate dependent. So you do kind of get some good from both worlds here. I think that's a really interesting way. The problem I have with most interest rate stories here is that if interest rates go back to zero, I have no interest in owning the security. But in this case, first of all, you're not paying for that interest rate call option. Secondly, if interest rates go back to zero, there's actually things that benefit them too. So it's pretty well hedged in my opinion. Fantastic. Fantastic. Cool. Well, hey, this has been great. We've done two. You sit two desks away from me at the WeWork. So I'll have to badger you back on about having you on for a third time here. But this has been fantastic. Thanks so much for coming on.

to include a link to your write-up, which I believe the write-up was public on your, it's review, right? You do it a review, not a substat. I have it. I have a version of the write-up on my website. Okay. So I'll be sure to include that. I'll link to that. In the show notes, I'll be sure to include a link to your Twitter. So if people can go find you on there if they want to talk more about interactive broker. But at least, thank you so much for coming on and we'll chat soon. Thanks, Andrew. A quick disclaimer, nothing on this podcast should be considered an investment advice. Guests or the hosts may have positions in any of the stocks mentioned during this podcast.

Please do your own work and consult a financial advisor. Thanks.