Interactive Brokers (IBKR): The Anti-Buyback Stock
Long rate exposure, few buybacks, low cost, and ever accumulating assets
I am not typically one to see investments in terms of themes, buckets, or any other such neat categorisation. Adverse selection aside, I’m reminded that virtually all the successful business people I know became wealthy because of an association with just one business. However, at some point it’s unavoidable to notice that many of one’s investments more a accurately resemble one bet, than several.
As I look over my own portfolio, it is impossible not to notice how many of my positions have accumulated an ever more acute short rate exposure, despite varying levels of pricing power. While I tend to think that the inherent business positions of each of my holdings is enough to obviate any adverse rate environment, I have found it an interesting exercise to at least study some of the ‘quality’ businesses which have a decidedly different exposures.
In another life, I was interested (I wouldn’t say successful) in trading equity volatility. One of the first things you learn about ‘vol’ is that it has a fundamental connection with prevailing interest rates. Rising rates typically result in higher levels of volatility. The more extreme the rate of change in rates is, typically the more extreme the change in the vol regime is.
Long vol exposure, however, comes with a price - which is carry. This is the same kind of dynamic involved in purchasing insurance. You’ll pay premiums for the right to limit your exposure to, or benefit from, a particular set of outcomes. What makes investing in businesses interesting, as opposed to participating in the strictures of certain risk markets, is that from time to time you find situations where the laws of economic gravity get suspended. Sometimes you get to have your cake and eat it too.
Interactive Brokers IBKR 0.00%↑ is a name I know well. If I’m ever smart enough to actually buy it, it’ll be one of the few Peter Lynch type investments I might ever make. Many people reading this will also have first hand experience of its services - and perhaps that’s the point. IBKR is an institution for many people involved in financial markets (the traditional ones anyway), and it has a number of unique characteristics that make it the quintessential anti-Buyback business. These are:
A low cost value proposition (heresy around these parts), augmented by,
Scale advantages derived from proprietary technology that feed into efficient marketing,
Due to its conservative financial positioning, and the nature of its business, it has been a direct beneficiary of higher interest rates.
A great asset light business can often be run on negative equity, which infers an explicit short rate exposure. Holding cash in excess of the needs of the business infers an explicit long rate exposure, either through the interest that cash can earn or via the expectation of being able to make investments with that cash at more advantageous prices in the future. IBKR fits neatly into the latter category.
This conservative financial position is likely not just prudent, but intelligent given the customers and products that IBKR traffics in. It should go without saying that anything can happen in financial markets, and being well capitalised can allow for a financial business to be a beneficiary of market turbulence.
Without wanting to incur the wrath of the value investing Gods - I post the following:
IBKR’s similarities with the historic Geico are striking. It’s a relatively small player, with a structural cost advantage, that is almost destined to take a greater share of a large existing market, and the incumbent players can’t change due to internal incentives that make veering of course all but impossible.
Historical Context
“When I entered into this business some forty years ago, I was a computer programmer and ever since that time I have remained a computer programmer and surrounded myself with other computer programmers. So, unlike other businesses, we do not, as much, focus on sales ... which may be a problem ... but we focus on building technology. Our forte is to automate everything and everybody we can automate. That gives us the opportunity to service our customers at a much, much lower cost than our competitors do and for that reason we can charge very low commissions. So, it's magic. The magic is called automation.”1
Thomas Peterffy, Founder and Chairman of Interactive Brokers
Petterffy has a quintessentially American success story. An immigrant, he arrived in the United States in 1965 following his father who had fled Hungary after the failed 1956 revolution. He originally worked in architecture before fatefully picking up an interest in computer programming. As mentioned above, his predilection for engineering (and later computer programming) alluded to his life’s calling - automating everything!
Peterffy later worked for a software company that specialised in financial modelling. What he saw was an industry ripe for automation. Prior to the computer revolution, financial markets were rife with gatekeepers, toll bridges, and various other inefficiencies that kept a cadre of professionals well paid. Leaving his work in software, he bought a seat on the American Stock Exchange (AMEX), introducing the first hand held computers onto the floor in the 1980s. His initial work as a pit trader (read market maker), would birth the initial iteration of Interactive Brokers, Timber Hill.
Timber Hill effectively lead the electrification of trading across virtually all equity, futures, and options markets. From the late 1970s they slowly, but surely, became the dominant market marker across a slew of exchanges using computers to render up immediate fair pricing for pit traders. In the early 1990s Interactive Brokers Inc. was incorporated, and registered as a US broker dealer, primarily with the aim to offer the internal technology that they had built at Timber Hill to the wider investing community.
In the run up to the GFC, IBKR had two businesses. Firstly, the market making (MM) operations in equities and equity options world wide. While IBKR’s position as a market maker has changed significantly since this time, it did have some interesting properties. Typically the MM operations were long gamma, and vega. For the purpose of this discussion - this generally means that the firm stood to make a profit when realised volatility exceed implied volatility. They were also delta hedged at all times, meaning they were not taking directional risk in the markets they operated in. Aside from this, the MM business was driven by spreads (the difference between bids and asks in any given market), and volumes. It shouldn’t be a surprise that each of these fundamental drivers are cyclical. Volumes do well during speculative orgies, and also in crashing markets, but have historically tampered down after such episodes. This was certainly the case after the GFC. While MM was IBKR’s historic business, it was one that was reliant on continuing to be at the forefront of technological progress. The advent of high frequency trading outfits (HFTs) and collocation would prove to be a serious threat in this regard.
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