For years, traders have used the adage “sell in May and go away” to suggest avoiding stocks for what have often been the disappointing returns of summer. Truth is, though, investors started selling in 2009 and stayed away for nearly half a decade.
Earlier this year, however, the retail investor showed signs of fully returning and embracing the market, just as it hit new highs. This may not be a good thing for investors, who have a track record of buying high and selling low. But it certainly is pleasant for the major discount brokerages – Charles Schwab Corp., E*Trade Financial Corp., and TD Ameritrade Holding Corp. – who serve them.
All three hit 52-week highs March 21, but have fallen 12 per cent to 20 per cent since, on concerns about perpetually low interest rates and potential new regulations. Investors who are bullish on the economy and capital markets may find all three are a buy – but each offers a different set of risks and rewards. The one with the Canadian connection may be the best buy of all.
Here’s the good news: trading data so far in 2014 suggest that online brokers “are potentially seeing a breakout in trading activity,” with levels above pre-crisis peaks, writes analyst Rob Rutschow of CLSA Americas LLC. The best trading volumes were posted in January and February; while the numbers fell slightly in March and April, they were still significantly above 2013 levels.
“We haven’t had this kind of strength in online trading for some time,” Ken Leon of Standard & Poor’s Capital IQ said in an interview. “And what’s interesting is that it seems to be stable-to-strong growth without the stories of crazy trading based on some sort of bubble market. It’s self-directed investors interested in being in equities.”
Every little extra trade counts – a lot. The brokerages have large fixed costs for their trading platforms. Once those are covered, however, “the added expense of an incremental trade is very small,” analyst Gaston Ceron of Morningstar said in an interview. “So a lot of it flows to the bottom line.”
In TD Ameritrade’s March 31 quarter, trades per day, and the revenue associated with them, rose 30 per cent year-over-year. Operating income rose 36 per cent, and its operating margin expanded by five full percentage points.
And yet, trading fees are not the only story. The discount brokers make interest income on the margin loans they make to customers. And while margin loan volume is up, it’s not up quite as much, on a per-account basis, as trading volume, CLSA’s Mr. Rutschow says. More importantly, interest rates have been near rock bottom for years. When they rise, the amounts the brokerages make on these loans will rise, too. Sharply.
“Retail trading is not going to be the biggest driver of earnings over the next two to three years – it’s going to be short-term interest rate moves,” Mr. Rutschow said in an interview. Schwab, which also manages money-market funds for its clients, has had to waive somewhere between $700-million (U.S.) and $800-million in fees on those funds to compensate for abnormally low returns. Mr. Rutschow figures they’ll get those fees back with a one percentage point increase in the U.S. Federal Funds rate.
Mr. Leon of Capital IQ said that “when you look at the entire investment bank/brokerage universe, Schwab is probably best-positioned to benefit from a rise in interest rates.”
Each of the three discount brokers has taken steps over the years to diversify their earnings beyond the individual traders who have been AWOL the last five years. Schwab’s fund management and other services for registered investment advisers is a good example of that. E*Trade’s decision during the U.S. housing boom to engage in mortgage lending is another example, although it was a disaster for the company.
The March retreat in the three companies’ share prices was caused by two factors, analysts say. One was the frustrating reversal in interest rates, headed lower rather than higher, once again denting the thesis that rates are finally marching upward.
Another was the publication of (and publicity surrounding) the book Flash Boys by author Michael Lewis, in which he argued the stock market is rigged in part because big traders can pay for preferential treatment of their stock orders. All of the brokerages, to some degree, receive “payments for order flow,” as they’re called, and likely collect near-pure-profit on them. If that went away because of regulatory pressure, earnings would take a hit.
“I don’t think the practice will go away, so I think some of the concerns are somewhat overblown,” says Morningstar’s Mr. Ceron. “But it’s certainly clear the scrutiny of the practice hasn’t been a positive.”
It’s the mix of businesses at the three companies that is driving the stocks’ valuation – and creating differing views of which is the best buy.
A number of analysts are hesitant on Schwab, despite the franchise’s quality, because of its valuation. Mr. Rutschow has a “sell” rating on the company, noting it trades at a premium to TD Ameritrade even though its asset growth has been in the low to-mid single digits, compared with higher rates at TD Ameritrade. This suggests Schwab is a buy only for investors who think interest rates are headed higher faster than most people expect.
E*Trade remains a turnaround story that’s generated a fair amount of excitement, with the shares tripling since late 2012. (They’re still more than 90 per cent below their high of March, 2006, however, suggesting amazing possibilities if it ever sheds its ill-considered mortgage business.) Its forward price-to-earnings ratio is below 20, according to Capital IQ. (Its trailing price-earnings ratio tops 40, indicating expectations are for quite the profit jump this year.)
That leaves TD Ameritrade as many analysts’ favourite, as its P/E of just under 20 is the lowest of the three. Toronto-Dominion Bank owns 40 per cent of the company, which helps shore up the broker’s credit rating and gives it access to U.S. federal deposit insurance for excess cash in brokerage accounts.
Mr. Rutschow, who has a “buy” on the stock and $39 target price, versus Friday’s close ofclose of $30.34, calls TD Ameritrade “smaller and perhaps more nimble” than Schwab and capable of higher growth. And Mr. Leon gives the stock his only “buy” rating of the three, saying “we felt there was a more attractive entry point on valuation, and TD Ameritrade can execute well from its performance in the first quarter.”
If investors make one trade after May, perhaps it should be buying TD Ameritrade.