Monthly Archives: March 2015

Interactive Brokers as a GARP investment?

Interactive Brokers isn’t your typical value stock: it’s trading near an all-time high with a P/E ratio of 44x and a P/B ratio of 2.6x. But despite that the company managed to get a spot on my research list. It’s one part curiosity simply because I’m a customer at the firm and one part because I strongly believe that Interactive Brokers is awesome. I have experience with a large number of different brokerages and not a single one comes even close to Interactive Brokers. I’m clearly not the only investor who shares that opinion since the number of customers has grown at an almost 17% CAGR since 2008:

Account growth at Interactive BrokersWhen you look at a graph like that I think it’s pretty easy to justify a lofty multiple, but before we do that we should try to understand the business and the competitive landscape a bit better.

Business model

The first thing to realize is that Interactive Brokers is, despite their awesomeness, not a broker for everybody. They target sophisticated investors who already have significant experience, are more active than average and have more money than average. What they offer are, among other things, lower fees and better trade execution. For the past twelve months, IB reported that their customers average total trading cost was 1.2 basis points of trade value compared to daily VWAP (I’m sure you know this, but it’s worth emphasizing: one basis point is one one-hundredth of one percentage point!). Other brokers don’t disclose this statistic, and presumably for good reasons since they not only charge higher fees but also execute trades at worse prices.

IB all-in trading costs

IB can offer lower costs because of their superior technology that allows them to automate many aspects of their business. Technology is also part of the reason why they are able to execute trades at better prices: their order routing is better, and they don’t sell their customers order flow to internalizers. They also pass-through exchange rebates to customers which reduces the incentive to route customer orders to exchanges with a high rebate – that the broker can pocket – at the expense of price and/or fill rate.

Another good thing about their business model is that IB attracts the most valuable customers. Most electronic brokers have to spend a significant amount of money on advertising to attract customers, and most customers that they attract are small accounts from inexperienced investors. These accounts are not very profitable (if at all) because they usually don’t generate a lot of trading commissions and they do place a heavy load on the customer support department. I couldn’t find the source, but I do remember hearing that Binck – the biggest online broker in the Netherlands – is generating more than 80% of its revenues from just 0.1% of its customers. I think that’s bad news for Binck because exactly those large and active accounts can presumably gain a lot by switching to Interactive Brokers.

The latest annual report of Binck is in my opinion worth reading because they explain their business model very well. They write the following about their weaknesses:

  • Heavy dependency on volatile transaction income and a relatively small group of very active customers for online brokerage
  • High fixed cost base (infrastructure)
  • Still not enough volume to make optimal use of economies of scale

While IB’s fixed cost base is without a doubt higher than Binck’s their strengths are basically Binck weaknesses. They do have economies of scale and because of the rapid growth in customer accounts this competitive edge is only getting bigger. At the same time, they have an offering that is especially well tailored to the most valuable customers of other brokers. Binck’s risk is Interactive Brokers opportunity.

I think that looking at revenue/employee is a useful exercise that shows the combined impact of higher automation and having active customers at IB. They are generating by far the highest revenue/employee while – based on revenues – they are just a small brokerage. The fact that Binck is lacking economies of scale also shows nicely in this table:

Broker revenue per employee comparison

While Binck ($600M market cap) is of course very small compared to TD Ameritrade ($20B), Schwab ($39B) and E-Trade ($8.0B) I actually think that they probably don’t differ that much with regards to the type of customers that they have and attract. I bet they are also making the most money from a relative small number of active accounts: accounts that can gain a lot by switching. The latest presentation of IB has a nice slide that shows that many customers are indeed price sensitive and switching from the big US brokers to IB:

Effect of IB's low margin rates

What we see here is that IB has rapidly taken a large part of the pie, and for a good reason because IB offers margin loans at rates that are a magnitude lower than the competition. Customers that use margin are presumably predominantly the more sophisticated active traders. At the same time, this data point is not good news with regards to IB’s growth prospects since it seems that they have already managed to grab decent market share in the US. Tripple IB’s size and they have 100% of this market: that’s never going to happen.

Growth prospects

Luckily for IB the market is bigger than the US. Interactive Brokers already gets ~50% of revenue from outside the US, but I suspect that that number has a lot of room to grow. A large part of the readers of this blog are from the US, and I think that they probably don’t realize how good they have it with regards to broker options. Brokers like TD Ameritrade and Fidelity might not be cheap, but at least they are somewhat reasonable and not total crap. In many European and Asian countries, there are really no solid options. You get crap trading possibilities combined with sky-high fees for everything. I think that this is driving IB’s impressive growth in Asia:

Geographic shift IB customers

How far they can continue to grow is a tough question. IB’s CEO, Thomas Peterffy, is very bullish, expecting accelerating growth in the near term and a long runway. From the Q4 results conference call, when asked about account growth:

Thomas Peterffy – Chairman and CEO
All I can tell you is that I am surprised that it’s not ramping up faster. So I think that next year will be over 20%. That’s what I think.

And from the Q3 results conference call:

Thomas Peterffy – Chairman and CEO
Well, if you really want to know my honest opinion, I think that in 10 years we could be the biggest broker in the world, and I am not kidding, because our technology is way out ahead.

One thing to realize is that a growing number of customer accounts doesn’t directly translate into profits. The first graph that I posted in this article looked pretty sweet, but when we look at the number of trades that customers make we see that growth is lower and less consistent:

IBs growth in DARTsIt makes sense that the average number of daily trades is way more volatile than the number of accounts since it depends heavily on market volatility: clients don’t trade if nothing is happening in the market. But I do think it is telling that DARTs have grown at a CAGR of 8.8% since 2008 versus an account growth rate of 16.8%. I think that many of the most active traders have already made the switch to IB years ago: a lot of the low-hanging fruit has been picked.

The second major component of IB’s income is interest income and this source of revenue is better correlated to the number of accounts since IB’s customers use roughly 30% margin as percentage of their equity. Thanks to rising markets IB’s customers have steadily increased their average equity per account. Of course, there is a risk that a new crisis can undo all these gains. In 2014 approximately 56% of brokerage revenue consisted of commissions, 36% interest income and 8% other.


When valuing a growth stock I think it is often most useful to reverse engineer what kind of assumptions are required to justify the current market price, and see if you think those assumptions are (at the minimum) reasonable and something you can be comfortable with. Before we start with that we first need to understand IB’s corporate structure:

Corporate structure Interactive Brokers

The publicly traded stock is just a small part of the whole company, the remainder is still owned by Thomas Peterffy. The current market cap of the whole company is $13.6 billion, but this also included a market making unit with a book value of $1,036 million that consists of liquid securities. The market making unit is still generating a solid profit, but is at the same time struggling a bit in recent years because of competition from high-frequency traders. Simply valuing the market making business at book value is reasonable I think.

So that leaves us with a $12.6 billion value for the brokerage business, a segment that managed to generate $588.5 million in pretax earnings last year. IB is currently paying a tax rate of less than 10%, but as far as I understand that is caused by the fact that the company doesn’t recognize the tax payable by the IBG LLC partnership. Accounting for the fact that IB does a lot of business in foreign countries with a low tax rate, I think that using a 25% rate is reasonable.

A simplistic valuation can be made with the H-model that assumes that the initial high growth rate linearly declines in a certain number of years to a long-term growth rate. When we make the simplifying assumption that earnings are roughly equal to free cash flow we can use the following set of assumptions to arrive at a $12.6 billion valuation:

H-model valuation IB

It’s a very simple model, but I think these growth assumptions aren’t very aggressive nor is an 8% discount rate very low in today’s interest rate environment. The model also doesn’t account for operating leverage that is presumably present in IB’s business model.


IBKR is probably an interesting stock for people who specialize in buying growth at a reasonable price. The stock is not cheap, but you also don’t have to envision some extreme sky-is-the-limit story to justify the current price. One interesting question to ask yourself when you consider investing in IBKR: what’s your edge versus fellow investors? There are going to be a lot of smart investors who use the broker, understand their business model and know firsthand how they compare to the competition. IBKR isn’t some obscure stock that no-one knows about.


No position in IBKR

PV Crystalox Solar: now trading at 40% of NCAV

FFP was not the only portfolio company that reported annual results yesterday: PV Crystalox Solar also released their results. But unlike FFP it wasn’t all good news for Crystalox, and including yesterday’s decline the stock is now down ~65% since a year ago. Luckily the stock has been one of my smallest positions because the company already partly liquidated at the end of 2013. Since the management team had shown to be shareholder friendly I was happy to see if they would be able to turn the business around. Given the price decline and the availability of the latest results I thought this was a good moment to reevaluate my position in the stock. Is this an opportunity to add, or should it be jettisoned from the portfolio?

Asset value

The company has currently a market cap of just €19.5 million euro while net current asset value is a whopping €48.1 million. This means that Crystalox is trading at just 40% of net current asset value. That’s really cheap! Graham famously suggested buying stocks at less than 66% of NCAV: Crystalox needs to gain 65% just to hit that level. The balance sheet looks as following:

Crystalox balance sheet 2014

What we see here is that on the asset side the two biggest items are the cash balance and the inventory. While the solid cash position is nice, it is worrying that a lot of money has disappeared compared to the end of 2013 while at the same time the amount of inventories has ballooned. This is caused by the fact that the company is locked in (unfavorable) contracts to buy polysilicon (the raw material needed to create solar panels) while their production levels are very low. They try to trade the excess polysilicon, but obviously they haven’t been very successful in 2014. In the presentation that accompanied the results the company writes: “some improvement in polysilicon trading seen in Q1 2015”. So hopefully they will be able to turn some inventory back into cash soon.

Related to these contracts to buy polysilicon are the provisions on the liability side of the balance sheet. The good news is that these contracts will almost completely end in 2015 since €14.5 million in provisions are current liabilities while the non-current provisions are just €1 million. I think there is a good chance that these provisions are at the moment materially smaller because of the depreciation of the euro versus the dollar and the yen. In 2014 the company also recognized a huge exchange gain on their onerous contract provision, and in 2015 the euro has already declined as much as in the whole of 2014:

Crystalox onerous contract provision

While exchange rates were a positive influence in 2014 there was also a negative surprise in the form of an additional provision. Crystalox provides the following explanation for this:

These gains were offset by €9.7m of additional provision required as a result of movements in pricing assumptions where it has been seen over the past six months that the polysilicon sales price the Group has achieved no longer reflects the spot price. As such whilst quarterly negotiations have resulted in a ‘predictable’ purchase price (in that movements have broadly reflected spot movements), the price at which polysilicon can be sold has reduced resulting in an increased loss and therefore an increase in the provision.

Given their statement about better trading conditions in the first quarter of 2015 I think that at the moment the company is not at risk of needing to recognize more provisions, but of course anything can change during the rest of the year. The company has absolutely no influence on the pricing of polysilicon, and it’s certainly not a very predictable and rational market.

Cash flows

When I decided to hold on to my Crystalox positions one of the attractions was that management promised to operate roughly cashflow breakeven while trying to wait for better times. They did indeed manage to generate some operating cash flow in 2013, but operating cash flow was a very negative €15.6 million in 2014. The main cause of this was the increase in inventory: without growing inventory levels operating cash flow would have been a more manageable minus €878 thousand.

This doesn’t mean that I think operating cash flow breakeven is in the cards for 2015 if inventory levels don’t increase further. In 2014, they received a €8 million payment from a customer that had defaulted, and they generated a lot of cash from liquidating accounts receivable and other assets. They do expect another payment from a customer settlement in 2015, but that payment should be significantly lower than the €8 million received in 2014. Another long-term customer is simply not willing to pay, and Crystalox is trying to seek resolution through arbitrage by the International Court of Arbitration of the ICC in Paris.

To get an idea of the current earnings potential of the company I have made a quick EBITDA estimate based on the 2014 income statement, but with a couple of important adjustments to remove the effects of the one-time gains and losses:

Crystalox 2015 EBITDA estimate

The EBITDA estimate is a crude proxy for operating cash flow in 2015 and ignores the fact that they will need to spend a bunch of money to eliminate the onerous contract provision. While I don’t like to turn cold hard cash into raw materials inventory it’s the last year that they have to deal with this burden, and exchange rate movements should lessen the blow. Given exchange rate movements in 2015 we could perhaps expect a similar currency gain.

What will happen?

This year is probably not going to be a good year for Crystalox, and they are most likely going to burn through a bunch of cash unless they successfully manage to trade their excess polysilicon. But the company is trading at a huge discount to net current asset value, and management has shown that it is willing to do the rational thing and quit if it seems that losses will continue. In the 2014 annual results presentation, we can find the following slide:

PV Crystalox Solar 2015 outlook slide

That last bullet point seems to suggest to me that they will consider liquidating/selling the company if they are unable to develop a cost structure that allows the business to make money.


You can’t expect to find a solid business trading at 40% of NCAV, but considering the price I think Crystalox is actually alright. The business prospects are at the moment crap, but their balance sheet has a low amount of leverage and there is a large cash position. They are going to lose money next year: perhaps something around €10 million. Not pretty, but manageable with €48 million in net current assets. Most importantly I don’t think I have to worry about a cash burn that will continue into the indefinite future because I trust management to do the right thing if they need to.

So taking this all into consideration I have decided to more than triple my stake in Crystalox to a portfolio allocation of a bit more than 2%. It’s still not a big holding because I think you want to be reasonable diversified when you buy crappy net-nets.


Author is long Crystalox

FFP announces 2014 results, reinstates dividend

FFP, the French holding company that owns a large stake in Peugeot, announced their results for 2014 today. Since the portfolio contains mostly publicly traded securities the increase in NAV wasn’t a surprise, but the fact that the company decided to start paying a dividend was:

With the company returning to profit after two years of losses, the Board of Directors has decided to propose a dividend of €2.00 per share to shareholders in the General Meeting, of which €1.20 of ordinary dividend and €0.80 of special dividend.

The €2.00 dividend represent a 3% yield. It’s not a whole lot, but it is nice since it is a tangible way to get fair value out of a vehicle that is trading at a sizable discount. I have updated my spreadsheet based on the 2014 results and the sale of call options on Peugeot earlier this year by the holding company. The discount is now at 44%, just a few percentage points lower than when I initiated my position at the end of 2013:

NAV FFP based on 2014 results


Author is long FFP

Are fundamental weighted indices better?

While browsing around on the web today I encountered an article from early 2009 that argued that most/many claims that are made in favor of fundamentally weighted indices are flawed. Before continuing reading this post, I would suggest reading the article. It’s just three pages in a large font, and I don’t want to repeat the complete argument :).

Intuitively the argument for fundamentally weighted indices is compelling. If the market is not efficient then stocks that are overvalued have a bigger market cap than they should have and stocks that are undervalued have a smaller market cap than they should have. If you now buy this market you must by definition underperform compared to the case where every security is fairly valued, right? Or perhaps wrong? Can you argue with the example below?

Consider a two-company world. Company A has a fair value of $10 billion with a market value of $9 billion, and Company B has a fair value of $5 billion with a market value of $6 billion. If we have a $150,000 market-capweighted portfolio, it will have $90,000 in Company A, the undervalued company, and $60,000 in Company B, the overvalued company. It will not have most of its money in companies that are above fair value—it will have most of its money in the company that is below fair value.

He is absolutely right that you have more money in the undervalued company in this example than in the overvalued company! But what is important to note that the undervalued company is less undervalued than the overvalued company is overvalued. The result is that the total market value of both companies remains equal and, as a result, both market efficiencies offset each other. If you would buy the complete market it would cost you $15 billion in both cases and in both cases you get company A and company B. Doesn’t matter if you overpay $1 billion for company B and underpay $1 billion for company A. The net result is exactly the same!

So when we add as a constraint that if the market as a whole is fairly valued the conclusion that the author draws is inescapable: there is no hidden performance drag by buying a market cap weighted portfolio. If you don’t overpay for the market as a whole it doesn’t matter that for some individual securities you overpay and underpay for others.

But this is of course only true if the market as a whole is correctly valued. Whether or not this is true depends on how market inefficiencies manifest themselves. Let’s take a look at a market with two companies, but to make things even simpler both companies have a $10 billion fair value. Let’s say that on a single day there is a 50/50 probability that a company drifts 1% away from fair value, either up or down. After one day the market is expected to look as following:

Fair value Move Market cap
Company A $10 billion +1% $10.1 billion
Company B $10 billion -1% $9.9 billion
 Total $20 billion $20 billion

So it seems like everything is still well for the argument that market inefficiencies – represented by random movements away from fair value – don’t make a market cap weighted portfolio inferior compared to buying the stocks at intrinsic value. If you would buy the whole market you still get the same two companies at the same price!

While this model appears to be reasonable there is one major flaw, and that is the fact that these returns introduce a bias when we start compounding across multiple periods. A plus 1% return followed by a minus 1% returns doesn’t net out to zero. If we would alternate a long series of +1% returns and -1% returns the market cap of both companies would converge to zero. That wouldn’t make sense! To remove the bias from the expected returns we need to combine random movements of plus 1% with minus 0.9901%:

  • $10.0 billion * 1.01 = $10.1 billion
  • $10.1 billion * 0.990099 = $10.0 billion

What we are basically saying that market prices are log-normally distributed around fair value. The log-normal distribution is asymmetrical, as it should be because asset prices can’t go below zero. I think that by now you can guess what the impact will be if we redo our table:

Fair value Move Market cap
Company A $10 billion +1.00% $10.1 billion
Company B $10 billion -0.9901% $9.90099 billion
 Total $20 billion $20.00099 billion

Because of the small difference in the up- and down move we lose the result that the market as a whole remains fairly valued, and as a result, a market-cap weighted approach will be at a disadvantage compared to a fundamentally weighted approach. Buying these two companies at fair value is better than buying them at their combined market cap.

Is this a reasonable result? Small-caps stocks are known to outperform large-cap stocks. The traditional academic view is that the difference in performance is the result of differences in risk between small and large stocks, and to some extent that is probably true. But a part of the performance differential could also be caused by the fact that undervalued companies have a smaller market cap than overvalued companies when they have an identical intrinsic value.

So, to summarize: I think that the intuitive idea that a fundamentally weighted index should outperform a market cap weighted index is actually correct. Whether or not it works in practice depends on how inefficient the market is compared to the added trading costs that will be incurred by a fundamental weighting.

An unexpected catalyst for Rella Holding

Value investing often requires a leap of faith, especially when you buy something cheap with no real catalyst on the horizon. While Rella Holding had an active share repurchase program – so you could do far worse on the catalyst spectrum – I wouldn’t have expected that anything big would happen in the near future. Rella owns a large stake in Aller through non-voting B-shares, and the majority of the value of Rella is derived from the cash and securities that are owned by Aller. With insiders strongly at the helm at Aller – a struggling weeklies company – you wouldn’t expect any change anytime soon. See my write-up from 2012 for more details.

But when there is a large discount between intrinsic value and market price there is always the possibility that something good will happen. Yesterday Rella Holding announced that they would sell their complete stake in Aller to Aller and liquidate the company. Estimated distributions will be 77DKK per share versus a share price of 46.70DKK: representing a premium of 65%. I think it’s a reasonable fair price. My latest value estimate of Rella is a bit outdated, but the net current asset value + real estate values haven’t changed a lot:

Rella 2013 look-through balance sheet

They are paying a bit less than my estimated liquidation value of 83.40DKK/share, but I think that’s fine: to make a good deal it has to be a win-win for both parties. This transaction allows Rella shareholders to realize value and Aller can purchase a huge chunk of stock at a big discount to book value (and a slight discount to intrinsic value).

With the stock currently trading at 72.50DKK versus expected liquidation proceeds of 77DKK I think it also offers a good risk/reward for those wanting to play the merger arb game. The transaction is expected to close before 1 July 2015, and the two biggest shareholders of Aller, representing 87.8% of the outstanding A-shares, have already agreed to vote in favor of the transaction. The only thing that will be required is shareholder approval at Rella.


Long Rella. Might sell soon when the price is right