The retail investor is back in the stock markets, buying stocks, dumping bonds, and generally becoming more active. This is usually a sign of a market top, as “mom and pop” traders tend to be late to the rally and early to a bust.
Some companies make more money on rising asset prices and activity. Let’s take a look at two different asset managers and brokerage firms:
TD Ameritrade Holding Corp. (NYSE:AMTD) delivers stellar operating margins of 36% on income derived from transaction fees and net interest margin on customer accounts. In the most recent quarter, commission revenue fell by 2%, with TD Ameritrade logging an average of 378,096 trades per day.
The company is growing solidly in its asset management and asset-based business. This segment grew 4% year-over-year with net interest margin coming in at 1.52% on its assets. The company is a perpetual float generator, taking in investor capital and investing it in positive carry assets that help it generate an income on its customers’ cash. Much of the spread is earned on the company’s margin offerings, whereby it uses free cash which can be loaned to investors trading on margin.
TD Ameritrade Holding Corp. (NYSE:AMTD) has unmatched exposure to an increase in trading activity and rising interest rates. Some 40% of revenue comes from the commissions, with the remaining coming from net interest margins.
One challenge remains: the firm needs to attract new clients inexpensively and keep trading activity high on fee-generating trades. The company’s foray into exchange-traded funds could put a damper on commissions. The company offers a very extensive collection of commission-free ETFs which its customers can buy and sell for free. Free customers can still be profitable, though, as unused assets can be levered for margin loans.
At 18 times forward earnings expectations, TD Ameritrade Holding Corp. (NYSE:AMTD) is worth a second look. Rising trading commissions and higher rates will lead this company to disproportionately large bottom-line growth.
Charles Schwab Corp (NYSE:SCHW)
Charles Schwab Corp (NYSE:SCHW)’s core business is in asset management, fee-generating accounts, and net interest margin, which make up nearly 80% of the company’s revenue. The company has lost some ground in trading, as its higher fees are less competitive in the world of online discount brokerage. Trading makes up less than 20% of its total revenue.
Exposure to asset management makes Charles Schwab Corp (NYSE:SCHW) a relatively “safer” bet on higher stock prices. Seeing as the company generates income as a percentage of assets under management, higher asst prices beget more fee income. Higher asset prices also tend to boost the company’s brokerage and transaction fee business.
Charles Schwab owns OptionsXpress, one of the most trusted and preferred brokerage services for option traders. This presents an opportunity for growth in capitalizing on a customer that has never been core to Charles Schwab Corp (NYSE:SCHW)’s asset management business.
The company trades at 21 times forward earnings estimates, which is rich given its reliance on interest rate policy to generate net interest margin.
Going long on brokerage firms
Brokerage firms have significantly more exposure to higher interest rates than they do transactions. Investors who want exposure to the capital markets would do better to invest in big-scale transactions: the buying and selling of businesses by businesses. Here’s 3 investments that capitalize on mergers and acquisitions.
Retail may be back, but until the market offers brokerage firms a bigger spread on margin accounts, the business simply isn’t particularly attractive. TD Ameritrade Holding Corp. (NYSE:AMTD) makes for the most compelling pick in the space, but investors should wait for the company to take a haircut – 18 times forward earnings is a high price to pay for a slow-grower with a binary catalyst in higher interest rates.
The article Retail Is Back: Buy the Brokers? originally appeared on Fool.com and is written by Jordan Wathen.
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