Business Breakdowns
· Jacopo Di Nardo
[00:00:00] S2: It's really a combination of everything you've mentioned. I think to an extent today the ROE of a business, we can look at it in two ways. One is obviously including the excess capital and one is excluding it. One thing you realize quite quickly is actually how capital-light it is compared to normal financials, especially when you back out the excess capital. So it might make 15 to 20% ROE, including the 19 billions of excess capital, but it might make 10, 15 times as much excluding that. Earnings and price to earnings, normalized earnings are also another way we look at it. So sticking in our own assumptions obviously of accounts growth and trades per account and commissions, and then looking at what a normalized and average net interest income could be given the prevailing rates of interest around the world. But as you say, it is not one of the simplest businesses to value on either of the two metrics. So we do focus really on both and see how both interact with each other at the same time. We do not feel yet confident enough to assume a significant capital return of the excess capital. So we let it build in our model with our mind going 5, 10, 15, 20 years from now, what will that capital eventually earn? But so far I think they've proven to be fairly good stewards of it.
· Freddie Lait
[00:00:00] S1: One other way to think about it is to invert it. Given the competitive advantages, given the demonstrable success across these verticals, which are all very nascent, given the arguments we've made around the sort of the limited reduction in revenue per account, either from NIM Sensitivity, which will bobble around or from the commissions and trading per account, you're making roughly $1,500 an account in revenues at the moment. What's the probability they can get to 10 or they can get to 20, thus making 15 or 30 billion dollars in revenues? And they make a 75% operating margin. I think they make a 75% net margin. It'll probably be around there. It could go up a little higher. But that's with their generous offering back. You're talking about a very profitable, rapidly growing business. And the question one really needs to ask is: who's going to stop that happening? Is there a competitor in the marketplace that will stop that? If not, how fast or how slow will it happen is the bigger question. And something Thomas has said is we can grow at 30% with no advertising. We can probably grow at 40, 50% if we do more targeted advertising. But they're not looking to do that right now. But I do think they could accelerate the account growth if they wanted to because there's a lever they haven't pulled yet.
· Zack Fuss
[00:00:00] S0: Obviously much of what has been said about this business has been overwhelmingly positive. But when you're dealing with a business that interacts with leverage, margin, long and short side of the investment industry, there's inherent risks. I would love to hear about how you guys assess those risks and maybe some of the stress tests the business has faced. Even as recent as a few weeks ago, we saw the broader market sell off 10, 15, 20%. And what that meant for their business, I think, would show kind of the resilience and durability of the model that they have here.
· Freddie Lait
[00:00:00] S1: Yeah, I think one of the key things to remember if anyone else goes away from this and analyzes the business is that this was a market-making business in a large part as well in the past. So it's very different to 2009, and 2014 was the day where they really exited most of that business. So this is now a middleman, a broker, far more than the sort of asset risk. So the risk, as you say, slightly lies in that margin loan piece and their ability to risk-manage and collateralize against those loans. Because obviously when they make these loans or they do the securities lending, they take and hold collateral, and something Jacopo mentioned earlier, these accounts are stopped out automatically now as if and whenever they get too close to that margin limit. And so it's all an automated process they have. They claim to have very good risk management systems, but I've never met a financial business that doesn't claim to have good risk management systems. So your question again is right: How have they fared through the last decade of quite a lot of stress tests? I'd argue whether Covid or big drawdowns in 2022 in the very popular stocks or the recent hit. Their largest loss was really from a very strange sort of move in the Swiss franc 10 or 12 years ago, maybe even 14 years ago, where they lost about 1% of their equity capital today. So a very bearable amount for a business that is multiple times capitalized. And through the recent turmoil of the last three to four or five years, it's de minimis the risks from margin, the losses, the bad account balances. It's not been an issue for the business. So the risk management system ex post has clearly been working.
· Jacopo Di Nardo
[00:00:00] S2: If you think about how financials businesses run into trouble, it's some sort of liquidity mismatch that exists between assets and liabilities. And I think in that, new investors to the company should take quite a bit of comfort. But most of the assets are really 30 days in duration. Now some of that is a function of how the yield curve has been looking for the past four or five years, which is flat to inverted. So there was no point in taking interest rate risk and duration risk in the capital of a business. But in general, I think the company has always taken a prudent approach to risk management. I think that again stems from probably Thomas's beginning as a market-making risk manager. And if you think about the mother of all stress tests, which was the great financial crisis when the business still owned a market-making business, one of the leading market-making businesses in options. The company decided quite early on in 2007 to stop making prices to customers in long-dated options, which eventually ended up being part of a market. But not a lot of people talk about today that was entirely illiquid and where losses just piled up. So I think analyzing the liquidity of the balance sheet and in general risk management choices is where one can get comfortable that downside risks are fairly well managed in terms of long-term risks. Freddie mentioned a little bit about competitive landscape and how it might evolve. I would add one to it which is, as you mentioned before, Zack, there has been a huge increase in participation in financial markets. Some of it is very healthy. New generations are learning earlier how to invest, and some of it is more akin to really gambling. And if you think about that and the ramifications it might have in terms of regulations in the future, or if losses actually pile up for retail investors, this is an area that is worth bearing in mind. You might have noticed that in the past 18 months they've been talking a little bit more about their new products called ForecastEx, which basically allows—it's almost like a sports betting platform on economic events—that allows customers to really express an opinion that is a yes or no on individual outcomes.
· Jacopo Di Nardo, Zack Fuss
It might be about inflation, about payrolls, and the simple fact that the CFTC initially didn't allow those products to go out because they were too akin to sports betting tells you that there is a component in financial markets today that goes through online brokerages that is more similar to gambling rather than what we would normally consider investing. [00:00:00] S0: And so a corollary to that last question is one that we always conclude with: lessons learned. When you guys evaluate this business, what can be applied to others? And from an operational perspective, what about the way that management runs this business do you think can be applied to other businesses to help drive better shareholder returns?