There has been much made in the press lately about how rising long-term yields will hurt stock and bond prices. Historically speaking, that is not a reliable assumption. Rising yields are usually correlated with rising stock prices, and as long as yields don’t rise uncontrollably, we would expect that correlation to remain intact in 2013. Some industry groups are particularly well positioned to benefit from even a small increase in yields. For example, this earnings season the big banks like JP Morgan Chase (JPM), Wells Fargo (WFC) and Citigroup (C) have exceeded profit expectations partially due to a more favorable yield spread environment.
Within the financial sector, discount brokers have really suffered in the low interest rate environment over the last 4 years. However, an increase in the yield environment would result in a windfall of additional revenue and profits without a reciprocal increase in costs. This upside exists for the same reasons higher interest rates have benefited the big banks.
Discount brokers accept deposits from their customers and pay a little interest on the unused cash balance. However, they earn a much larger premium on those same deposits. On average, this differential is just over 20 basis points (bps). A basis point is 1/100 of a percentage point. That average rate is roughly half what it was in 2009 due to the intervention of the Federal Reserve in the interest rate market.
20 bps may not sound like much, but when you have gathered $88 billion in assets over the last several years, just a few bps can make a big difference. In fact, a leading discount broker estimates that an increase of one percentage point in interest rates would bump earnings per share by 50% compared to the run-rate over the last 4 years. Investors know about this potential upside and have already been rewarding public brokers with the best operating margins with much higher stock prices. We think they can go much higher from here.
Who’s the Best in the Industry
Among the few public discount brokers there are a few leaders that we really like. Charles Schwab (SCHW) and TD Ameritrade (AMTD) are at the top of our list. There are a couple of undervalued companies like FXCM (FXCM) or Interactive Brokers (IBKR) that have stumbled over the last few years that could be interesting in the future. If higher interest rates in 2013 were an absolute certainty we may be more interested in the “dogs” of the industry immediately, but for now we will stick with the leaders.
We like AMTD the most within the industry for two reasons. First, they have done a better job than their peers at gathering assets from clients. They do this through a mix of service, education and premium software offerings. By the end of 2013 interest rate sensitive assets should be 40% more than they were in 2010, which represents a 10% growth rate year over year. That trend seems likely to continue, especially if the economy in North America remains stable.
Second, AMTD has spent an incredible amount of effort in establishing a dominant position as the public broker of choice for active investors. The real value of active investors has been hidden over the last few years because of market conditions. Low volatility in the largest asset classes like interest rates, futures, options, forex and stocks has kept activity muted over the last few years. That has kept commissions per trader lower than the historical average. This is something we would expect to change in the short term if the Fed is able to “taper” its involvement in the market. If volatility goes back to normal levels, traders will be more active and AMTD is positioned to benefit from that change.
Over 38% of AMTD’s client trades are derivatives, which are more profitable for the brokerage. This percentage is up considerably over historical averages and shows that AMTD’s clients are far more likely to trade higher margin products like options, futures and forex than their peers. In a business where base commissions for ETFs and stocks are nearly break-even for discount brokers, this is a significant advantage.
Click to EnlargeAMTD has already gained significantly this year. Not only was the company able to avoid the May-June market draw down but they are up 52% so far in 2013. Does this qualify as “too high” or is the bulk of the potential move still to come? We are quite optimistic about near-term prospects but even more conservative estimates indicate there is still plenty of upside for traders looking to profit from higher interest rates and trading volumes.
As you can see in the chart above, AMTD has been stuck in an $8 channel between 13.50 and 21.50 per share since 2006. There have been a few fakeouts at the top of the channel in 2011 and 2008 but nothing confirmed until now. A projection based on the width of the channel places an initial target just under $29 per share. If the stock continues to show momentum at that level we would raise the target to $40 per share by the end of 2013.
AMTD will be reporting earnings on July 23, which makes an entry at this point more risky, but we feel that the upside potential is much larger than the downside at this point. Getting into the trade before earnings is worth the risk. Even though it seems unlikely, some traders worried about a shock to the downside may opt for a call option where the downside is easier to predict over a long position in the stock.
Recommendation: We recommend buying AMTD at current levels with an initial target at $29 per share.
Options Alternative: Traders may consider the August 26 calls for 65 cents per share or less. Assuming the stock reaches the $29 target we would recommend closing the calls at that point and taking profits.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.