Interactive Brokers / IEX / Commission-Free Brokerages

Interactive Brokers has always been the leading innovator in the brokerage realm. Normally companies that last 40 years get stale and eventually break when they can’t keep up with technological or market trends, but IBKR has been surprisingly agile and has most definitely been on the leading edge of the curve the whole time – being able to develop their business (e.g. TWS giving all of its users institutional-quality levels of market access), create a moat (e.g. TWS, margin rates, trading execution, and on and on), and also have the ability to get out of businesses that no longer work for them (e.g. the disposition of their market making).

They were the first brokerage available to retail customers that offered two-factor authentication, something that makes me sleep a lot better at night. I would not recommend using any brokerage that does not use two-factor authentication for serious amounts of money.

IBKR is slowly getting into the banking and cash management side of things, which is another huge avenue for future growth. They clearly have an organic growth policy so when this policy will eventually pay out in spades is unknown, but I think they are on the right track.

Unfortunately, IBKR’s stock is only 18% publicly available – the trading entity (IBKR) only owns a slim minority (17.8%) of shares of the operating firm. Most of the stock is owned by the founder and CEO, Thomas Peterffy, who I regard as the Steve Jobs of the online trading business. He has been outspoken on many issues concerning the brokerage world and one of them is the issue of high-frequency trading and brokerages effectively ripping off their own customers.

This is one of the reasons why Interactive Brokers decided to re-list their shares on IEX instead of Nasdaq, starting in October.

In one of the typical understatements by Peterffy, he states:

We at Interactive Brokers understand that being the first listing on a new exchange may entail certain risk, but we think that individual and institutional customers who own and trade our stock will receive better execution prices and that advantage will outweigh the risk.

Peterffy has an advantage in that he doesn’t have to care whether IBKR trades in liquid amounts, and indeed doesn’t even have to care how much IBKR stock trades for since they have no need or reason to raise capital. Indeed, one of their strategic purposes for IBKR stock to trade was as a marketing vessel for institutional clients and given the statistics IBKR releases, it seems to be working quite well. It was only about a decade ago that they made the corporate decision to actually spend money on advertising. IBKR’s rise is well worth the history lesson, but I won’t go into it too deeply here.

Instead, what I want to focus on is the upcoming hype that came with Wealthsimple Canada’s announcement that they will have a commission-free stock trading platform in Canada coming soon.

The question a customer should ask is how brokerages make money.

In short order, some answers are the following (in no particular order):

a) Trading commissions
b) Interest revenues on customer credit balances
c) Foreign exchange differentials
d) Margin interest (i.e. customers borrowing money from the brokerage to invest)
e) Stock lending (if a customer buys stock, the brokerage can lend them out for short selling, which they will earn interest for the borrow)
f) Selling (or using) customer trading data
g) Selling order flow

Item (g) is what I will focus on. Firms such as Virtu (Nasdaq: VIRT) make a lot of their “bread and butter” purchasing order flow from retail firms and giving their clients less than optimal executions. As a result, while customers can save $5 or $10 on a trading commission, they are instead paying for it with a reduction in the ability to shave more money from the bid-ask spread.

After Flash Boys, people have been more conscious of this, but your average retail investor only believes the cost of trading is the commission, which is most certainly not true.

While the actual dollar amounts are inconsequential when trading with low sized accounts and the choice of brokerage has little bearing on the overall result, trading execution becomes much more critical with higher amounts of money and choosing a brokerage that makes money by offering inferior trading executions will cost customers real amounts of money, well beyond any commissions that would be saved. The more a customer anticipates trading, especially in lower liquidity securities, the more they will likely lose in inferior execution costs.

In finance and business, there is nothing that is truly “free”, and commission-free trading is most certainly included in that category.

Past Comments – Trans-Mountain Pipeline

From my July 1, 2018 post:

Trans-Mountain Pipeline

This is a political disaster for the Liberals. It will be an even bigger political disaster when they try to tender the contracts to build the pipeline. It is a recipe for over budget, behind schedule politics, especially since the protestors know that any construction will be fueled by even more political pressure than it being built by a corporate entity. I do not believe this pipeline will be built even after the federal government bailed out Kinder Morgan Canada (TSX: KML).

Just remember, the government that can’t even build a gun registry or payroll system for themselves without spending more than a billion dollars of taxpayers’ money are trying to build an energy pipeline. Best of luck!

Obsession with dividend investing does not prevent capital losses

There are quite a few financial websites out there dedicated towards investing in dividend-bearing securities.

Some give the impression that it is nearly guaranteed to produce returns superior to the overall market.

In addition, a lot of them convey that the production of income through dividends is somehow “safer” than investing in major index ETFs.

In general, I do not have issues with dividend-bearing equities. In a lot of instances companies do not have proper places to re-allocate capital and giving it to shareholders is the right decision – especially if their stock price is high and the cost of their debt is low.

Where I have issues with dividend investing is in companies that have suspicious cash flow profiles or give cause to believe that their earnings profiles are going to be less than what is implied by their market pricing.

I’ll give an explicit example. Cineplex (TSX: CGX) I have written about in the past. Specifically in a May 2014 article (when the stock was trading at around $41), I was puzzled why the stock was doing so well given the “dinosaur” aspect of their business.

A lot of people though will take a look at their current 5.4% dividend yield (currently trading at $32/share) and blindly buy on the basis of that number alone. What will not be asked is whether this can be sustained or whether the business is fundamentally sound to generate sufficient cash flows in the future. Maybe it will, but there is an awful amount of risk for that 5.4%, much more than I could justify for my own (cowardly) risk profile. The 5.4% doesn’t compensate for the risk of future potential losses.

Another example that I have not written about in the past is Laurentian Bank (TSX: LB). This got on my radar back in June when their CMHC securitization issues hit the headlines. After doing some deep-dive research, while I believe the financial institution in general will continue to generate cash, I determined that better prices in the future could probably be had. Their last quarterly report was a prime example of mediocrity that one would expect from a centuries-old financial institution and their stock got hit 5% on the day after the report. Dividend investors were screaming “buy, buy, buy!”, looking at the juicy 6% yield and apparent value (then trading around 17% under book value). How can you lose? Today, it is down another 5% from the day after they reported earnings. It would take a year of dividends and a flat stock price to “catch up” to even.

The real test of the veracity of dividend investors is what happens when the capital value of their investments go south, and I am not talking 5-10% – when they start seeing 20-30% capital losses across their portfolios, will these dividends be nearly as important?

Just note this is not a prediction on the future outcome of CGX or LB or the market in general. It is simply a commentary that dividend investing is not risk-free magic and it requires just as much financial rigour as other types of investing. For common share investments, I’m agnostic towards companies that either give out or do not give out dividends or distributions. It factors little in my investment decision-making. I’m much more concerned about what management does with the capital they have.

Trans-Mountain Pipeline / Enbridge / TransCanada

Nobody is laughing out louder today than the management of Kinder Morgan (NYSE: KMI) who have sold their $5 billion pipeline (TSX: KML) to the government of Canada, when a federal court effectively ruled the trans-mountain expansion project to a halt (the reasons of which are not too relevant to the analysis in this post).

(Update, August 31, 2018: See Kinder Morgan’s “laughing to the bank” announcement here)

I’m ignoring the fact that the original Trans-Mountain pipeline still exists and still operates and pumps oil down to the old Chevron Burnaby refinery now owned by Parkland Fuels (TSX: PKI). There is enough pipeline capacity to supply the refinery, but not enough for any meaningful export quantities. This doesn’t make it a complete disaster for Canada, but they sure paid a lot more for it what it is worth.

There are two big economic winners with this court ruling, and it is not Kinder Morgan (they had their victory back in May when the Government of Canada agreed to the sale).

It is Enbridge (TSX: ENB) and TransCanada (TSX: TRP).

The only way to get meaningful amounts of oil out of Alberta and Saskatchewan (other than by much more expensive rail) is now going through the Enbridge Line 3 project or the TransCanada Keystone Pipeline.

(Here’s a map of oil and gas pipelines in Canada)

The economic losers are the Government of Canada, and every major oil producer in Alberta or Saskatchewan: they still have to go through Enbridge or TransCanada pipelines and pay a very heavy differential to prevailing energy prices for a long, long time. Inevitably this will hurt the Canadian public as the purchasing power of their currency will be less than what it could be had we actually have a fully functioning economy, but these indirect effects are typically never measured nor felt as the absence of an effect is rarely lamented in the minds of most people.

Politically, there is one big winner: The BC Government. Premier John Horgan has a huge victory to show to the environmental activist wing of his political party (the BC NDP) and this will give him more clearance to operate in the province without internal opposition (which is historically how the BC NDP loses power).

I am somewhat surprised Enbridge and TransCanada are not doing better in trading today.

Canadian Dollar vs. US Dollar

This chart has grabbed my attention over the past couple weeks:

The market is trading CAD up presumably on hopes that Canada and the USA can iron out some sort of trade deal on the NAFTA front. I’d be skeptical. The politics does not work very well for both President and Prime Minister for a quick agreement.

The other drivers of the Canadian currency are interest rates and the state of the commodity markets, and relative to the USA, neither appear to be favouring the Canadian dollar at the moment.

That said I do not pretend to understand all the nuances of Canadian dollar trading, so perhaps some other enlightened individuals can chime in.