Why Interactive Brokers is like a tech company: Money manager

On the latest segment of Yahoo Finance's Good Buy or Goodbye, anchor Julie Hyman is joined by Gabelli Funds Portfolio Manager Mac Sykes to discuss his portfolio recommendations for the financial services sector.

Sykes names Interactive Brokers (IBKR) as a buy, highlighting the company's substantial new client growth. He notes that Interactive Brokers has "built an incredible global moat" and is adding new clients through advertising and referrals. Sykes praises the company's impressive 70% pre-tax margins, saying the financial output is more akin to a technology company than a traditional financial services firm. Additionally, Sykes finds the company's valuation "compelling", with a favorable price-to-earnings ratio.

In contrast, Sykes identifies Upstart Holdings (UPST) as a stock to avoid. He notes that the company is not yet profitable, despite its innovative approach. Sykes also expresses concerns about Upstart's "lumpy revenue outlook" due to less demand for loans on its platform. Lastly, Sykes points to insider selling at the company, which he says "is not a confidence builder" for investors.

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This post was written by Angel Smith

Video transcript

[AUDIO LOGO]

JULIE HYMAN: It's a big noisy universe of stocks out there. Welcome to Good Buy or Goodbye. Our goal to help cut through that noise to navigate the best moves for your portfolio.

Today we're taking a look at financial services, which names are best positioned, which are best left behind. I'm here with Mac Sykes, Gabelli Funds portfolio manager. Thanks so much for being here.

MAC SYKES: Thank you for having me.

JULIE HYMAN: And you've covered financial services for a long time. So let's get to, first of all, the stock that you like here. And that's Interactive Brokers.

So interesting one. The stock's actually done pretty well over the past years we can see here. But let's run through your case, new client growth.

And this is interesting to me because IBKR's been around for a while. But we have had some other new brokerages come up. But they're still growing their client base.

MAC SYKES: So this is one of my favorite stocks, an incredible platform led by founder Thomas Peterffy. And they've just built an incredible global moat. And you see it in their client acquisition which is they've been growing over 20% plus over the last couple of years. And still pretty good visibility on that client growth. So they're obviously taking share on a global basis.

JULIE HYMAN: How are they getting those new clients in there?

MAC SYKES: So they do a lot of advertising. I also think they get a lot of referrals, too. I think people are very happy with the platform.

And then they're also their access to products. So they really have a more sophisticated platform. And so they're able to take advantage of that in terms of servicing clients.

JULIE HYMAN: Interesting. OK, let's get to your next point here. It's the margins on this business. 70% pre-tax margin.

MAC SYKES: Incredible, right? And if you think about financial services company, much lower in general for the industry. And yet here they are with 70% pre-tax margins.

And that's a reflection of their automation, the platform, the efficiency, and the ability to scale. So what you're getting is an incredible output of say a financial technology company. But you're getting it in a financial services company.

JULIE HYMAN: Interesting. All right. And then finally, there's the valuation here. You think the pay ratio is compelling at these levels.

MAC SYKES: Right. And so you add it up 20% plus growth, 70% margins, great capital generator. And it's trading at 17, 16 times earnings. So we think that's very compelling.

JULIE HYMAN: And just out of curiosity, interactive, their client base, the folks who are trading on it, how do they differ from other? Are they a more professional client base versus more retail? How does that look?

MAC SYKES: So they have a mix of clients. They got started with the self-directed professional traders, more active. They've evolved to serve as RIAs introductory, broker dealers, and also institutions as well.

So, at this point, it's pretty diversified. 2.7 million accounts. So plenty of room for growth, plenty of diversification in terms of the potential TAMs for those.

JULIE HYMAN: All right. And let's also talk about what could go wrong. We always like to point that out. And if we do see much lower interest rates, which especially after today is not looking like it's happening anytime soon. But what would be the effect here?

MAC SYKES: So they've benefited because they have huge balances, they have 460 billion of client equity. And that's in margin loans, credit, et cetera. And so they benefit from higher rates where they keep short duration securities. To the extent that we do get a lower rate, so let's say, maybe not today as we know, but 25 basis points decline. That would be about 60 million impact to net income.

And last year, interest income was about $2.8 billion. So it's about 2% impact to earnings, for a 25% decrease in rates. But over time, since you grow the balances, even though you might have a little lower rate, you eventually make up that income. So you're still on a pretty good growth trajectory even with the fluctuation of interest rates.

JULIE HYMAN: Gotcha. And do you hold shares of Interactive Brokers?

MAC SYKES: I do. Yeah, I do both personally and for our funds.

JULIE HYMAN: OK, all right, let's get to the stock you don't like here. That's upstart holdings. This is not as well-known a name, I think we can say. But it's a lender that operates online. And, first of all, it's not a profitable one.

MAC SYKES: Right. And Gabelli, one of our big folks is in terms of our research is we look for cash generative businesses. And this is a company, innovative platform, mobile application, very smart people running it. But at this point, they're still not profitable.

JULIE HYMAN: And what are some of the headwinds that you referred to as well?

MAC SYKES: So they do personal lending, auto lending. And we've had this incredible credit tailwind. And we're normalizing now. So as we come out of that, there's the potential for more write offs, bad loans, et cetera. So it'll be interesting to see how it comes out of the cycle.

JULIE HYMAN: And then also a lumpy revenue. What is causing that lumpiness in the revenue outlook?

MAC SYKES: So demand for their loans on their platform and how they're sourcing it. So a year ago, sequentially, they had about 4% increase in loans. But year-over-year, it was a 4% decrease.

And so they're testing the model. Obviously, they want to make sure they take on the right loans, et cetera. And so there's a little more lumpiness to it. So less visibility.

JULIE HYMAN: And then finally, we've seen some insider selling. We have a chart of this actually where we look at. Here we go. So this is the insider buying over the past three months versus selling. And then over the past 12 months, it's a little more notable that there's been a lot more selling. What's going on there?

MAC SYKES: Well, first of all, there some option exercises that sort of mask kind of this buying. But you can see that there's been some selling and consistency over the last 12 months. And there's a number of reasons for people to sell. I mean, to realize income, et cetera. But generally, when you have this degree of selling, it's not a confidence builder for investors like me looking to be interested in the business model.

JULIE HYMAN: So just like we talked about the risk to the upside for Interactive Brokers, the risk to your downside case here, is that the firm evolves that business model? Maybe get some more stability in that revenue.

MAC SYKES: So they're rapidly growing. They've taken some share in terms of personal lending, autos, et cetera. So to the extent that they can evolve the model into much more profitable entity and scale that up, then I think that would be of interest to us. But so far, we're a work in progress. And again, we have a discipline of being in those cash rich generative businesses.

JULIE HYMAN: Gotcha. And do you have any position one way or the other in upstart?

MAC SYKES: No.

JULIE HYMAN: OK. All right. Thanks so much. So let's summarize what you're telling people here by. Interactive Brokers for steady growth, solid margins, compelling price to earnings ratio. Avoid upstart at least for now for potential because of potential revenue headwinds and that revenue outlook also insider selling activity. Thanks so much, Mac. Appreciate you being here.

MAC SYKES: Thank you, Julie.

JULIE HYMAN: And thank you for watching Good Buy or Goodbye. We'll be bringing you new episodes three times a week at 3:30 PM Eastern.