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In 1951 Warren Buffett wrote up a stock pitch on Government Employees Insurance Co. (GEICO) and titled it “The Security I Like Best”. His pitched was largely based on the fact GEICO had “no agents or branch offices” and was therefore able to offer auto insurance to customers at “discounts running as high as 30%”. More impressively, GEICO was able to offer these discounts while maintaining a sizeable profit margin advantage over competitors (27.5% vs. 6.7% industry average). Legendary value investor Benjamin Graham served as Chairman at the time and “the 10 members of the Board of Directors owned approximately one – third of the outstanding stock”. Buffett also added that “In GEICO’s case, there is reason to believe the major portion of growth lies ahead”. Sounds like a pretty good pitch to me, and in hindsight his thesis played out with Berkshire earning a ~50x return on the stock before acquiring complete control in 1995.
I consider Interactive Brokers (IBKR) the “Security I Like Best” and think it shares many attributes with GEICO from 60 years ago. Starting with the most important aspect, I believe IBKR has a structural advantage in their low cost, automated brokerage operation. While competitors such as Schwab and Fidelity spend large sums on high-touch customer service, brick and mortar branches, and massive marketing campaigns, IBKR instead focuses on delivering the absolute lowest cost platform. How do they do this? CEO and Founder Thomas Peterffy explains it best:
“When I entered into this business some forty years ago, I was a computer programmer and ever since that time I have remained a computer programmer and surrounded myself with other computer programmers. So, unlike other businesses, we do not, as much, focus on sales ... which may be a problem ... but we focus on building technology. Our forte is to automate everything and everybody we can automate. That gives us the opportunity to service our customers at a much, much lower cost than our competitors do and for that reason we can charge very low commissions. So, it's magic. The magic is called automation.” – Thomas Peterffy, May 2014 interview
Automation is ingrained in the cultural DNA of Interactive Brokers. From the online application to the computer-entered trades, technology does the heavy lifting rather than people sitting on a trading floor. The composition of the company reflects this operating model:
“I’m a computer programmer, and so are all of the most important people in my company” and “Programmers outnumber other Interactive Brokers employees by a ratio of 5-to-1.” – Thomas Peterffy, November 2006 interview
The end result of this strategy is brokerage commissions that are significantly lower than competitors. Barron’s conducted a price comparison as part of their 2015 independent survey, which named IBKR the Best Online Broker for the 4th year in a row:
While claiming to be “discount brokers”, Schwab, TD and others operate a totally different model and are not capable of competing directly with IBKR. While targeting the “mass affluent”, these large brokers tout heat maps, buy signals, and other gimmicks in their constant stream of ads on TV. They each operate hundreds of branches with thousands of employees. The end result is commissions and fees that add up to total costs 2x – 3x more expensive than IBKR.
A natural follow-up question may be “why don’t Schwab and other automate as well?” This is of course a question Peterffy has faced many times, and his answer is succinct:
“They cannot do it the way we can do it because, as I said, we're computer programmers. They are businessmen.” – Peterffy, May 2014
It would probably be a better bet to start from scratch rather than attempt to mold a company like Schwab into IBKR, but even then they are 38 years behind when the fanatical Peterffy started.
“My idea is to create a platform that is so superior to anything else out there, so much more valuable and so much less expensive to use, that it will just sell itself” – Peterffy, 2006
Annual Advertising Expense
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While businesses can have many forms of competitive advantage, I consider the low-cost / scale advantage to be the strongest. This is because it is one of the few competitive edges that can actually widen over time. If I created a luxury brand that consumers find desirable, I can use that edge to charge an unusually high price on the item and earn excess returns on capital. However as my sales grow, I will be forced to water down the product to reach new markets, and my competitive edge will slowly narrow as my brand becomes generic (see Coach, Michael Kors, others). Conversely companies such as Amazon, GEICO, and Interactive Brokers are able to create a positive cycle or “flywheel” in which the benefits of serving as the low-cost provider only strengthen the moat over time: