Let’s begin with a review of a few economic highlights from the third quarter of 2020:
Q3 2020
- Nearly 230,000 people have died in the U.S. from the virus, which has infected nearly 9 million in the country.
- As a result of coronavirus’ impact and the ensuing fiscal stimulus from the federal government, the real gross domestic product (GDP) increased at an annual rate of 33.1% in the third quarter of 2020 according to the "advance" estimate released by the Bureau of Economic Analysis. For comparison, in the second quarter, real GDP decreased 31.4%. These represent dramatic swings when compared to a typical year in which the US grows in average of 2-3%. Despite the recent massive increase the US GDP for the third quarter, the total economic output is still negative year to date.
- Employment in the United States is still more than 10 million jobs below its level in February.
Since my first commentary written back in April, the coronavirus pandemic has continued to ravage the country, and our economy as a whole. We have endured incalculable suffering, both in terms of human and economic loss. And yet, if you look at the performance of the S&P 500 index (commonly referred to as “the market”) is slightly above where the year began having increased by 1.2% as of market closing on October 30, 2020. While this seemingly does not make sense, it helps to dig a little bit deeper. Due to the success of the largest companies, specifically - Apple, Microsoft, Amazon, Google and Facebook - the index has become increasingly concentrated at the top. Those five companies now represent about 25% of the S&P index and their average performance of this year of 40% has lifted the entire index. There are still several public companies struggling, and this can be evidenced by viewing the performance of an equal weighted S&P 500 index that is down nearly 7% year-to-date by comparison.
I continue to employ a strategy of buying and holding quality companies, including four of the five aforementioned star companies buoying the market. The companies that survive the pandemic will emerge strong, having proven they can navigate the obstacles of a pandemic and all the resultant ripple effects.
Company Spotlight: Robinhood
Instead of focusing on a public company that I have invested in, I’d like to take some time to write about the profound impact that a privately held company has had on the financial services industry. Robinhood is the proverbial new-kid-on-the-block discount brokerage firm. Founded in 2013 by two brilliant millennial entrepreneurs, Vladimir Tenev, 33, and Baiju Bhatt, 35, the company’s mission statement is to “democratize finance for all,” and is named for the legendary medieval bandit who stole from the rich to give to the poor.
After the regulation of brokerage commissions occurred in May of 1975, pioneering firms like Charles Schwab appeared on the scene as the first so-called “discount brokerage” to offer 24-hour quotes and lower cost trading commissions. As trading costs fell, more investors dabbled in the market and low commission fees became a marketing tool for these brokerage companies to attract new accounts. Robinhood took this one step further by offering $0 commission trades and its popularity “forced” the incumbent discount brokerage firms such as Schwab, Fidelity, E-Trade, TD Ameritrade, and Morgan Stanley to follow suit.
On the surface, Robinhood is a well-intentioned FinTech company that aims to help the average Jane begin her investing journey, but there is a nefarious underbelly behind the supposedly righteous stated goals.
Robinhood is designed with many of the same “social psychology” and “growth hacking” tools used by the social media companies to promote engagement. The Robinhood app is free, easy to use, and just as addictive as any social media platform. For example, the app flashes with animations and vibrates whenever users buy stocks. With its user friendly interface and no commission fee to trade, combined with a $0 minimum account balance required to begin, the company has attracted more than 13 million accounts in only seven years; for comparison, Charles Schwab has just over 14 million accounts after nearly half a century in business. In fact, Robinhood has become such a disruptive force in the discount brokerage industry, that it has triggered consolidation among some of the biggest players. Having lost a meaningful revenue opportunity, some incumbents merged to increase their assets under management and lower their overall cost structure. This year alone Schwab purchased TD Ameritrade for $26 billion, and Morgan Stanley bought E*Trade for $13 billion.
So, without charging commissions to make trades, and no minimum account balance to begin, you might be asking yourself, how on earth does this company make money? As you can see from the chart below, Robinhood makes 70% of its revenue from PFOF or “payment for order flow.”
What is PFOF, and why does the fact that Robinhood earns a majority of its revenue from it fly in the face of its stated mission? Simply put, it is the legal practice of a brokerage firm selling order data to the “market makers” to execute trades. That may sound like jibberish, so let me attempt to explain it:
When you or I want to buy shares of a company, like Microsoft for example, we log into our online account and choose the number of shares to purchase. It looks like this:
There is a lot of information here, including the type of order you want to place, and the bid/ask prices. These are key terms when understanding what is happening behind the scenes that enables companies like Robinhood to not charge a commission. Instead, the cost is embedded within the investment itself.
But first, a couple of definitions:
Bid – This is an aggregated value that reflects what “the market” is willing to pay to BUY one share of a stock. In the case above, the price that is being offered to buy a share of Microsoft is $202.30.
Ask – The counter to what an investor is willing to buy a single share, the ask reflects what “the market” is willing to SELL a single share of a stock. In the case above, the price of that is being offered to sell a share of Microsoft is $202.53.
Bid/Ask Spread – Simply put, this is the value of the difference between what investors are willing to buy versus what those holding the stock are willing to sell a stock for. In the above example, the spread is 23 cents.
Whenever you are quoted the price of a stock, whether it’s on Yahoo Finance, or any app you use, the price shown is the midpoint between the bid/ask at that moment in time based on the aggregated orders. In the early days of the stock market, there was one exchange (think Eddie Murphy in the movie Trading Places) with middle aged men shouting offers to buy and sell shares of companies. Today, there are several exchanges that are operated by massive servers and data centers that process millions of trades every hour.
Brokerage firms do not actually execute the trades themselves. Instead, they route their orders to a “market maker,” a company like Citadel or Two Sigma, who will execute the trades. The market makers pay the brokerage firms to execute their trades. This process is called payment is called Payment for Order Flow. The market makers are willing to pay for the execute the trades because it arms them with data on how much people are willing to buy or sell a stock form. The market makers will then enter the exchanges and buy shares for slightly lower than the investors are willing to pay and then sell them to the Robinhood investor thereby executing the trade and pocketing the difference. While a penny here or there will have seemingly little direct impact, when executed at a scale in the hundreds of millions a day, the volume results in big money.
While Robinhood did not invent the practice of Payment for Order Flow, it derives a much higher portion of its revenues than the other firms and possibly warping its incentive structure. For example, Charles Shwab only derives 3% of its revenue from PFOF, compared to 75% for Robinhood.
What makes Robinhood’s account holders particularly attractive is that many of their users tend to trade frequently, and in volatile stocks that have wide bid/ask spread (the bigger the bid/ask spread, the more opportunity for a market maker to make money. The so-called “Robinhood traders” are thought to be responsible for the massive swings in bankrupt firms like Hertz and Kodak, with the resultant volatility seen as a feeding frenzy to the market makers.
The most lucrative type of trades for Robinhood that market makers will pay for are options trades. Options contracts at their core are represent a form of leverage that investors can use to give them the right to purchase or sell shares of a company at a predetermined price at a specified date. In fact, the investing platform gets paid more than three times for options deal flow than a comparable order of regular stock. This is due to options’ illiquid nature and higher bid/ask spread (remember that a wider spread equates to easier profits for market makers). A telling statistic is that while only 12% of Robinhood trade options, the revenue derived from their deal flow accounted for 62% of Robinhood’s PFOF revenues in the first half of 2020. Options contracts are investment tools that require a level of education to use properly, and without it can lead to disastrous results. Robinhood needs to improve access to educational modules, instead of enticing users to borrow money to trade these risky investment vehicles. I believe the firm is beginning to understand this fact after the worst possible scenario occurred with the devastating incidence of a college student taking his own life after thinking he owed the company $730,000 from a losing trade.
Final Thoughts
If Robinhood were a public company, I am not sure it is the type of company I will choose to invest in for myself or my clients. While I applaud Robinhood’s stated mission to democratize finance and increase the accessibility of investing in the stock market, I don’t agree with the opacity with which it earns its profits. In the end, I am happy to benefit from the lack of a commission fee when I make an investment, and my philosophy of owning companies for the long term is not harmed from the pennies shaved off by Citadel and others.
I am not in the business of “get rich quick” schemes that many Robinhood users seek. I continue to look to buy and hold companies with strong fundamentals and significant future growth opportunities. The process has yield strong results for me. I have generated returns of 16.24% over the past fifteen years (almost triple the S&P). So far this year, my clients have enjoyed positive returns and to date are on track to have net returns ranging between 30-47%, handily beating the S&P 500.
Thank you for taking the time to read my thoughts and perspective from the third quarter of 2020.
Samuel C. Muffly
Sources:
https://www.bea.gov/news/2020/gross-domestic-product-third-quarter-2020-advance-estimate
(https://www.cnbc.com/2020/10/29/us-gdp-report-third-quarter-2020.html)
https://www.forbes.com/advisor/investing/robinhood-bankrupt-hertz/
Important Notice: The above commentary is provided for informational purposes only, and should not be considered investment advice. Please do your own research before completing any financial transaction.
