Why Have Stock Exchanges Outperformed Discount Brokerages?

In the asset management space, discount brokers play a middleman role. They link consumers to exchanges where transactions are completed.

Here’s a look at how three major brokerage stocks have performed over the last five years compared to three major exchanges.

Figure 1: Total returns from 10/8/14 - 10/8/19; source: Bloomberg

Why have the exchanges outperformed so dramatically?

Exchanges are special businesses with unique competitive advantages and powerful network effects.

*     CME Group is the exclusive home of S&P 500 e-mini futures and is where 97% of all interest-rate futures in North America trade.

*     Nasdaq is known for its equity exchange, but also has proprietary data products and technologies it licenses at high margins, because there are no easy substitutes.

*     CBOE has pricing power tied to exclusive offerings like S&P 500 options and VIX futures.

CME, Nasdaq and CBOE boast operating margins of 55%, 41% and 44% respectively. Those numbers blow away the S&P 500’s operating margin of 13%.

Discount brokers like Charles Schwab and Ameritrade saw share prices plummet recently, after Schwab announced it was dropping its commission rate for U.S. equity and ETF trades from $4.95 to zero. It seems fitting the firm that pioneered the discount brokerage model back in the early 1970s is the first major brokerage to go all the way to zero.

Almost immediately, rivals E-Trade and TD Ameritrade followed suit.

A lot of folks are now left wondering what this new era of “free trading” means for investors going forward. And yet, it may turn out to be much ado about nothing.

“Declining per trade commissions have been an industry trend for decades,” per Stephen Biggar of Argus Research. “While the timing and extent of the drop is surprising, we see Schwab’s move as accelerating the inevitable.”

Schwab’s move was “inevitable,” because ruthless price wars are common in commoditized businesses. And that’s essentially what the modern trading landscape has become.

Trading commissions represent less than 10% of Schwab’s revenue, and it’s not where they make their margin. So, free commissions are essentially a loss leader to help funnel assets to other business lines, such as fixed income and asset management.

When you scale the numbers, zero commissions aren’t much of a gamechanger for customers, either.

Think about it: does a $4.95 charge to trade really put a dent in most people’s bottom-line?

Sure, cheaper trades help the average investor’s cause, but the most important thing is making smart investments.

Keeping with that spirit, I want to highlight a simple principle that can make you a better investor.

Try to avoid firms that play a “middleman” role

You don’t need to be an expert in Porter’s 5 Forces to understand why middlemen have a hard time surviving. Just recall why there aren’t milkmen anymore, and you will start to connect the dots.

It’s hard to differentiate in the middle of a supply chain. Without differentiation, there’s no pricing power. And without pricing power, it’s hard to achieve high profit margins.

This has always been an important business principle, yet it’s particularly relevant today. Around the world, the middle layers of supply chains are being gutted at lightning speed. Firms are feverishly cutting costs to stay competitive, because modern technology has created unprecedented price discovery. That also makes differentiation more important than ever.

Firms trying to compete on price alone are destined to face a grueling race to the bottom, which only the biggest players have any real chance of winning.

That’s what is transpiring in the field of asset management, evidenced by the price war between discount brokers like Schwab and E-Trade.  

It’s also happening in retail, evidenced by the price war between Amazon and Wal-Mart.

And it’s also happening in the cable industry, evidenced by the price war between streaming providers like Netflix and Disney.

If you stop to think about how many industries are experiencing price wars, it makes sense why there’s low inflation.

Low inflation can benefit consumers. However, it also creates a tougher environment for certain types of businesses (i.e. middlemen without pricing power).

The Producer Price Index (PPI) unexpectedly fell this week, suggesting weaker demand is likely forcing firms to cut prices. As shown below, changes in PPI have been a pretty good leading indicator for the Return on Equity (ROE) profile of the S&P 500. This may have implications for earnings season, which kicks off next week.

Disclosure: I own shares of CBOE in accounts I professionally manage.