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Online
Brokerages Feel
Economic Pinch the Most
by Andrew Leckey
Your
personal portfolio may have endured some hard knocks in recent
months.
But imagine what brokerage
firms must feel like as they try to cope with 2001.
How low can you go?
There are lower trading volumes, lower stock prices, lower expectations
and lower earnings in their own bottom line. Revenues from initial
public offerings and mergers and acquisitions are lower as well.
The supposed power
of Internet trading, now 13 million customers strong, hasn't
broken their fall.
Online broker Ameritrade
Holding laid off 230 of its employees who answered customer calls,
while cost-cutting at discount giant Charles Schwab Corp. included
pay cuts for top bosses.
They're not alone,
for cutbacks and layoffs are the industry norm.
Even though the decline
in business has affected all brokerages, the greatest pressure
is on online brokers who must justify their enormous advertising
budgets. They also have an army of new customers they must satisfy
with good service if they are to successfully retain them long-term.
"We typically
see a summer slowdown in market volume, but this summer slowdown
has lasted 10 months," observed Matt Carrick, research analyst
with Gomez.com online industry consultants in Waltham, Mass.
"In addition, hyperactive traders, which includes day traders,
have declined from 50 percent of market share two year ago to
only 3 percent today."
Gomez.com is downscaling
its expectations for online trading growth, predicating that
brokerages will now emphasize holding the clients that they already
have. Its research indicates that the next wave of online growth
will be mainstream investors who are not as tech-savvy and therefore
require greater ease of service in placing trades.
Even though the stock
market has thrown a monkey wrench into the works, the potential
of the industry remains strong.
"I'm bullish on
the brokerage business overall because I think the asset flows,
the aging Baby Boomers and the demand for services will be very
strong," said Greg Smith, analyst with JP Morgan H&Q
in San Francisco. "There's room for both online and full-service
firms, since it would be hard for Merrill Lynch to compete at
$8 a trade, just as it would be difficult for (online firm) E*Trade
to compete in providing services to a $12 million customer."
As it stands now, investors
with $100,000 or less to put into the market are gravitating
toward online brokers, he said. As full-services brokers move
upscale, this opens up a bigger market for the online firms.
Still, earnings remain much more predictable at full-service
brokers who get paid based on assets, unlike the online firms
that are so dependent on transaction volume.
"Online brokers
are sensitive to trading velocity because commissions and payments
for order flow represent from 40 to 75 percent of their revenues,"
explained Matthew Vetto, Internet financial services analyst
with Salomon Smith Barney. "However, customers don't have
to worry, because the level of service continues to improve as
the industry adapts to this slower trading environment."
Stock prices of the
online brokers have been badly beaten up, and if you can envision
their long-term future, they appear to be bargains.
The stock of E*Trade
Group (Nasdaq: EGRP) is recommended by both Smith and Vetto.
It boasts a dominant brand and diversified earnings, with rapidly
growing online bank that is proving helpful in cross-selling
with brokerage clients. It now owns a mortgage originator as
well. Besides having 3 million customers and being poised for
international expansion, it could well become a takeover target
at some point.
Ameritrade (Nasdaq:
AMTD), known for its non-stop humorous commercials that encourage
average folks to trade stocks online, merits Vetto's "buy"
rating because of its proven effectiveness as a low-cost processor
of trades.
Knight Trading Group
(Nasdaq: NITE), a Smith stock recommendation, executes a
large volume of online orders and recently posted better-than-expected
earnings. Its core business is making markets in Nasdaq and listed
stocks, but it has lately seen its options business accelerate
significantly. It now hopes to repeat in Europe the same trading
success it has enjoyed in the U.S.
Full-services brokers
have remained in the trading hunt by adding online services to
their exiting business. Rather that fight'em, they joined'em.
"Online service
is not a business model but a feature or a function," contends
Mark Constant, senior research analyst with Lehman Bros. in San
Francisco. "There was a mistaken belief that the E-Trades
were going to destroy the full-service brokers, but all the full-service
brokers had to do was develop those same capabilities for their
existing and new customers."
His favorite brokerage
stock is Merrill Lynch (NYSE MER), a company that he believes
proves that better value, higher quality and more consistent
earnings growth are more easily found in the asset management
business than in the trading business.
Consumers should always
shop for the best service and price.
The top Internet brokers,
ranked by Gomez.com for ease of use, customer confidence, on-site
resources, services and cost, were recently: 1) Charles Schwab,
2) E*Trade, 3) Fidelity Investments; 4) DLJdirect and 5) TD Waterhouse.
The top Internet full-service
brokers, according to Gomez.com, were recently: 1) Merrill Lynch,
2) Morgan Stanley Dean Witter, 3) PaineWebber, 4) Salomon Smith
Barney and 5) Prudential Securities.
Editor's Note:
Andrew Leckey's column, "Successful Investing" appears
regularly in the print version of The Bull & Bear Financial
Report.
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