Robinhood Markets (HOOD, Financial) has certainly had its fair share of spotlights and controversy since entering the public markets in 2021. The trading app disrupted the industry and forced other big brokers to go commission free, which should be applauded by investors for increasing accessibility.
That doesn’t necessarily make the stock attractive as an investment, though. Now that we're past the big headline-making hype of Robinhood, does the company have long-term value as an investment prospect? The market cap has fallen to $8.78 billion, 72% below the IPO price, so one could say it is "cheap," though that only applies if the company can grow and become profitable.
The short-term risk with the stock is fairly high at this point given the declining macro environment putting a damper on trading activity, but the long-term, I believe the potential of the company to grow into a fintech powerhouse remains high as well.
Buffett and Munger on Robinhood
One of the big points against Robinhood is that Charlie Munger (Trades, Portfolio) and Warren Buffett (Trades, Portfolio) are not fans of this company. I can't blame them really. Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) did own 12% of Salomon Brothers in the early 1990’s when the company had a rogue trader submitting bids in excess of Treasury rules. Buffett had to step in, and well, we know how Salomon Brothers ended.
Given their history with Salomon Brothers, it's easy to see why Buffett and Munger dislike how Robinhood helps "gamify" the stock market. However, I'd argue the market has always been gamified with stock brokers calling to pitch hot tips decades before the Robinhood app. All Robinhood did was make life slightly easier for day traders.
Creating a better customer experience is not going to make it any more addictive for the gambler or trader who already has those tendencies. And for the long-term term investor, Robinhood offers a commission free trading platform that is second to none in terms of user interface technology.
The meme stock frenzy
Half a year before Robinhood went public, the company infamously halted trading of GameStop (GME, Financial) and several other trending stocks as the company faced challenges with platform capacity and financial obligations. As the short squeeze continued and GameStop soared, Robinhood found itself responsible for a greater amount of collateral than it possessed in order to settle the unexpected surge in trade volume.
Robinhood survived the first big meme stock meltup and GameStop stock is now down 75% from all-time highs. However, Robinhood's decision to halt trading of GameStop shares led to rumors among users that Citadel Securities might have directed the action. In response, the market maker issued a statement to refute this "absurd story."
Investors filed a lawsuit arguing that they incurred losses when unable to trade out of GameStop and related stocks. Citadel Securities, which executed a significant portion of Robinhood's trades at the time, operated under a widely-used industry model called payment for order flow. Court documents previously revealed high-level communication between Robinhood and Citadel Securities on the day trading restrictions were imposed. However, both companies denied the allegations that the trading halt was done to protect Citadel's and Robinhood's financial interests.
The speculation resulted in both parties participating in a House Financial Services Committee hearing. During the hearing, Citadel Securities founder Ken Griffin denied any wrongdoing, and in November 2021, the U.S. District Court dismissed a class-action lawsuit against Robinhood and Citadel, determining that there was no evidence of collusion between the two companies. With that ruling, the issue was considered resolved, though distrust was planted in the user base of Robinhood.
Payment for order flow
One of the reasons Robinhood is able to offer free trading is the revenue model called payment for order flow. Payment for order flow is a practice in which market makers such as Citadel Securities compensate brokerage firms for directing retail buy and sell orders to their systems rather than sending them directly to stock exchanges. This arrangement typically benefits all parties involved - including the retail trader.
In addition to enjoying zero commissions, traders and investors often receive better execution prices when using market orders, as their orders are matched within the venue's system. This frequently leads to price improvements compared to the NBBO (national best bid and offer).
In the past, brokerages had to pay fees to stock exchanges like NYSE and Nasdaq when a trade removed liquidity, and they charged clients commissions for each transaction. Nowadays, brokers avoid fees for removing liquidity from stock exchanges when routing retail orders to venues. Almost all major retail brokers now offer zero-commission trading for stocks and options. Robinhood was a huge part of that change.
In 2022, north of $3 billion was paid to leading retail brokerages TD Ameritrade, Robinhood, E*Trade, Charles Schwab (SCHW, Financial), Fidelity (FNF, Financial), Webull, TradeStation, Ally Invest, Bank of America (BAC, Financial) and Wells Fargo (WFC, Financial). So, it’s not just Robinhood that takes advantage of this. To look up the relevant disclosures, you can search “public 606 disclosure [brokerage name]."
In 2021, Robinhood’s pay for order flow (filed under brokerage commission on the income statement) accounted for more than 77% of its revenue. Last year, PFOF was less than 60% with interest and dividend income up big to $448 million.
Robinhood and the customer
What I find incredible is that Robinhood went from zero to 23 million funded accounts in less than a decade with around 11 million monthly active users in 2022. It didn’t acquire this many customers without an incredible customer experience. For comparison, Charles Schwab has 34 million accounts, albeit at much greater average size, that took around for 52 years to build.
Currently, Robinhood only has $62 billion in assets under management. This is mainly the result of offering free trades with zero account minimums. The average account size is only about $2,700, but at one point investors scoffed at online trading and today E*Trade has an average account size of $127,000. Robinhood could eventually get to that point or surpass it.
That said, there are two new products that Robinhood has introduced, and it has pulled ahead of competition again. The company just unveiled a 4.4% yield on uninvested cash with Gold Membership, which costs $5 a month. That also brings with it lower margin rates, real time data and instant deposits up to $50,000. Without the Gold Membership, the company still gives 1.5% interest on uninvested cash, better than most bank savings accounts. The other new product is the only one of its kind on the market and will likely be followed by many other brokers - an IRA with a 1.0% matching contribution. This is 100% a ploy for young and new investors. There are a ton of them out there that are not putting money into IRAs, and Robinhood wants to be the company for them.
What’s Robinhood worth?
Robinhood will not stay a money loser forever. In fact, the company is on track to turn a consistent profit within a few years according to its estimates By then, how big it could grow is anyone’s guess really. With a current market capitalization of $8.78 billion, the stock looks like a bargain to me considering the brand is still standing firm.
For a comparison, let’s look at a small competitor. Interactive Brokers (IBKR, Financial) has 1.68 million accounts with $373 billion in equity and a $222,000 average account size. On that, it generates $4 billion in revenue and has a market cap of $34 billion. It’ll be pretty hard for Robinhood to get the 23 million account holders to that size, but it doesn’t need to. On average, Robinhood just needs to get the average size to around $16,000 for total accounts, or $34,000 from monthly active users, to get to the same asset level.
Don’t rule out crypto either. Despite my own misgivings with Bitcoin and the others, crazy things can happen and crypto could become a permanent part of the financial system.
