TheStreet.com held its Net Stock Summit on Friday in its lower Manhattan offices. This is the fourth installment of the edited transcript of the Summit, which TSC is publishing throughout the week. (Click here for Part 1, here for Part 2 and here for Part 3.) This installment looks at the effect online brokers may have on Wall Street's white-shoe firms. An archived audio version of the Summit is available here.
Let's focus on one of the more specific areas where the Internet's having an impact and that is the online broker world. We asked our readers whether online brokers will kill off white-shoe Wall Street firms. I'm not sure whether non-white-shoe Wall Street firms will be OK, but apparently they're in better shape: 38% polled agreed that the online brokers would kill off the white-shoe Wall Street firms and 62% disagreed. We're talking philosophically about the impact of the Internet, on a specific industry that everyone here is familiar with. I won't ask Henry to jump in right away, so Brian, when you think about the online brokers, the Internet and Wall Street as they exist today, first of all, what do you think is changing? Second of all, what are the investment opportunities that change is creating?
Obviously the biggest change is that you're enabling people to take more control over their own investing and at a lower price. It gives freedom to individuals who choose to do that. We have invested in a few of the online brokers because we think they have tremendous growth in their future, but we are not believers that 100% of the investing retail public is going to go to the online side. There is still value in advice, there is still value in asset allocation, and there are some people that just don't want to take the time to do this.
I think, beyond just the Internet enabling this, the bull market is pushing this, and investing is a hobby now. My mother calls me a couple times a week to ask about my favorite stock picks and to compare them with hers. She knows very little more about a company than how to spell their name. Investing has become a hobby, and these online brokers allow people to engage in their hobbies. Regarding the comment before that a bull market makes a lot of people think that they're smart; that kind of mentality drives growths for a lot of these companies. Over time, the market will get more selective. People will find out that they don't like $8 commissions when they lost 70% of their investment. That might push some more people who are geared for the traditional back in the back space. But, those who take the time, who do the research, who understand what they're buying, I think will continue to use online brokers. I think that there's growth in both areas.
"Over time, the market will get more selective. People will find out that they don't like $8 commissions when they lost 70% of their investment." -- Brian Salerno
Jim, do you think online brokers are a threat to Wall Street brokers?
Well, I'm long
. I'm long Merrill Lynch because at certain points when
passed Merrill Lynch in value, I think Schwab's a very good company, but I think that was a misunderstanding of the business model of Merrill Lynch and a belief in an image of where Schwab could go. Merrill does not make a lot of money off commissions. It happens to be a great repository of assets, which is a terrific, fabulous business to have the credit balance without any kind of building of real estate risk a bank would take or a third-country risk. Merrill does not have a lot of risk from Indonesian bad bank loans. Merrill is a super bank with a great brand name that has been penalized because the people who are running Merrill are trying to come up with a business model that allows for online trading without hurting the 3,000 or 4,000 top producers in the firm. In the meantime, everyone has written them off at a time when their business is quite strong.
So I think that it's an investment opportunity. I am also conscious of what Andy says. Am I long Merrill Lynch because I think that it has a great long-term future? I think it's mispriced. I don't know whether Merrill Lynch in the 70s is
at 40, and Gannett went out today at 66; Gannett is being overly penalized. I don't know whether Merrill can grow as fast as it would like, given that it doesn't have a good commission stream coming. But Merrill is a different creature from what the online people think. It's a good institution that is extremely profitable.
That said, I think the notion of high-priced commissions, even with human help, is history because there's not enough provability between the people who lose money for you who are brokers and the people who lose money for themselves without brokers. When I was a broker at
, I always thought I did a good job, but I was in a bull market the whole time I was there. I think it's just as easy to lose money with a real, live broker as it is to lose money by yourself. There are some people who have the time and they want to do it by themselves, and I support that. I've been trying to be a champion of that, but there are other people who don't have the time or the inclination, and there will always be a few brokers who do a great job for them.
Does everybody just walk away happy at the end of the day?
Firms with a large number of brokers, meaning three offices in Milwaukee or something, that's the cavalry, and they need to build tanks. Now Merrill Lynch picked up this back-office, online trading system from
. So they're at least doing the right thing.
The other thing I learned from working on the sell side is that the salaries on Wall Street are
paid out of commission. So it's a money-losing business. Money is made in the flow. If you get the business and you get in the flow, that's number one; and number two is on investment banking fees. I was told, Andy, you're not going to make money -- I worked at
-- you're not going to make money for the firm at 6 cents a share or 60 cents a share. You're gonna make money in this firm on a 7% investment -- IPO fees. I think that online trading is a weapon for
Wall Street firms, and everyone, I think, is moving rather quickly to implement them.
a good investment?
I'll let you know this is actually an area that we stayed away from. Last year it was a good move; this year, you second-guess yourself. You see E*Trade going up 10 points a day. In general, we try to steer clear of companies or industries where the underlying fundamentals are deteriorating. What we've noticed with this industry is that although it's a hyper-growth industry, as are a lot of Internet companies, depending on which company is pushing down the gas pedal under sales and marketing in any given quarter, that's when they tend to acquire the most customers.
So I think with businesses with these fundamentals, they will clearly go down. There will be $6 trades and $2 trades. Even though we've had a little stability here, someone will come in and mix it up a little bit. We're pretty sure about that. And quite frankly, I think as takeover candidates they look attractive, but not at these prices. And we generally will stay away from companies just in the hopes of being taken out. We want to feel comfortable owning a company based on its underlying fundamental growth and where we see it maybe three, four, five years out.
With Merrill Lynch today buying the back-office trading infrastructure from D.E. Shaw says that, 'Hey, maybe they're going to build instead of buy here, and maybe they've already looked at it internally.' I don't think that's a real positive implication either.
"I think with businesses with these fundamentals, they will clearly go down. There will be $6 trades and $2 trades. Even though we've had a little stability here, someone will come in and mix it up a little bit." -- Ryan Jacob
If I could add something here. Some people view the installed base of brokers at brokerage houses as a liability. I would like to say I don't think you should underestimate the value of customer touch. Churn rate of customers is not discussed enough as we talk about everything being online and everything being low-commissioned. I think the ones who are investing have done a good job at keeping churn rates lower than their target rate.
The example comes to mind that
, an ISP, calls their customers if they can. They try to call their customer within the first month that they're using the service. And they notice that it cuts down the churn rate by X percent, 30%, 40%, 50%, 60%. If you just say hello to somebody and say, 'I care about you,' I think that's one thing that the Internet is going to enable for companies all over, even in old-line businesses. The Internet will serve as a whole one-to-one marketing, mass-customization from being able to reach your customer. If you don't love your customer, if you don't show them that they matter to you, they're going to leave. I think that applies to the brokerage industry as well as something as simple as the PC industry.
I own a
PC at home. I bought it two years ago. They've never called me. Why? They know who I am. I dealt with them directly. They should. They should be calling me. And when companies realize that, they'll realize that the value of their company is no longer in the real estate they live in, the building they built to make their machines, but their value is in their installed base of customers. That's the true aspect of a company.
Here's a specific, maybe not so specific to Merrill, but there are two other things. One is that traditional Wall Street companies spend more of their percentage of sales on computers than any other industry. When I was at
, I used to spend about $2 million a year on computer systems and services. That may be a little unusual to hear, but I dealt with computer people at Merrill and that is one of the most technically proficient companies in the world, and they are an e-commerce company. You can use all that asset pile and that huge customer list to generate fees, for paying bills and all kinds of other things. They will definitely have a role in this.
It is astonishing to see an industry that knows computers so well not have more of a thrust online. It makes me wonder if they may sit back too long and have to pay top dollar to buy out some of the companies that are out there now.
What I don't understand is while speaking to a financial professor today, he's telling me about his students and how they're all day trading, and they're making money, and they're losing money, but the one thing they're doing is they're understanding investing. They're getting more involved in investing. Does that mean that 10 years from now investors will be more intelligent, so that when a broker calls them, they'll listen, and they can deal with a broker and weed out a bad broker?
But then again, once they get the hang of it, they will still do it and do it themselves. So I'm not sure about the hand-holding part of this whole thing and what role the brokers will play if it'll just be a pared-down sales force, because they'll have plenty of people who need and want good advice. I just don't know how that all fits into this scenario.
What's interesting is the issue of customer service and it's the issue of cultural intransigence, maybe at a Merrill or at a news company. It's interesting how these nonquantitative things have such a big impact.
It's just like in the record industry, this is a great thing for them and you don't see them reaching for it. That's actually kind of confusing.
Actually we're focusing on a Merrill or some of those companies that really haven't embraced online trading. There have been a couple of actually big success stories. One,
, they were very aggressive very early on in the market. And then another one is
, which they've done a fantastic job. And, you know, obviously they won't slap the Morgan Stanley brand on that until they decide to use
, but it's doing phenomenally well. So there are some that aren't getting it and there are some that actually are. They're not out there as much as E*Trade and Ameritrade, but some of them are getting it.
Why aren't they selling research for 5 bucks a page? That's what I don't understand, there's a couple of million people that actually would pay.
Present company excluded, it's not worth 5 bucks.
Yeah, but I'm kind of a grinder. Remember, I'm furnishing my house out of
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