Robinhood Markets (NASDAQ: HOOD)

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January 30, 2024

One of the top contributors to the Fund in Q4 was a newly purchased position in Robinhood Markets. We understand this may surprise some of our partners as a money losing, VC-funded financial technology company appears to conflict with our investment history of preferring highly profitable companies with low valuations. We had followed Robinhood for several years before purchasing shares. In fact, we shorted the stock from December 2021 to April 2022. We continued to follow the stock and have admired Robinhood’s innovation of the mobile app, engagement with its customer base, and its introduction of zero-commission stock trading.

After reporting earnings in early November 2023, Robinhood’s stock declined 15% due to a slight adjustment in guidance as a result of changes in market interest rates as well as a seasonal slowdown in customer trading activity during September. We did not think either of these issues justified the stock declining 15%. We also believed the valuation was attractive and started to buy shares.

Here was our investment thesis when we purchased Robinhood in November 2023:

1. Robinhood was trading at $8.07, and its tangible book value was $7.92. This valued Robinhood at just above 1.0x book value. We felt this valuation provided a good amount of downside protection. In fact, Robinhood has been buying back its shares in recent quarters because of the low price. Robinhood is marginally profitable, and we do not see book value declining except in severe market scenarios.
2. Robinhood is growing accounts and consistently attracting new net assets from customers onto its platform on a monthly basis. Robinhood adds about 30,000 new accounts per month and attracts over $1.0 billion of customer inflows per month. At this rate of customer inflows, Robinhood is growing at an 18% per year rate without considering market appreciation from their customers’ investments.
3. Robinhood has better positioning as a customer advocate than industry leader Schwab. Although Schwab has a great franchise and large market share, we think the company has wrecked its business model in the name of imitating Robinhood. When Robinhood was launched, the company’s innovation was free stock trading. Schwab copied Robinhood’s free stock trading model. Schwab’s move caused Ameritrade’s management to panic and agree to an acquisition by Schwab. Schwab’s management team thought they could make up for the lack of stock commission revenue by forcing their customers into holding their excess cash in Schwab’s affiliated bank and paying an unreasonably low interest rate on this excess cash. The table below shows the interest rates major brokerages pay their customers on excess cash.

Schwab is clearly on the wrong side of customer advocacy on this issue.

4. Robinhood is introducing new products at an impressive pace. They have already introduced Gold Subscription Accounts, retirement accounts, UK accounts, and credit cards. In addition, Robinhood has several new exciting products that they’ve announced but not launched, such as futures and advisory accounts. They can also introduce other products in the future, such as trust accounts, corporate accounts, advisor accounts, and mortgage lending. We believe these new products will help Robinhood take market share and grow faster than the industry.
5. Robinhood appears to be getting its expenses under control. Robinhood has been reducing its expenses, including stock-based compensation. In Q3 2023, Robinhood beat analysts’ estimates for EBITDA by $30 million due entirely to lower expenses than previously forecasted. We think Robinhood’s management is realistic about reducing the company’s expenses while still investing in new products.
6. There is historical precedent for stock market investors to place high valuations on discount brokerage firms during periods of high growth. In late 1998 and early 1999, Ameritrade’s stock price climbed 17x in six months as individual investors opened new brokerage accounts to trade stocks at the beginning stages of the Internet bubble.
7. Robinhood’s business is still small, but this allows Robinhood plenty of room to grow. We think this potential growth will create substantial shareholder value.

There are risks to Robinhood:

1. Low-end customer base – Robinhood’s average account value is only $4,000. It has millions of very small accounts. Most of these accounts will never amount to anything. There is also the risk that existing customers will look to “graduate” from Robinhood when they start saving and investing more substantial amounts of money.
2. Potentially damaged reputation from meme stock operations – When GameStop’s stock went parabolic in early 2021, Robinhood’s customer base traded the stock like crazy. Robinhood’s systems had trouble keeping up with the order flow, and Robinhood had trouble meeting its skyrocketing net capital requirements from the increase in customer trading. Robinhood paused the trading of certain stocks during very volatile days, and customers could not transact. There were many stories of customers not able to trade out of losing positions. The damage to Robinhood’s reputation continues. But, we believe the damage is dissipating as Robinhood continues to show growth in customer accounts and customer assets.
3. Robinhood has had consistent insider selling. Several executives have programs in place to sell shares regularly. We don’t have a satisfactory answer for this selling given what we believe is a low stock price.

Although Robinhood’s price is above where we purchased shares, we think Robinhood is still attractive because the downside is limited to tangible book value. The upside could be multiples of the current stock price depending on customer acquisition and market share gains. We are excited about management’s efforts to grow the business by introducing new products to attract additional customers. Management also recognizes the opportunity to gain wallet share with existing customers. We believe the industry needs additional competition after Schwab’s purchase of Ameritrade. We think Robinhood has the potential to produce good returns as they step into the opportunity left open by the Schwab-Ameritrade merger.

Disclaimer: The discussion of any security is meant solely as an illustration of our investment and thought process and should NOT be considered as a recommendation or suggestion to buy or sell any securities. Before you make any investment, do your own research and talk to your own financial adviser. Information in this report is received from external sources. Therefore, we can make no guarantee as to the completeness or accuracy of the information provided.