E Traders' Stocks Are A Good Bet

Given the popularity of online trading and the astounding runup in Internet stocks, you might have expected shares of online brokers to have doubled or tripled this year. But the stocks of the few publicly traded online brokers are all well below their 1997 highs. E*Trade Group, the No.2 online brokerage, is up only 3% this year. Ameritrade Holding spent $34 million in the past two quarters on advertising that helped double its accounts--but its stock is up only 6%. Charles Schwab, by far the largest online broker is down 17% through May 11.

Why the retreat? Fierce competition and rampant price-cutting are scaring investors off. But this could actually be a good time to buy. The price-cutting may be waning, and online brokerages still have huge profit potential. In fact, Internet stock trading is booming. The number of online accounts more than doubled last year, to over 3 million. Forrester Research, a Cambridge (Mass.) technology research firm, predicts 14.4 million accounts by 2002.

Online competition is cutthroat because this form of trading is cheap to offer. Electronic brokers have used the savings they generate to keep commissions low and grab business from conventional brokers who still operate face-to-face or over the telephone. The number of E-brokers grew to 70 from roughly 30 in the past year. But the average commission at the top 10 brokers fell from $53 in the first quarter of 1996 to $16 by the fourth quarter of 1997, says Piper Jaffray.

Now, commissions are stabilizing, at least among the top discount brokers. As the price war wanes, the emphasis is on strengthening brands--the strong suit of the big-name online brokers. "This is a marketing game," says James Marks, who covers all three electronic brokerage stocks for Credit Suisse First Boston. He rates Ameritrade a strong buy, largely because of its high rate of account growth. E*Trade gets a lesser "buy" rating because it "strayed from what made it successful" by not promoting its low price enough. And Schwab gets a "hold" because of its high valuation relative to its growth (table), even though it's "in by far the strongest position," says Marks.

Bill Burnham, who covers E-commerce for Piper Jaffray, also thinks brand loyalty is the driving force. "If you believe in the long-term trend, I recommend a basket play"--buying all three, on the theory they'll gain equally from the shift to Web transactions. Compared with other Internet plays, the stocks are "incredibly reasonable," Burnham says, with forward price-earnings ratios in the mid 30s.

One thing to consider: This trio is apt to drop fast if the stock market falters. But with the Internet becoming the tool of choice for do-it-yourself investors, E-brokers are a good long-term bet.

Before it's here, it's on the Bloomberg Terminal.