How Real Is That E Broker?

Investing in newly online brokerages is a high-risk play

For most of its 39 years, ever since founder Martin H. Meyerson gave up selling cars in favor of stocks, M.H. Meyerson & Co. has been known as a small, family-run brokerage with few retail clients but a large, profitable over-the-counter trading desk. But that all changed when--in a Cinderella-like makeover--Meyerson was transformed from a little-known New Jersey broker into--voila--a hot Net stock!

With the stocks of leading Internet brokers, such as E*Trade Group Inc. and Ameritrade Holding Corp., enjoying powerful rallies, Meyerson put out a brief press release early on Feb. 2 indicating its plans to offer Internet trading--under yearend. That was enough to send Meyerson's moribund stock--which had been below $1 as recently as November--into orbit: Within two days, the stock had jumped from around $3 to over $20 and now trades around $6 (chart). With the surge, Meyerson and other insiders dumped a chunk of their holdings.

Meyerson's move symbolizes the rush by even the most obscure of brokers to remake themselves as Net stocks and the rush by investors to buy into the dream. With Wall Street gripped by Internet mania--and even white-shoe firms such as Goldman, Sachs & Co. exploring Net-based trading--the biggest market moves have been made by third-tier brokers such as Meyerson. They include firms such as J.B. Oxford Holdings Inc., whose brokerage unit has a troubled regulatory history, and Eastbrokers International, trading at $2 in late December, which jumped to as high as $13 on speculation the firm would start Net trading. But they bet wrong, says Chairman Martin A. Sumichrast. Eastbrokers is now at $6. Or look at Rushmore Financial Group Inc., an insurer-turned-cyberbroker, that recently announced plans to start a day-trading operation on the Net. That pushed the stock from $4 to $14 before settling back at $5. No matter that the company is losing $2 million a year or that it couldn't even sell out its initial public offering last April.

NO LAYUP. Indeed, the search for the next E*Trade has grown so frantic that traders bid up the shares of Bull & Bear Group, from $4 to $15, even though the firm had announced in December that it would sell its brokerage unit to Royal Bank of Canada. The shares now sell around $4.

What's driving the mania? Already, one of every seven trades is executed through the Internet, and investors are betting that an E-trading site is a license to print money. But industry analysts warn that making money on the Net is no layup. The technology and marketing costs to establish a beachhead are enormous, and the territory is crowded. Roughly 100 online trading sites are up and running. Still, traders are betting on every new entrant. They argue that after system outages at Charles Schwab, Ameritrade, and E*Trade--whose computers crashed three straight days in early February--frustrated customers will shift accounts en masse to J.B. Oxford and other less-trafficked brokers.

After easing back in subsequent weeks, the Net-broker frenzy broke out again on Feb. 19 when Merrill Lynch & Co. announced its acquisition of D.E. Shaw's Web brokerage-technology unit. That led to speculation that the deep-pocketed brokers would buy up the small fry. "There's a school of thought that many of these second-tier brokers could become acquisition candidates for banks or full-service firms like Merrill," notes John Robb, a principal with Gomez Advisers Inc., a Concord, Mass., Internet consultant. "Me, I think they're all grasping at straws."

Executives of the E*Trade wannabes say their newly enhanced stock prices reflect their rosy business prospects. "We thought it was a grossly undervalued firm with a bright future," says Christopher L. Jarratt, a Nashville real estate investor who bought control of Los Angeles-based J.B. Oxford last year. "Investors probably see the value that we saw." Oxford stock soared from a low of $1.50 in January to nearly $26 on Feb. 4. By Feb. 24, the stock was near $9. There was no particular news item that set off the runup. Oxford has operated an online site for several years. The firm is also under FBI investigation for market manipulation, although Jarratt, who now serves as chairman, says that none of Oxford's current management team is a target of the probe.

"PRUDENT PLANNING." The runup in these stocks created a windfall for some savvy day traders--and the brokerage executives themselves. As the online brokerage stocks soared, execs at Charles Schwab, E*Trade, and National Discount Brokers all cashed in some of their shares at fat profits.

The biggest winners may have been at Meyerson: On Feb. 4--two days after its Internet announcement--Meyerson's two sons, the president and the controller, together sold $1.2 million worth of stock. Meyerson told BUSINESS WEEK that he himself sold "several hundred thousand" shares. Meyerson chafes at the notion that the Internet press release was timed to allow him and other executives to take advantage of the market mania. "We call it prudent planning here," he says, noting that he and other executives had just been granted additional stock options and that they needed to sell some shares to diversify their holdings.

That's small comfort to the countless investors who bought at the top. Patricia Herzenberg of Pompano Beach, Fla., says she lost $5,000 after buying 500 shares of J.B. Oxford at its peak. "I broke my own rule: Never place a market order for a volatile stock," she sighs. But the schoolteacher turned day trader remains upbeat about smaller brokers' prospects and proved it by scooping up another 500 shares of Oxford. "Online trading is the future," she says. "Everybody who is serious about trading is going to have at least one online broker."

But Wall Street analysts question whether bit players such as Meyerson, Oxford, and others can muster the resources to woo customers from online giants like Schwab, E*Trade, and Discover Brokerage, the online unit of Morgan Stanley Dean Witter. E*Trade, for instance, plans to spend $100 million on an aggressive ad campaign to woo new customers this year, plus millions more to upgrade its trading system. For good measure, E*Trade is giving new customers $50 bonuses simply for signing up. "I don't think there is room for many more players at this late date," says Genni C. Combes, an analyst at Hambrecht & Quist. "The capital spending, not to mention the marketing costs, [needed] to establish a brand name, have just become phenomenal."

How Real Is That E-Broker?

What's more, Wall Street pros worry about the E-brokers' margin lending. These pros fear that if the market crashes, E-brokers, such as Oxford--which has only $14 million in shareholder's equity supporting $345 million in assets--won't have the cushion to absorb losses from customers who can't meet their margin calls. Oxford's Jarratt says he's raised margin requirements on fast-moving stocks. Says Jarratt: "We haven't incurred any margin losses, and our credit department monitors it by the minute."

For small brokers, just moving into cyberspace can make their companies a lot more valuable very quickly. But eventually the market should realize that few if any of them stand a chance of becoming the next Schwab or E*Trade. That's going to be a hard landing for investors who placed big bets on these little firms.

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