Stocks

Opinion: Here’s why you should buy Robinhood stock — despite these big negatives

Robinhood is going public. Should you buy the stock?

This is especially relevant for Robinhood Markets Inc.’s
HOOD,

18 million users, including me, because the app-focused discount-brokerage company will direct up to 35% of the initial public offering (IPO) to us.

Here are the main pros and cons. The IPO will likely happen the week of July 26, according to Renaissance Capital. We’ll learn more at that point about the missing piece of the puzzle — the IPO price.

Let’s start with the six positives. Though Robinhood is controversial, it’s clearly a great company.

Read: The five most eye-popping disclosures in Robinhood’s IPO filing

1. Growth is speedy

Robinhood’s public relations disasters — a frozen trading platform during critical moments, a record regulatory fine — haven’t killed user growth. It’s explosive. Last year, accounts grew 143% to 12.5 million, and revenue rose 245%. That continued in the first quarter, when accounts grew 151% to 18 million, and revenue jumped 309%, year over year.

“What stands out to me is their growth. and the fact that customers are first-time investors,” says Matthew Kennedy, senior strategist with Renaissance Capital, which manages the IPO exchange traded fund Renaissance IPO ETF
IPO,
-0.37%
.
First-time investors are likely to stay with the brokerage for a long time.

Sure, growth will slow. But the momentum will continue, and there’s tons of room for more. Competitor Charles Schwab
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-1.05%

estimates U.S. investors have $50 trillion in investment accounts. Robinhood has $81 billion in customer assets.

2. Robinhood has built a powerful brand

The company has gotten dinged for platform outages, promoting the “gamification” of investing, and restricting trading in meme stocks like AMC Entertainment
AMC,
-4.17%

and GameStop
GME,
-0.75%
.
This has led to lawsuits and fines. But the public has a short memory, and stats confirm the power of Robinhood’s brand and the likeability of its platform.

Over 80% of new accounts come from customer referrals or people signing up on their own, unprompted by ads. (Robinhood calls this “organic” growth.) Nearly half of all new retail accounts opened in the U.S. from 2016 to 2021 were on Robinhood. That’s pretty amazing. Brands are key in retail customer-facing businesses, especially when they lead to defensive moats.

3. The company is founder-run

Academic studies and my own experience as an investor confirm that founder-run companies outperform. This is one of the key qualities I look for when suggesting companies in my stock letter, Brush Up on Stocks (the link to the letter is in my bio, below). Company founders including Jeff Bezos at Amazon.com
AMZN,
+2.27%

and Elon Musk at Tesla
TSLA,
+0.14%

are driven by more than money. They have a passion for developing businesses. This is the kind of manager you want in your investment mix. Robinhood was founded in 2013 by Vladimir Tenev and Baiju Bhatt, who are now CEO and chief creative officer.

4. Profit margins could be big

In part because its brand and platform attract customers at a low cost, the company’s profit margins could be big. Robinhood’s primary source of revenue is payment for order flow — routing trades to market platforms including Citadel — and the costs are low. “There isn’t a whole lot of cost of revenue here,” says Kennedy. “Payment for order flow is inherently a high-margin business.”

5. There’s plenty of room to grow

Robinhood has a land-and-expand strategy. It lands in the life of the young demographic — people just starting out their financial lives. As they progress and demand more products, Robinhood will provide these and extract more revenue per customer. “They have a number of young and very eager costumers, and they will need new services like car loans, credit cards, mortgages and retirement advice,” says James Angel, professor of finance at Georgetown University’s McDonough School of Business. These markets are huge. U.S. credit card purchases were $3.6 trillion last year, and peer-to-peer payments were $4 trillion, according to Square
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-0.32%
.
Robinhood also has room to grow in Europe and Asia.

6. Executives are free to think long term

Robinhood likes to boast its mission is to “democratize finance for all.” So, it’s ironic the company is anything but democratic. It has set up special share classes that concentrate the voting power in the hands of a few people. This sounds terrible. It’s “undemocratic.”

But here’s a little secret: This can be a big plus for investors. Hear me out. By removing the threat that disgruntled outsiders will attain board seats, Robinhood attains the freedom to “annoy” short-term investors by sacrificing near-term profits to plow earnings into the business. This gives management the incredibly valuable freedom to think long term and make better decisions. Many of the best-performing companies used this quality to their advantage, including Facebook
FB,
+0.09%
,
Amazon.com and Alphabet
GOOGL,
+2.30%
.

Robinhood investors will have to grapple with serious risks. Here’s a roundup.

1. Regulators crack down

Politicians and regulators are concerned about how easy Robinhood has made it for customers to interact with the market. Critics describe it as “gamification.” The user-friendly nature of its app opens the door for this. Regulators worry it could promote behavior — such as like excessive trading — that’s not in the interest of customers.

The Financial Industry Regulatory Authority (FINRA) has already fined Robinhood $70 million, in part for allegedly not vetting customers well before approving them for options trading and margin accounts, or properly explaining risks. The Securities and Exchange Commission (SEC) fined Robinhood $65 million after charging the company with misleading customers about how the app makes money and failing to deliver best execution of trades. Massachusetts regulators are going after the company, accusing it of predatory marketing toward inexperienced investors.

“Very clearly the SEC and FINRA are taking a look at the user interface,” says William Mann, the director of small-cap research at The Motley Fool. “At some point there will be a critical mass of individual investors who suffer losses enough that regulators will have to act and put some boundaries around the strategies that Robinhood uses to make trading exciting. We are a social brokerage crisis away from that being much more important for the SEC and FINRA.”

Next, around 80% of Robinhood’s $522 million in overall first-quarter revenue came from payment for order flow, which means selling trades to third parties. SEC Chair Gary Gensler argues this could create a conflict of interest with a broker’s responsibility to provide best execution. If regulators shut this down or restrict it in some way, it will be a challenge for Robinhood. Robinhood also faces private lawsuits for platform outages.

2. Crypto blows up

Regulators around the world might crack down on cryptocurrencies because of their use by criminals. Central banks don’t like the competition in money supply creation. Crackdowns would be a problem for Robinhood since it got 17% of its $420 million first-quarter transaction-based revenue from crypto trading, points out Kennedy, at Renaissance Capital.

3. The retail trading boom fades

“The boom in retail trading clearly benefits them, and we don’t know how stable that is,” cautions Kennedy. “A lot of their traders have made money. Meme stocks have done well and so has crypto. But if the returns go away, you will see that revenue dry up,” he says. Robinhood may be particularly vulnerable among brokerages because it gets so much revenue from risky options trading, about 38% in the first quarter. “Traditional brokerages have lower percentage of revenue coming from options and crypto. If you have a huge market downturn, all that trading could dry up pretty easily.”

4. A bear market wipes out revenue

Is Robinhood “calling” the market top with its IPO? It’s possible, and Robinhood would not be the only company doing this. The first quarter was the biggest period for IPOs ($40.7 billion in gross proceeds in the U.S.) since the last quarter of 1999, points out Kennedy at Renaissance Capital. The big tech crash followed in 2000.

The bottom line: You have to remember that companies choose when to come public. So, guess what? They do this when it suits them, not you, the investor. The current IPO frenzy suggests the S&P 500
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+0.75%
,
Nasdaq
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+0.81%

and the Dow Jones Industrial Average
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+0.44%

could be at or near a top. “There is a lot of frothy stuff coming to market,” says Angel, at Georgetown. Market-related companies such as brokerages and money-management businesses suffer badly in bear markets. That will happen, sooner or later, and Robinhood will see a sharp decline in payment for order flow and customer growth.

Michael Brush is a columnist for MarketWatch. At the time of publication, he had no positions in any stocks mentioned in this column. Brush has suggested SCHW, FB, AMZN and GOOGL in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.

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