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Profit From 'The Rebirth Of Retail Investing' With This Stock

Michael Vodicka

The S&P 500 Index's 28% return this year has come as a big surprise to even the most bullish investors.

But in spite of ongoing weakness in the global economy, there's a very good reason the index is on pace for one of its best performances in the past 35 years.

Individual investors scared away from the market during the financial crisis of 2008 are back.

Inflows into domestic mutual funds are expected to top $450 billion in 2013, more than the last four years combined and the biggest annual inflow since 2000. Bond funds are also seeing big movement, with $31 billion in outflows through October, also the most since 2000's $50 billion.

It's clear that with the S&P 500 trading at an all-time high and the Federal Reserve losing its battle against higher interest rates, investors are shifting into a more active approach to stay ahead of the curve.

That's why I'm bullish on an industry-leading brokerage firm that benefits from higher trading volumes and flows in and out of mutual funds and other securities.

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Not only does this well-known company offer strong operating leverage against higher trading volumes and the financial services industry, it's also shareholder-friendly, with a growing dividend and ongoing share buybacks. That has driven a market-beating return of 78% return 2013. 

With total client assets topping $556 billion and an enterprise value of $16 billion, TD Ameritrade (NYSE: AMTD) is one of the largest brokerage firms in the world. The company offers brokerage services to individual investors as well as other financial services firms such as registered investment advisors, hedge funds and money managers.

In the short run, TD Ameritrade will continue to benefit from higher trading volumes as investors and advisors take a more aggressive approach to the portfolio management process. But in the long run, the company still has plenty of room to grow.

TD has strategically positioned itself to cash in on the booming RIA (registered investment advisor) industry. RIAs continue to steal business from the legacy broker-dealer model and see huge capital inflows because they are compensated as a percent of total assets under management. 

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That model aligns the interests of advisors and investors, offering a big upgrade from brokers who generate more income from persuading their clients to trade more regardless of whether it's in their best interest. That's why market research firm Curelli Associates estimates RIAs will capture 25% market share by late 2014, a big jump from 19% in 2010.

As an early and ongoing leader in RIA services, TD already has more than 4,500 RIA clients, 15% of the entire RIA market. That places TD in position to capitalize on the secular growth trend in the RIA business.

TD will also benefit from a highly scalable business model that incurs minimal variable expenses in adding new clients. In fact, TD's margins have actually been expanding along with revenue, with operating margin jumping to 39% in its most recent quarter. At the same time, total assets under management rose 18%, and funded accounts increased by 50,000, to 6 million.

The company is using its strong revenue and earnings momentum to reward shareholders. That drove a recent 33% dividend increase to $0.12 and a special dividend of $0.50 to be paid Dec. 15.

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Looking forward, TD has plenty of room to keep increasing its dividend. Free cash flow should top $800 million in 2014. But shares buybacks are limited to 20 million, or $560 million to stay under TD Banks 45% ownership limit. With a payout ratio of just 30%, TD has room to increase its current dividend yield of 1.6% to generate more value for shareholders.

TD's high-margin business model has strengthened its balance sheet, with $1.1 billion in cash and equivalents and $1.1 billion in debt. Its debt-to-equity reading of 23% is a sharp discount to its peer average of 46%. Although TD has talked down the rumors, its strong cash position and highly scalable model has led to speculation that it will purchase a small brokerage firm such as E-Trade (Nasdaq: ETFC) or Scottrade to gain additional operating synergies and cost savings.

Risks to Consider: Retail investors have a history of pouring into stocks and the market at the top of long-term cycles. Although general market volatility would drive trading volumes, a downturn in the S&P 500 would present headwinds for its RIA business.

Action to Take --> In spite of its impressive gain this year and industry-leading position, TD Ameritrade's forward price-to-earnings (P/E) ratio of 22 is only a small premium to its peer average of 20. And with a current yield of 1.6% expected to continue rising, TD offers a solid combination of growth and income to capitalize on the rebirth of retail investing and growth in the RIA business.

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