The Charles Schwab Corporation (SCHW)

Key Statistics

Price/Book = 1.82x

Return on Equity = 14%

Earnings Yield = 6.67%

Debt/Equity = 38%

Summary

Charles Schwab has long been a financial industry powerhouse. With the merger with TD Ameritrade, it is going to become the dominant player in this market.

Schwab’s origins are as a discount brokerage. They offered cheap commissions for DIY investors. Perception around the stock is that this is what Schwab’s business still is. The truth is that brokerage commissions were a trivial component of Schwab’s business, which is why they were so quick to cut it to zero in an effort to clobber their competitors. They continue to make money on trading activity, via order flow. The financial media gets incensed about this, but I don’t think anyone really cares.

They cut commissions to zero to clobber their competition, which is rapidly disappearing. By merging with TD Ameritrade, the only serious challenger to their business is Vanguard. The sheer scale gives them the ability to cut costs and offer services at a lower fee. In my mind, this is a moat. They’re like Wal-Mart in 1990 taking on small mom and pop retailers, Clover, and Bradlee’s.

The stock is cheap for a simple reason: interest rates are low and investors think that will last forever. When clients leave cash in a brokerage account, Schwab offers the client little interest, and then they invest that cash in short duration fixed income products. With interest rates low, that income is reduced. There are also jitters about the merger with TD, but I think that the merger is only going to strengthen their competitive position.

My Take

I don’t think that the trend of investors cutting expensive mutual funds and expensive financial advisors is going to stop. There is a lot of money wrapped up in high fee financial services. As younger investors inherit that money, they’re going to invest it themselves and I think much of it is going to continue migrating to Schwab and Vanguard.

I don’t see how this trend stops. It’s hard to imagine how much of this money won’t migrate to Schwab one way or another.

There are challengers to Schwab, but I don’t see how they succeed.

There is Betterment, which offers robo-portfolios, but they’re a small player of an industry where scale matters more than anything. Additionally, an automated portfolio of asset classes tailored to age & risk tolerance isn’t an amazing innovation and it is easy to duplicate. In fact, Schwab already has automated investing portfolios of their own.

There is also E-Trade, but E-Trade is losing this war, which is why they sold to Morgan Stanley.

There is also Robinhood, but I think Robinhood’s emerging reputation as the home of Millennial and Gen-Z gun-slinging daytraders is not going to help them attract future capital, particularly after this insane market inevitably rolls over. It’s a reputation that they need to shed and I’m not sure if they will succeed.

I think Robinhood’s strategy is to lock in younger investors in now. Then, those investors will continue to accumulate assets as they save and inherit money – and they’ll keep it in Robinhood.

I don’t think it will work this way. My guess is that Millennial and Gen Z investors will see Robinhood as the wild person they dated when they were 23, but not the person that they’re going to marry.

The year is 2025. You’re 30 years old. Let’s say that you inherit $100,000 from a dead relative. Are you going to put it in Robinhood – where your 25 year old friend lost a bunch of money daytrading in 2020 and made a bunch of TikTok videos about it? No. You’re going to figure out a “serious” way to invest it. This isn’t $500 on an app that you’re fooling around with. This is $100,000. This is serious money. Your desire to invest “seriously” will probably lead you to Schwab or Vanguard.

If you don’t want to DIY it, then you’ll turn to Schwab or Vanguard for advice, which is a lot cheaper than hiring a traditional financial advisor. In fact, Schwab offers a flat consultation fee of $300 to set up your portfolio, and then they can roll it into one of their automated solutions for $30/month. This is where much of the Boomer & Silent money currently getting charged 1-2% of AUM in an ocean of high fee mutual funds is going to migrate to.

Here is another scenario. Let’s say you worked for a company for 10 years, you get a new job, and have a nice amount stashed in a 401-k. Let’s ask the same question: where are you going to roll over that 401-k into? Chances are it will go to two places: Schwab or Vanguard.

Are you going to entrust this money with a financial advisor at a bank? Boomers might have done this in 1989, but Millennials hate banks. They’ve had an adversarial relationship with banks for most of their adult lives. Banks are the institutions that charged them 30% on their credit cards and a $35 fee when they accidentally went over in a checking account because the Netflix renewal hit before payday. They hate banks and don’t trust them.

The irony is that Schwab is structurally a bank (they take deposits and earn interest on it), but that’s not how they are perceived, and they’re not an institution that most people have had a negative experience with. They’re not engaged in the risky behavior that many banks routinely find themselves making headlines for (trading scandals, risky loans, stupid nonsense with derivatives, clashes with regulators, breakdowns in risk & controls, aggressive practices). They’re not a bank that set up a fake account or that charged you a crazy rate on a credit card. As a result, Schwab is more reputationally sound than most banks.

The main worry with Schwab is over interest rates – which is the concern hanging over the entire financial sector. I see this as a temporary problem. Investors seem to think that interest rates will be low forever. They think this because of what the Fed tells them. In my opinion, the Fed’s word is worth very little. If inflation emerges as a problem, the Fed will be forced to raise interest rates. It’s hard for modern investors to fathom this because most living investors have invested during a 40 year period of declining rates.

Interest rates are obviously something out of Schwab’s control. Schwab should simply focus on increasing the size of the assets that it manages, which is something that will continue to happen naturally due to its size and reputation.

Over time, interest rates are going to do their own thing. Schwab should focus on what it can control: increasing the assets that it manages and scaling up the business. This lowers prices and eliminates competitors. This is exactly what management is doing.

Schwab is incredibly cheap relative to its history due to the interest rate worries and jitters over the merger.

For the last decade, it usually trades in a range of 2-4x book value. It currently trades at 1.8x book. Meanwhile, I think the book value will continue to grow. In terms of multiple appreciation, I could see this easily returning to 4x book value if interest rates increase even a little bit.

Meanwhile, over time, I think that secular trends will make that book value continue to grow regardless of what happens to rates.

Schwab has earned 10-17% on equity for the last decade (a decade of low interest rates), and I don’t see how that doesn’t continue in the future. If interest rates remain low, it will earn the low end of that ROE, while the equity will continue to grow organically.

This means that even without multiple appreciation, Schwab should offer a satisfactory rate of return over the next 5-10 years via increasing book value and strong ROE. With multiple appreciation, it will offer a fantastic rate of return.

I also look at the size, reputation, rock solid balance sheet, and strong management as factors that will prevent a permanent loss of capital and make this a safe long-term holding.

Random

I’ve been listening to a lot of Prince lately. 1984’s Purple Rain has to be one of the best albums of all time.

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