Charles Schwab Corp. (SCHW, Financial) is a leader in the financial services industry. The company provides retail brokerage and banking services for individuals, as well as custodial, trading and support services for independent investment advisors. Schwab ended February with 12.5 million active brokerage accounts and $3.9 trillion in total client assets (up 7% and 9%, respectively, from a year ago). As shown below, client assets have increased at an 11% compounded annual growth rate over the past decade. Over the same period, earnings per share compounded at 15% a year.
Importantly, these gains include a significant contribution from organic core net new asset growth (as opposed to asset growth attributable to higher equity markets). In my opinion, sustained mid-single digit organic net new asset growth points to Schwab’s attractive positioning in the industry - for example, growing alongside independent RIA’s. In addition, I think the company has a unique brand voice that will enable it to stand out from many of its peers and continue taking market share. In both cases, I think Schwab’s outsized growth will prove sustainable.
In terms of the company’s business model, Schwab has undergone a meaningful transition over the past decade. As shown below, the revenue mix has changed significantly, with net interest revenue climbing from 30% of total revenues in 2009 to 63% of total revenues in 2019.
Net interest revenues are equal to income generated from interest-earning assets (like mortgage backed securities and U.S. Treasuries) minus funding costs (primarily bank deposits). Based on recent developments, it’s likely that Schwab will fall well short of the 2.4% net interest margin (NIM) reported in 2019. Management had previously guided to NIM compression of roughly 20 basis points in 2020, but that was before the aggressive actions recently taken by the Fed.
Considering how important net interest revenue / NIM is to the company’s results, it may seem unusual that I don’t have much to say on the topic. The reality is that I have no idea where interest rates are heading. Personally, I’m working under the assumption that, over the long run, the yield curve will eventually normalize. In addition, the company will engage in efforts to grow the mix of non-spread income (for example, by introducing services like Schwab Intelligent Portfolios Premium). Again, I have no idea on the timing for these developments; neither will happen overnight. But I think the price I’m being asked to pay accounts for this uncertainty.
Schwab recently completed a 12-year process of transferring roughly $130 billion of sweep money market fund balances to bank and broker-dealer sweep. That process required the company to retain a significant portion of its earnings, limiting capital returns to shareholders. Going forward, that will change; as management noted at the February 2020 Business Update, “Supporting long-term growth remains our top priority, but we anticipate excess capital return to continue to play an important role in our financial story going forward.” Note that the company repurchased $2.2 billion of stock in 2019 at $40 per share, nearly 40% higher than where shares currently trade.
Valuation
Trying to estimate what Schwab will earn in the current interest rate environment is difficult. As a long-term investor, I don’t think the results in any given quarter or year are particularly relevant anyways. What I can say is if you believe the interest rate curve will eventually return to something more “normal,” at least from a historical perspective, then the business is under-earning. Personally, I think it’s helpful to look at Schwab’s valuation relative to client assets.
Currently, the valuation is around $0.01 per dollar of client assets. As you can see, that is well below where the stock has traded, on average, over the past five-plus years. In addition, Schwab recently agreed to pay $0.02 per $1 of client assets in both the USAA Investment Management Company deal ($1.8 billion for $90 billion of client assets) and the pending TD Ameritrade deal ($26 billion for $1.3 trillion of client assets). In other words, management has been willing to pay twice as much per dollar of client assets in private transactions than what Mr. Market values Schwab at today. Over time, I think we’ll see that management's assessment of value is more appropriate than Mr. Market's.
In summary, I think this is a high-quality business that will continue to deliver mid-single digit organic growth, with the potential to deliver high-single digit or double digit earnings per share growth over the coming years. In addition, I think it has a best-in-class leadership team (particularly CEO Walt Bettinger) that will continue making intelligent long-term decisions, even when those decisions hurt short-term earnings. Finally, at $29 per share, I think the valuation is attractive.
For those reasons, I recently initiated a position in the company. I plan to hold the stock for years and will likely add to my position if the price continues to be under pressure. I say “likely” because that will depend upon the rest of the opportunity set available to me in the future.
Disclosure: Long SCHW
Read more here:
- From Long-Term Investing to Market Timing
- Dollar Tree: The Pressure Months
- FLIR: Likely to Buy Again
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