Charles Schwab: The Investment Advisor's Choice

Considering the carnage in financial markets, people today need financial advice perhaps more than they ever have. Unfortunately, it was mainstream Wall Street, the traditional dispersers of financial advice, that let investors down. Consequently the highest earning and theoretically best advisors are leaving the big name firms and opting for independence. Facing a pervasive discontentment on their clients’ part with main stream Wall Street, big producers are setting up their own shops in droves. This spells a potentially huge opportunity for Charles Schwab Corporation (SCHW) as they are a preferred and respected choice for clients and independent advisors alike.

Based in San Francisco, California, Charles Schwab’s primary focus is on individual investors and independent financial advisors. This has allowed them to build the leading discount brokerage and investment services firm in the world. They are the largest provider of custody services to registered investment advisers with about twice the market share of their nearest competitor, Fidelity Investments (privately held). Over the past two decades Charles Schwab has produced compounded earnings growth of over 25% per year with only a few glitches along the way. (See Figure 1 below.)

Fig. 1. SCHW 20yr EPS & Price History Correlation

The recession of 2001 led to a drop in earnings in 2001 and another modest drop in 2002. (See red circle, Figure 1.) However, this was followed by strong earnings growth and price advances from 2003 through 2007 and up to September 30, 2008. (See purple circle, Figure 1.) We believe the short-term pain of Schwab’s earnings and stock price in 2009 will lead to long-term gain as Schwab is perfectly positioned to exploit today’s environment.

Figure 2 below illustrates that the consensus of 16 leading analysts reporting to First Call forecast Schwab to grow earnings at 20% per year for the next five years.

Fig.2. EPS Forecast

Therefore, based on census forecast, we feel that Charles Schwab Corporation is fairly priced at a PEG ratio of 1, (PE 20.5). Also, with debt at only 18% of capital, Schwab has the financial strength to continue paying its dividend with money left over to purchase shares of its common stock. Its current dividend yield of 1.4% has grown at a compounded rate of over 25% since 1992. In addition to this excellent dividend growth and even at its more than 30% discount from its previous high of $25.72, Charles Schwab has generated a 25.6% compounded return (excluding dividends) for shareholders since 2/31/1990. (See Figure 3 below - historical price performance and dividend growth.) Take special note that this return correlates almost perfectly to their compounded rate of change of earnings growth. (See Orange Circle in Figure 1.)

Fig. 3. SCHW 20yr Historical Price Performance & Dividend Growth

Thesis for Growth

In our opinion, Charles Schwab is an extremely well managed company. Financially, Charles Schwab is very healthy. Historically, they have generated industry leading returns on equity. Although their return on equity did fall in 2008 due to the recession, we are confident it should return to normal as financial markets improve. Also, management is focused on a low cost capital structure and targets a long-term debt to capital ratio of less than 30%. It currently sits at 18%. Schwab has over 300 offices, 7.6 million client brokerage accounts, 1.5 million corporate retirement plan participants, 620,000 banking accounts and over $1.3 trillion in client assets. They have three reportable business segments:

1. Investor Services: 63% of operating income.
2. Advisor Services: 31% of operating income.
3. Corporate and retirement services and other: 6% of operating income.

Schwab has been very proactive in response to the record number of financial advisors moving to the independent Registered Investment Advisor (RIA) channel from the full-service wire house brokerage firms. On August 17, 2009, Schwab released its latest white paper – “A Case for Starting or Joining a Registered Investment Advisory (RIA) Firm.” Then on September 1, 2009, Schwab unveiled a significant redesign of its website for financial advisors. In short, Schwab worked hand-in-hand with advisors to develop a site that allows them to save time and better serve their clients. We believe this improved and more intuitive website will be seen as a major plus for advisors seeking independence. We believe these progressive moves, as a prolific innovator, will enable Schwab to grow its market share, especially considering that many discount broker competitors are struggling.

As an aside, we admired Chuck Schwab’s recent stand against New York Attorney General Andrew Cuomo’s suit regarding Auction Rate Securities. Although we support government efforts to reduce greed and corruption in the Financial Services industry, we equally support a free functioning marketplace where risk and reward are administered appropriately. We are concerned that excessive involvement in the financial markets by big government is potentially more disruptive and devastating than the corruption and greed was.

Conclusion

Charles Schwab, although in the financial services business, did not participate in toxic paper like their full service cousins did. However, their stock price in 2008 was treated like it did. This differentiates them in a very positive way. With their reputation in tact, They are likely to see significant customer growth as perspective investors are disgusted with the big wirehouse firms. This should be very good for Schwab's business.

We believe in the long-term ownership of excellent businesses purchased at sound and/or attractive valuations. Our objective is to make our returns based on the operating performance of the company over a business cycle which we define as normally a 3-5 year period. In other words, we hold a business perspective on investing. On that basis, we believe that Charles Schwab is an excellent choice for achieving above average long-term growth coupled with a potential for a growing dividend income stream as well.

Full Disclosure: Long SCHW at the time of writing.

Comments

[Tom Armistead:]

Chuck, maybe you should talk to Chuck (Schwab) and see if you can get a job there.

Sep 04 07:11 AM

[casey00001:]

Ya but Chuck doesn't have a purple helicopter. Roger does. I'll stick with Roger (Scottrade).

Sep 04 08:45 AM

[John Nelson:]

I own Schwab shares myself and think the stock will probably rise to about $24-$25 over the next 18 months before it loses steam. I agree with your positive view of the company but you left out two key points that any investor needs to think about. First, they are being forced to take fee waivers on their money market funds because of the ultra-low interest rate environment. This is a big part of their business model. If interest rates are still this low in 18 months then my $25 price target probably won't happen. I consider this the biggest risk to my thesis. Second, Schwab has benefited from net new client asset flows that amounted to low teens organic growth (mostly from the advisor channel). Can that continue over the next five years? My price target assumes 18% earnings growth over the next five years (I'm expecting a weak bull market, expanding margins, and the end of fee waivers), but then 7-8% growth thereafter simply because I don't think they will be able to keep expanding margins and because the law of large numbers will hurt their organic growth rate.

Sep 05 03:32 PM

[Jake2:]

I have nothing against Schwab but this piece is pie in the sky. I agree with Armistead. Thus: Buyer beware.

Sep 07 02:04 AM