Charles Schwab Swept Up In Brexit Chaos

| About: The Charles (SCHW)

Summary

Schwab stock has a record of 20% annual returns since 1989.

It has now fallen to the 20x earnings mark, indicating investors can get a fast-growing business at a fair price.

Schwab's relationship to the adverse effects of the Brexit are attenuated at most, suggesting Friday's 12% drop-off is irrational.

Just three years ago, uncertainty regarding Greece's financial future dragged the price of Berkshire Hathaway (NYSE:BRK.B) stock down into the $80s. It was a great opportunity to pick up shares in a great company at a moderately discounted price, as Berkshire's ties to the source of political turmoil were decidedly weak.

As I survey the scene post-Brexit vote, that is the question I keep focusing on: What is unjustifiably down? If a stock falls by a double-digit percentage rate, and doesn't stand to lose a double-digit source of earnings, there is a presumption that the stock just became mispriced. One of the babies being thrown out with the bathwater in this debacle is American banking and brokerage powerhouse Charles Schwab (NYSE:SCHW).

Although it doesn't get a great deal of coverage on Seeking Alpha, it is a best-in-class financial sector investment. It has compounded at a rate of 20.7% annually since 1989, turning a $10,000 investment into $1.6 million over the past twenty-six years.

Because of its long-term record of building wealth for shareholders on the back of double-digit earnings growth, it is hard to find moments where it doesn't feel like you're overpaying for the stock when you add it to the portfolio. The P/E ratio was 34 in 2010, 21 in 2011 and 2012, 26 in 2013, 28 in 2014, and 30 in 2015.

With today's sell-off in the market, Schwab has fallen to the $26 mark in after-hours trading, for a total daily decline of roughly 12%. Given that Schwab is expected to post profits of $1.25 per share this year, the current price of $26 brings the P/E ratio down to 20.8x earnings.

Those are very fair terms for potential Schwab shareholders. The last time this moment happened? It was back in the summer of June 2011 when Schwab's valuation flirted with the 20x earnings mark. And the investors that purchased the stock back then would have reaped 14% annual returns over this five-year time frame. Finding a fast-growing company at a fair price is a great formula for double-digit returns, and the decline in Schwab's stock price today was a strong pivot into fair price territory.

What I find most interesting is the possibility that Schwab may actually benefit from market turmoil, including the market's aftermath of the Brexit vote. Almost 75% of Schwab's business comes from investment services, which largely refers to the commission earned through buy and sell activity. When the markets get a little more volatile, people have a tendency to buy and sell more. Either they get scared and sell what they have, or they opportunistically put capital to work in search of opportunities. Whatever emotion is triggered and acted upon, Schwab gets to collect a fee for the process.

Also, there is no "exclusionary" risk facing Schwab. By that I mean, there is no market Schwab investors will be cut off from as a result of this vote. If there are any extra costs associated with accessing the London Stock Exchange, it won't be anything even close to the Dodd-Frank bill that Schwab grumbled about while still finding a way to grow shareholder earnings by 17% annually in the aftermath.

Part of the reason why Schwab has retreated by a double-digit rate is the increased sense that interest rate hikes will not be coming sooner (and perhaps even rate cuts or other monetary stimuli are back on the table).

If ten-year government interest rates ever get up to that 4% or 5% range, Schwab will see net interest income returns shoot through the roof and add $0.30 to $0.40 to the existing earnings base of $1.20 per share. Heck, it's sitting on almost $32 billion in cash and could boost the costs of margin borrowing in the event of a rate hike. Because the rise in interest rates is now less foreseeable than it was before the Brexit vote, I do understand why Schwab is valued less.

But that is the kind of thing that ought to take a stock down a percentage point or two, not twelve percentage points. And also, the countervailing force of increased activity as higher volumes lead to more commissions has a distinct chance of proving more valuable to Schwab shareholders than any gains that would come from an interest rate hike. We won't know for sure until the next Schwab earnings report, but it is common-sensical that having 900 million more shares trade hands than usual will generate commission charges that will benefit Schwab shareholders.

If there is more volatility, Schwab has a good chance of gaining even more ground as iterations of this story play out over and over again. If there are more independence votes, or more days of unusual volatility as Britain separates itself from the EU, it likely means that Schwab will collect a commission on all the traders and investors entering and exiting positions at this higher rate. Panic sells and sober buys profit Schwab shareholders just the same.

Every investor has their sweet spot style. For me, my favorite investments to contemplate are those businesses with established histories that have a probable likelihood of generating 10% to 13% future earnings growth while trading at a P/E ratio in the 18x earnings to 22x earnings range. It's my ideal blend of value, quality, and growth. The Brexit effect on Schwab is minimal at worst if it involves additional regulatory hassle. At best, it is actually a boon for shareholders as higher trading activity allows Schwab's owners to get a small piece of each transaction. The 12% fall today, coupled with its minimal connection to Brexit activity, warrant a close look at this stock.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.