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Shares of The Charles Schwab Corporation (NYSE:SCHW) have fallen victim to the turmoil in the financial sector caused by issues at SVB Financial Group (SIVB), which have sent a shockwave throughout (regional) banks and related financial institutions.
While the situation for Schwab is by no means comparable, investors are fearful about similar trends, that of deposits leaving the business and losses being reported on the investment book, as that combination is causing real questions marks across the entire banking and wider financial industry.
The Impact
Since the problems at SIVB emerged on the 8th of March, shares of Charles Schwab fell from $76 to $62 in the times span of just two days, causing a massive early 20% pullback in the share price, shedding about $25 billion in value in the process. The move lower brings shares back to the lows seen over the summer, when markets at large were trading at their lowest levels for the year.
The pullback is interesting, as it is somewhat of an oversized move in relation to the market move, as investors fear contagion, at least, so it seems. This comes as Schwab has been an excellent long-term investment, as a $10 share in 2012 had risen to the $50 mark in 2020, as shares peaked in the low $90s early in 2022, amidst the peak in markets at large.
With the exception of a pullback to $60 over the past summer, shares have recovered to $80 in recent weeks, now falling to $60 basically overnight. These huge long-term gains for long-term holders have been driven by strong growth in the business, as total assets have risen from about $140 billion to $550 billion over the past decade, with sales and earnings rising subsequently.
What Are Investors Worried About?
At the first glance, the 2022 results provide few reasons to be cautious. The company grew full year sales 12% to $20.8 billion, as GAAP earnings rose 23% to $7.2 billion, equal to $3.50 per share, with adjusted earnings coming in as high as $3.90 per share.
This is quite an achievement in one of the most difficult years since the economic crisis, amidst the war in Ukraine, rising inflation, and interest rates, while the world economy is still recovering from the pandemic. Despite $1.5 trillion in lower asset values, the company still ended with $7.05 trillion in client assets, as new asset inflows of $428 billion trailed the losses reported by the clients.
The concerns relate to two items that relates to the interest spread and losses on the investment book. If we look at the spread, the performance at Schwab looks quite alright. Full year interest revenues rose from $8.5 billion to $12.2 billion as annual interest expenses rose from less than half a billion to $1.5 billion, for a $10.7 billion net interest income number (which rose sharply in 2022). This number rose to $3.0 billion in the fourth quarter, albeit that both interest income and expense rose sharply amidst rising interest rates.
The broker ended the year with total assets of $552 billion, actually down a lot from the year before. Bank deposits of $367 billion are being paid a mere 0.46% per annum in the fourth quarter, which by no means is competitive versus short-term Treasuries. With pre-tax earnings running at $9.4 billion in 2022, there is real room to boost these margins, likely needed to maintain deposits.
On the other hand (of the balance sheet), the company holds $148 billion in available for sales securities and another $173 billion in held to maturity securities. Perhaps importantly, the company actually transferred some of these investment securities to designate them as held to maturity, which is interesting given the times we find ourselves in. These carry a yield of just 1.7-1.9%, which is below both short- and long-term rates, indicating that these are likely underwater to an important extent. SVG posted a loss around 10% on the (nominal) value of these investments, although only to be recognized once it faced significant deposit outflows.
This is not a fair comparison to Schwab, of course, as SVG was quite aggressive in moving up to the duration curve. Nonetheless, even investments in short term maturities could result in losses equal to a couple of percent of the asset base which exceed $300 billion. This could pose a serious dent in the capital base, but only if the company is forced to incur the losses, if deposits actually leave the business.
Of course there is no indication for this, as Schwab is large and furthermore has large earnings power to raise deposit rates. The 10-K filing for 2022 reveals a net unrealized loss of around $14 billion for the year, after it was flattish a year before, as an indication that it, too, has incurred some losses, which are no issue provided that the deposit base remains stable.
And Now?
In the time frame of just a couple of days, shares of The Charles Schwab Corporation have fallen about 20%, moving from a 19–20 times earnings multiple to 15-16 times earnings. This pullback is huge, and this is not necessarily driven by earnings power, although Schwab will likely have to offer higher rates as well to attract deposits, as this might hurt near term earnings power significantly.
Nonetheless, the broker seems very well capitalized and very large, and the situation is by no means comparables to SIVB, yet the concerns of the industry is the pace and magnitude of rate hikes, clearly creating a competitive positioning issue for the banks and creating some substantial unrealized losses here and there in the system.
In all likelihood, this is a great The Charles Schwab Corporation buying opportunity for long-term investors, but the reality is that the situation scares me a bit as well, even as the business is among the larger and better-capitalized business out there, with real earnings power from activity levels as well. Given the uncertainty and a 15 times multiple, I am not happy to buy The Charles Schwab Corporation dip just yet, despite a great long-term track record.
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