YCG Investments
“If you buy above average businesses at below average prices, on average, we believe you should come out ahead.” — Brian Yacktman

Charles Schwab: Creating Value for Customers and Investors

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Recently, we accumulated shares of Charles Schwab, one of the largest brokerage, banking, and asset management firms in the United States, with over $2.4 trillion in client assets, almost 9.4 million active brokerage accounts, and nearly $96 billion in interest-bearing banking deposits. Other large firms in the industry include Fidelity with over $4.9 trillion in customer assets, Blackrock with over $4.3 trillion, Merrill Lynch with over $2.2 trillion, Morgan Stanley with over $2 trillion, Wells Fargo with $1.7 trillion, Goldman Sachs with almost $1.2 trillion, Capital Group with $1 trillion, TD Ameritrade with $653 billion, and E-Trade with $290 billion. The total industry size is probably best approximated by total U.S. household assets of $95.4 trillion, including total financial assets of $66.8 trillion.

In an industry full of firms focused on extracting as many fees as possible from clients, both through high transaction fees and through advisors’ pushing of expensive internally managed products, Schwab stands out from the crowd as a result of its laser-like focus on low-cost, technologically superior, and transparent financial product offerings. This approach has turned Schwab into an asset gathering machine, enabling it to grow assets since the end of 2006 at 9% per year, made up of 6.7% in new client asset growth and 2.3% in asset appreciation. Impressively, this growth rate includes the global financial crisis of 2008 and 2009. We believe Schwab’s advantages remain firmly entrenched even today, with many traditional brokers (representing tens of trillions of dollars of client assets) still charging hundreds to even thousands of dollars per trade, offering maddeningly buggy and inferior trading and administration platforms (we’ve tested them), and continuing to be financially incentivized to put clients into their own firms’ most expensive and complex offerings. Thus, we believe it’s likely Schwab will continue to grow new client assets at comparable rates to the past. If the next five to ten years don’t include a global financial crisis and the asset appreciation component grows faster than the 2.3% cited above, then Schwab may even be able to grow assets at 10% or more per year. Since its business model is much more technological in nature with far less leakage to high-priced stockbrokers, Schwab’s cost structure is more fixed than most brokerage firms, resulting in total costs as a percentage of assets having fallen from 22 basis points in 2006 to 15 basis points in 2014. This fixed cost structure should enable Schwab to grow earnings at an even faster pace than the 8 to 10% revenue growth rate we expect. Even at today’s valuation of 25x next year’s earnings, we believe we’ll do well over time given Schwab’s compelling business model and potentially rapid future earnings growth. However, we believe the investment case for Schwab is far better than the one presented thus far because much of Schwab’s earnings power remains latent due to artificially low interest rates.

In 2014, Schwab made 42% of revenues from asset management and administration fees, 37.5% from net interest revenue, 15% from trading revenue, and 5.7% from other revenue sources. Schwab is under-earning in both the asset management and administration fee category and in the net interest revenue category. First, in the asset management and administration fee category, a substantial portion of this revenue is generated from fees Schwab charges on its proprietary money market funds. Currently, because interest rates are so low, Schwab is rebating a large percentage of these fees back to clients. If short term interest rates were to return to 2006 levels of roughly 5% (see Fed Funds Rate History), Schwab could completely cease giving these rebates, resulting in approximately $0.40 of additional earnings, a huge increase relative to current 2015 Wall Street consensus earnings estimate for Schwab of $1.10.

Second, in the net interest revenue category, Schwab generates income by using the deposits of its banking clients and the residual cash of its brokerage clients to make margin, mortgage, and other types of loans to its clients. In addition, it invests some of this money into corporate, government, and asset-backed debt securities. It then makes a spread on the difference between the rate of return it receives on investments and loans and the rate of interest it must pay out to its depositors and brokerage clients. In 2014, Schwab lent out and invested its money at a weighted average rate of 1.71% and paid its depositor and brokerage clients 0.07%, resulting in a 1.64% spread. In most interest rate environments, the spread that Schwab can make is much larger. In 2006, for example, Schwab could lend money in a low risk manner and still earn a weighted average rate of 6.16%. However, because many clients 1) have nominal amounts of money in their banking and brokerage accounts, 2) value the liquidity of these accounts, 3) don’t want to go through the hassle of switching banks, and/or 4) value the safety and security of Schwab or other reputable big institutions, many customers will accept less than the risk-free short-term rates of interest on their money. In Schwab’s case, during 2006, it paid a weighted average 1.98% to its depositors and brokerage clients. Thus, Schwab earned a net interest margin of 4.18%. If interest rates returned to 2006 levels and remained there, Schwab’s net interest margin would increase substantially over time, possibly eventually to a rate around the 4.18% it earned in 2006. (Side note: Because the deposits and brokerage client cash are all variable rate and the investments and loans that Schwab makes are a combination of fixed rate and variable rate, some with durations of over 10 years, we estimate that, if short-term risk free rates went to 5% tomorrow and stayed there, net interest margin would expand by 20-30 bps immediately and then keep expanding up to the 4% level over the next 5 to 10 years as the longer duration securities mature.) The magnitude of this expanding net interest margin impact is very large. If Schwab’s 2015 net interest margin were 4.18% instead of the current 1.64%, it would earn an additional $1.80, and this potential earnings impact will grow over time at a rate roughly in line with the growth rate of Schwab’s deposits and brokerage client cash. Overall, combining both the money market fee waiver and the net interest margin effects, we believe Schwab’s 2015 “earnings power” in a higher rate environment is approximately $3.30 versus the $1.10 Wall Street consensus earnings estimate.

In our base case scenario for Schwab, we believe the company can continue to grow client assets, deposits, and total revenues at 8-10% a year and earnings at 10-13% as a result of ongoing fixed cost leverage, even with short-term interest rates at zero. Then, as interest rates rise, the money market fee waivers should subside relatively early on and, combined with the slow increase in net interest margin, should provide an immediate 20-40% boost to earnings per share. The 2016 Wall Street consensus earnings estimate of $1.57 implies this sort of immediate impact. Thereafter, we believe earnings per share will continue to increase by the 10-13% organic rate with an additional 5-20% continued growth boost from rising interest rates, depending on how fast and how high they climb. If net interest margin were to increase to 4% over the next 8 years, we believe Schwab could earn over $6.00 in 2023. At a valuation of 15x earnings (versus 25x today), Schwab’s stock price would compound at an 18-19% yearly rate, including an estimated 2-3% from dividends or share repurchases. If interest rates don’t increase at all over the next 8 years but we’re right about the rest of our assumptions, we’d still compound at 8-9%, including 1% from dividends, at a 20x earnings multiple.

Given that we’re value investors, we can’t talk about the upside without also talking about the downside. The major downside risk would be a big stock market rout. In a repeat of 2008-2009, we estimate Schwab’s earnings could fall from the projected amount of $1.10 to $0.90, which is a far cry from the impact at that time (earnings went from $1.06 in 2008 to $0.38 in 2010 even though client assets rose by 9% and client deposits plus brokerage receivables rose by 139% from the end of 2007 to the end of 2010). The increased robustness on the downside reflects the fact that the largest negative pressure on earnings from 2008 to 2010 was the relentless decrease in interest rates and its enormous impact on net interest revenue and money market fees. Since short-term and long term rates have both been low for so long, we believe an incremental impact from a stock market crash on these two categories would be fairly benign. A Japanese-style deflation could cause significantly more earnings pressure, but we believe the probability of such an occurrence is low given the size, diversity, and innovativeness of the U.S. economy as well as the much more favorable demographics of the U.S. population. We also believe Schwab’s earnings multiple may be more robust to the next market downturn because, in the last crash, there was a concern that the money market business would be destroyed by new regulations. Since that time, the Fed has come out with new regulations that leave the money market business intact.

The last potential way to achieve an attractive rate of return on Schwab is through a takeout. Goldman and many other investment banks have been experiencing significant pressure in their trading businesses, and we believe they’re also being outcompeted in their wealth management businesses by Schwab. Thus, we give some credence to the intermittent speculation that Goldman or another investment bank may make a buyout offer, and we think founder Charles Schwab’s age increases the probability he would accept an offer if it were high enough.

Finally, Schwab gives us the opportunity to discuss another aspect of our investment philosophy. As we have mentioned in many of our letters to our investors, since we can’t predict the future, we always attempt to construct a portfolio that is robust to a variety of economic environments. Our portfolio is mostly made up of market dominant, moderately growing, geographically diversified, reasonably priced, consumer staple, toll-taker, and/or utility-like businesses. Generally, we would expect for these businesses to hold up much better than the market during periods of deflationary, downward shocks. However, in periods of stagflation or in environments of steadily rising interest rates, these stocks, along with almost every other asset class, will experience some pressure on their earnings multiples as the discount rate people use to value them goes up. Thus, another benefit of an investment in Schwab is that it serves as a good hedge for the rest of our portfolio since we believe its business and its stock price are likely to do very well in periods of rising interest rates.

Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Nothing said in this piece may be considered to be an offer to buy or sell any security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Data presented was obtained from sources deemed to be reliable, but no guarantee is made as to its accuracy. Past performance is no guarantee of future results.

Posted by: Elliott Savage | February 12, 2015 | Permalink

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