2023-08-22 10:59:59 ET
Summary
- Charles Schwab experienced strong long-term growth after shifting towards a banking-style business model and offering commission-free trading.
- Schwab faces the risk of deposit flight as customers seek higher-yield savings accounts and liquidity concerns arise, but this risk is being overestimated by the market.
- Schwab's strong capital buffers should give investors comfort that this company will continue compounding over time.
The Charles Schwab Corporation ( SCHW ) is a leading financial firm that has experienced strong growth in recent years. Schwab began its life as a proper broker-dealer, working only in the investment space. However, as the online brokerage market showed long-term downtrends, Schwab management made a key decision to adopt a more banking-style model in which they sweep client deposits into interest-bearing products. They did this by opening Charles Schwab Bank, an entity that would use funds swept from the broker-dealer Charles Schwab & Co to earn interest. This model has allowed them to enhance service and reduce fees over time with limited tangible impact on customers.
SCHW is largely credited with the revolutionary shift toward commission-free trading when they cut all trading fees across their entire network. The decision was likely driven partly by Vanguard's continued decrease in ETF expense ratios, but Schwab recognized the industry trend toward fee reduction and decided to lead the pack. Following this decision, Schwab's stock price dropped considerably, dragging competitors like E-trade and TD Ameritrade down with it. This ultimately provided Schwab the opportunity to buy TD Ameritrade, an acquisition that was completed in October 2020.
Commission-free trading allowed for strong AUM (assets under management) growth. Over time, AUM will be one of the key determinants of price movement in SCHW stock and an important indicator for investors to follow. Thus far, 2023 has shown promising growth in net new client assets and new brokerage accounts. Schwab customers were net buyers of equities in June, reflecting investor optimism in Q2 2023 relative to Q1 2023.
Schwab August 8th 10-Q
Schwab's Business Model
At any given time, a percentage of Schwab's customer assets are sitting as cash in their accounts. As shown above for the three months ending June 30 Schwab clients were holding 10.5% of assets as cash. For years, Schwab simply let this cash sit without earning interest.
Still, Schwab is not a traditional bank. Schwab's deposit base is very sticky. The cash they sweep is mostly sitting unused in an investment or savings account maintained by high-net-worth ("HNW") customers. Making money on this cash has allowed Schwab to decrease fees and improve service levels consistently while growing AUM without dramatic changes to their service model. In other words, Schwab made money on cash that customers weren't using anyway, and has used that money to reduce fees and improve customer experience over time. This strategy has worked wonderfully for Schwab, who has grown into a dominant force in the financial industry. Not to mention, HNW customers have different characteristics than retail customers. HNW customers enjoy a much more relationship-oriented servicing model which builds loyalty and trust. The key concern for Schwab investors is that of a protracted decrease in percentage of assets held in cash, but this does not pose a long-term risk at this time. The decrease from 2022 to 2023 is caused by the rate hike cycle, which is likely to shift to a rate drop cycle around 2025.
Retail customers are more fledgling and temperamental. Retail deposits are more likely to shift into higher interest bearing products, eating away at retail bank margins. Retail bank deposits are not sticky. Especially in the current rate environment consumers are not keeping much excess cash sitting in checking accounts. 2023 has been the year of high-yield savings accounts and an industry-wide flight of deposits for the first time in recent history. Banks need to offer higher-yielding products to continue attracting deposits, eating away at margins and leading to lower earnings. Deposit flight, caused by a combination of yield chasing and/or liquidity concerns (e.g. Silicon Valley Bank), is viciously dangerous for banks. Big banks need to maintain a capital buffer to protect from this, commonly referred to as CET1 , which requires capital to be set aside to ease illiquidity risks.
Again, one of the most important metrics to monitor with Schwab is total client assets. Over time, asset growth should reflect itself in share price growth. The management team laid out their strategy in the 2022 Annual Report :
Management estimates that investable wealth in the United States (U.S.) (consisting of assets in defined contribution, retail wealth management and brokerage, and registered investment advisor channels, along with bank deposits) currently exceeds $60 trillion, which means the Company’s $7.05 trillion in client assets leaves substantial opportunity for growth. Our strategy is based on the principle that developing trusted relationships will translate into more assets from both new and existing clients, ultimately driving more revenue, and along with expense discipline and thoughtful capital management, will generate earnings growth and build long-term stockholder value.
Risks
In March of 2023, we all saw a gruesome side effect of mark-to-market accounting. Silicon Valley Bank sent shockwaves through the banking system that are still rippling. Schwab's business model exposed them to this drawdown which has led to a very compelling opportunity for a Schwab investment.
Schwab is in a very safe position relative to the dynamics that are stirring fear in the market. The key to evaluating a bank's risk is the diversification and preferences of its deposit base. Diversification is important to shield retail banks from protracted downturns in any specific customer base. Many banks will provide breakdowns of deposits and deposit growth by customer segment. Consumer preferences are increasingly important as people have the opportunity to earn more in treasuries. Banks not only need to compete with each other for deposits but also with Treasuries for yield.
Schwab is fundamentally safer than regional or national banks because they are primarily reliant on high-net-worth customers whereas retail and commercial banks are dependent on average consumers and small-to-medium sized businesses. High-net-worth customers are more likely to allocate a percentage of their portfolio to cash regardless of rates. While this percentage may be eroded by high-yielding savings products or bonds, it does not pose an imminent threat to Schwab. While this isn't an existential threat to the business, it does give reason to reduce future growth expectations.
The Safety of a Schwab Investment
As characterized by the multiple contraction, the market is still cautious about Schwab. Much of this caution seems driven by asset write-downs. A few notes here.
For insight into Schwab's AFS (available-for-sale) securities book, we can look to AOCI on the income statement. AOCI, or Accumulated Other Comprehensive Income, primarily includes unrealized gains/losses on AFS securities, which are subject to mark-to-market accounting. Since AFS securities can be sold at discretion, companies must reflect their current value (impacted by interest rate movements) rather than book value (the value when they bought the security). Herein lies the catalyst for SCHW's multiple contraction:
SCHW 2022 Annual Report
Schwab carried a hefty AOCI loss into 2023. This neither impacts Schwab's core profitability nor poses a liquidity concern. Schwab's CET1 and leverage ratios are still strong compared to regulatory requirements (for category III institutions ($100B+ total assets but not a GSIB), regulations require a CET1 ratio of 4.5% and a leverage ratio of 4%). Schwab touts an impressive CET1 ratio of nearly 29% and a leverage ratio exceeding 7%, both up from last year. These numbers are core to Schwab's safety as an investment.
Schwab 2022 Annual Report
(note: CSC = Charles Schwab & Co. the securities broker-dealer, CSB = Charles Schwab Bank)
Schwab is a well-rounded behemoth with a balance sheet approaching fortress-level safety. Their differentiated business model has led to a loyal customer base and a strong moat compared to competitors.
What the market also seems to have forgotten amid the banking drama of 2023 is that a high-rate environment is actually really good for depository institutions. Interest-based securities like mortgage-backed and debt securities will lag rate hikes but as Schwab's back book begins to fill with the higher-yielding securities it's currently buying, its net interest margin should increase. Although the immediate effect results in asset write downs, 2023 is giving all financial institutions the opportunity to purchase high-yielding debt and other securities. This will allow Schwab to build a stronger and higher-yielding back book of interest-bearing securities.
Schwab August 8 10-Q
Valuation
My Strong Buy rating primarily considers Schwab's earnings multiple as its key for investment value. The P/E reflects investors' growth expectations, and since Schwab has historically grown quicker than its peers, it has commanded a higher multiple. As the multiple has sunk back down toward equivalence with competitors, the market has offered a compelling opportunity to invest in Schwab. Granted this is not as strong of an opportunity as the $40-$50 range that we saw earlier this year but it is still a solid entry point for a financial giant. Schwab touts a solid 1.5% yield that has grown 18% over the past 5 years. Coupled with ongoing cost discipline, Schwab looks well-positioned to continue growing AUM and earnings.
An investor in Schwab should consider its multiple relative to competitors. Schwab's multiple historically has far exceeded competing broker-dealers and big banks:
Schwab's multiple is currently undervalued relative to its historical average and I expect a material expansion in the multiple between 2023 and 2027. This expectation is driven by the resilience of Schwab's balance sheet and its strong business model. Caused mostly by lingering fears of financial industry turmoil, the market is currently undervaluing Schwab. This is a great opportunity for long-term investors. As noted earlier, the erosion of client assets held in cash does call for a lower earnings multiple, so a purchase at a multiple lagging the historical average provides, at worst, an investment at fair value.
Conclusion
Driven by a dramatic year in banking and finance, there are many extremely interesting opportunities in the space. Schwab is one such opportunity, which I believe is offering a very undervalued price for such a strong financial institution. Long-term investors will be rewarded by an investment in Schwab today. As Warren Buffet is oft-quoted, be greedy when others are fearful.
For further details see:
Charles Schwab: A Discounted Behemoth, Buy The Earnings Contraction