2023-07-24 09:00:00 ET
Summary
- Charles Schwab investors who braved the market's pessimism in March have been rewarded as we bought more shares. SCHW has significantly outperformed the S&P 500 since then.
- Despite near-term challenges, Schwab's wide economic moat business model and strong Q2 earnings demonstrate its fundamental strengths and potential for further recovery.
- SCHW remains relatively undervalued and is poised to resume its uptrend bias, suggesting it's too early to turn neutral or bearish.
- With the bearish thesis effectively dismantled, the company's earnings capability is poised to continue recovering as its cash sorting challenges moderate through 2024.
- I expect momentum investors to return progressively to support a further recovery in SCHW as they realize macroeconomic conditions likely aren't heading toward a hard landing.
The Charles Schwab Corporation ( SCHW ) investors who braved the market's pessimism from March to May and bought more shares have been rewarded, outperforming its financial sector ( XLF ) peers since bottoming out in March 2023.
However, the process hasn't been without challenges, as SCHW traded within a consolidation range between March and May, testing the conviction levels of the dip buyers. Despite that, I have consistently highlighted in my past articles on SCHW that the market's pessimism was likely overstated. Members of my service have also benefited from my exclusive real-time alerts, as we added SCHW aggressively from March to May. We have benefited tremendously from SCHW's recovery as it has significantly outperformed the S&P 500 ( SPY ) ( SPX ) since then.
Bearish investors were too focused on its near-term challenges but forgot that Charles Schwab boasts a wide economic moat business model with significant scale and profitability advantages. Accordingly, Schwab is rated by Seeking Alpha Quant with an "A" profitability and a "B+" growth grade, supporting its premium valuation.
As such, the company's robust second quarter or FQ2 earnings release last week didn't surprise me. Management took great pains to emphasize that these bearish investors were hampered by a " dense fog. " CEO Walt Bettinger articulated that these pessimistic investors were unduly concerned with Schwab's near-term headwinds but missed out on the fundamental strengths of its business model. Bettinger accentuated:
I would often look out toward Treasure Island early in the morning, only to see dense fog. And the fog would not only mask the beauty of Treasure Island, it would often be so dense that you couldn't even see the island out in the Bay. But as we all know, the fog clouding Treasure Island ultimately lifts and the beauty of Treasure Island becomes clear. And, of course, Treasure Island represents Charles Schwab. - Schwab FQ2'23 earnings call
As such, the company demonstrated the strength of its well-diversified business model, as the cash sorting issues slowed dramatically. Moreover, management reminded it's on track to pay off its higher-cost supplemental funding "over the next 18 months, with most of it paid off by the end of 2024." Coupled with cost synergies of about $1B through 2024, Schwab's core earnings strength is primed to recover, suggesting that this year's challenges are likely transitory.
The revised consensus estimates indicate that Schwab's revenue growth is expected to decline by 6.7% YoY, better than management's updated outlook of a 7.5% YoY midpoint decline. Therefore, Wall Street analysts have likely priced in peak pessimism in its cash sorting headwinds. Management also assured investors Schwab is "already past the peak usage of temporary supplemental funding." As such, investors should anticipate a further "unlocking" of the company's core earnings capability.
With that in mind, analysts' projections suggest Schwab's adjusted EPS is poised to recover by 27% YoY in FY24 after this year's 16.5% decrease. The momentum is expected to carry forward through FY25, suggesting a 2Y adjusted EPS CAGR of 27%.
SCHW last traded at an FY25 adjusted P/E multiple of 12.7x, well below its 10Y average of 18.3x. Therefore, I gleaned that while the risk/reward upside in SCHW is much less attractive than in March to May, it's still undervalued.
Moreover, I assessed that macroeconomic conditions are expected to improve, pointing to a soft landing. In addition, Schwab's net interest margin, or NIM, is expected to bottom out from its Q2 low of 1.87% and subsequently inflect higher above the 200 bps zone. Therefore, I posit that the market's discounting against SCHW's long-term valuation average is poised to be normalized over time.
SCHW price chart (weekly) (TradingView)
SCHW's momentum indicators suggest that it's overbought for now. However, it appears to have decisively retaken its 50-week moving average of MA (blue line), auguring well for recovering its uptrend bias.
Hence, while a near-term pullback should be anticipated, I expect dip buyers to return to defend robustly, as SCHW remains relatively attractive.
Investors with little or no exposure should still find the current levels appealing, while investors with heavier exposure should consider a pullback to improve risk/reward.
Given SCHW's improved buying sentiments, constructive valuation, and potentially bottomed operating performance, I remain confident in my bullish thesis.
Rating: Maintain Buy.
Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. The rating is also not intended to time a specific entry/exit at the point of writing unless otherwise specified.
We Want To Hear From You
Have constructive commentary to improve our thesis? Spotted a critical gap in our view? Saw something important that we didn’t? Agree or disagree? Comment below with the aim of helping everyone in the community to learn better!
For further details see:
Charles Schwab: Why I Remain Bullish Despite Its Earnings Surge