CHUCK SCHWAB WANTS to profit from Wall Street’s misery.
Taking advantage of the turmoil and confusion at many remaining brokerage firms, not to mention the anger of their clients, his firm is cutting prices, reducing minimum investments, and rolling out new products aimed squarely at luring customers—for what he believes will be a radically different investment environment over the next few years. It’s also putting more resources behind some of its proprietary mutual funds.
Schwab, chairman of the namesake financial-services firm he founded in 1971, expects a prolonged period of low returns, potentially higher inflation, more lucrative overseas markets, and substantial competition for funds from expanded government borrowing, he tells Barron’s.
Charles Schwab the firm is aiming to turn this to its gain by offering solid products at good prices. In a striking example of its approach, Schwab (SCHW) in May cut the expense ratio of its Schwab S&P 500 Index (SWPIX) fund to 0.09%, less than cost-conscious Vanguard’s hugely successful Vanguard 500 Index Fund (VFINX), which carries an expense ratio of 0.15%. At the same time, Schwab cut the minimum amount required to invest in the fund to just $100, compared with Vanguard’s $3,000 minimum. It was “a call to action to get back into the market” for individual and institutional investors, says Randy Merk, Schwab’s president of investment-management services. He adds: “We’ve seen a nice little pop. We’ve seen exactly what we’re hoping to see. We’ve seen transfers from Vanguard and Fidelity based on price and minimum investment.” (Spokesmen for Vanguard and Fidelity said their businesses are in good shape.)
As part of this push to draw in more clients, Schwab is also seeking Securities and Exchange Commission approval to roll out its own family of exchange-traded funds. The latest moves complement a strategy that already seems to be working. In 2008 — when many money managers were struggling to keep funds in house — Schwab, with its many money-market funds, took in $113 billion (through funds, brokerage accounts and pension and retirement products), or more than Citigroup, Morgan Stanley, Merrill Lynch, E*Trade and TD Ameritrade combined. It now warehouses a total of $1.1 trillion across all of its businesses, and is the country’s 13th-largest fund complex, with $242 billion in assets. Founder Schwab, 71, and new Chief Executive Officer Walt Bettinger believe the firm’s assets will grow at a rate of 8% to 10% per year, based on recent growth and the firm’s positioning.
TODAY, SCHWAB IS COMPRISED of a brokerage unit (called “investor services”) that accounted for 21% of revenue in 2008. Asset-management and administration, driven by Schwab’s institutional-services unit, accounted for 46% of revenue. Then there’s Schwab’s bank, which holds excess cash from certain brokerage-client accounts and also provides mortgages and home-equity loans. Net interest revenue brought in another 32% of revenue last year.
In addition to its own mutual funds, Schwab has an extensive fund platform of outside funds. The Mutual Fund Marketplace, launched in 1984, has $311 billion in 14,533 available funds. OneSource, launched in 1992, offers funds without transaction fees. Layer on the advice — the Schwab Center for Financial Research screens funds quarterly—and you can see why the platforms are so popular. At the center of the Schwab business are independent financial advisors, many of whom quit their jobs at wirehouses to hang up their own shingle. They’re about 40% of Schwab’s business and key consumers of Schwab funds — particularly OneSource, its mutual-fund supermarket that has no transaction fees.
Of the $113 billion in net new assets for 2008, independent advisors accounted for more than half. Low-cost proprietary funds clearly play to that constituency. Says Peter Bourbeau, a portfolio manager at ClearBridge Advisors, a unit of Legg Mason: “There’s a roughly $2 trillion opportunity in the advisor channel, and they have 25% of the market — double the nearest competitor.”
Schwab uses the a “high-touch” approach with this vital clientele. For example, it regularly holds splashy “Impact” conferences each year to bring advisors and fund companies together. They upped the hand-holding this year with the market downturn, producing 400 events for advisors, up by a third from 2008. One representative conference in California featured: quantitative fund-manager and investment theorist Rob Arnott, who talked about the viability of diversification; U.S. Global Funds chief Frank Holmes, who addressed global markets and the boom in commodities; and Santa Clara University (Calif.) financial-behaviorist Meir Statman, who talked about helping clients feel comfortable about getting back into the market. “It is very high-end,” says Holmes.
Soon to come will be proprietary ETFs. Schwab, by its own estimate, already handles about 22% of all retail-ETF flows, and about 10% of all outstanding ETFs are held in custody at Schwab. Yet the ETF business has put some pressure on Schwab: If a client moves from an actively managed mutual fund on One Source to an ETF, the firm loses revenue on fees that fund companies pay to Schwab to be on its platforms. And if that same client dumps a Schwab fund for an ETF, Schwab loses the investment-management fee itself. Thus Schwab has sought permission to offer ETFs, as a response to the popularity of these cheap, tax-efficient, and hedging friendly products. Merk won’t say much, but Schwab will offer an ETF that mirrors the Dow Jones U.S. Total Stock Market Index and 10 other ETFs. The funds will undoubtedly be low-cost, passive products at the outset (there are, after all, only two ETFs tracking the Standard & Poor’s 500, versus 140 open-end mutual funds), although Schwab wants to offer actively managed funds too. Schwab already offers a popular, highly rated target-date fund that could be one of the first consumers. Says Schwab: “We are seeing ETFs as a major beginning for us.”
ANOTHER BIG SCHWAB constituency is made up of the retail investors it was originally created to serve. There are certainly more of them with the company these days, since many felt they’d been abandoned by their wirehouse brokers during the downturn.
The number of new brokerage accounts at Schwab rose 10% last year. But a growing group is made up of those laid off during the savage bear market, and who rolled their pensions over to Schwab. Some 15% of the households that came into retail last year originally came through Schwab’s corporate-and retirement-services operation.
These clients are a different breed — “more buy-and-hold investors, as opposed to traders,” says Scott Burns, director of ETF Analysis at Morningstar. Although they’re unlikely to trade, Schwab could still collect the investment-management fee from them.
The firm’s executives believe that investors will continue to need more, not less, advice from professionals — and see Schwab’s role as twofold: 1) Reassure investors that the deck isn’t stacked against them; and 2) Reiterate the need to own equities.
Says Jeff Mortimer, chief investment officer at Schwab’s investment-management division: “People are still underinvested, and have not enjoyed the ride back. Round One is behind you. Now what do they do?”
There’s only “a small trickle away from safety today,” says Mortimer. But money markets are yielding zero, and investors ought to complain not about fees but “that Nasdaq went up 50% without them.” For longer-term investors, he says, if the markets simply return to old highs, they’d have doubled their money. “The only way to be right,” Mortimer continues, “is to stop being wrong” — and to buy equities
Aside from independent advisors and retail investors, there’s a Schwab asset that generally gets little mention: Charles Schwab Bank, which accounts for a third of revenues and makes mortgage and home equity loans. Delinquencies are a scant 0.05% of outstanding loans, substantially less than the 6.9% national average. Schwab has marked its Alt-A mortgage backed securities to market. If the value of these securities rises, that could fatten the earnings stream down the road. In the meantime, Schwab is nicely capitalized.
To be sure, Schwab hasn’t totally dodged the credit crisis. It’s still in litigation with investors over the disastrous performance of its Schwab YieldPlus fund.
Moreover, in theory, the growing proprietary-fund family could put Schwab on a collision course with fund companies and advisors, although Schwab through the years has adeptly served any number of constituencies. Then, too, the market could head south for a sustained period, meaning that the fee cuts will do little to turn investors from money funds. The latter are an expensive proposition for now: With rates at lows, Schwab has been waiving fees on the money funds.
Meanwhile, Fidelity and Vanguard are no slouches. Fidelity recently hired Charles Goldman, a top Schwab executive skilled at marketing to independent advisors. (Coincidentally, growth in the independent-advisor space was showing signs of slowing down this year, although Schwab sees it as temporary.)
THE VERY EARLY RETURNS on the effect of Schwab’s price-cutting should be more evident on July 16, when it reports quarterly earnings. Wall Street expects it to earn 18 cents a share on $1 billion in revenue.
Analysts on average expect Schwab’s 2009 earnings to fall to 75 cents a share, on revenues of $4.3 billion from $1.06 a share last year on revenues of $5.2 billion. The decline is due to the generally poor markets and low yields. Key variables for this year include equity-market values and the level of short-term interest rates.
But some portfolio managers think it can do better than that. “The consensus sees 75 cents in ’09 and $1 in 2010—we think that’s understated,” says Paul Rasplicka, who manages AIM Capital Development Fund (ACDAX) and AIM Dynamics Fund (IDYAX). In fact, he thinks earnings will beat expectations by at least 20%.
And Rasplicka likes the stock. At 16.50 last week, the shares are trading at 17 times earnings, and give a total market cap of $19 billion. Schwab, he says, ought to trade at a multiple of 20, which would put the stock in the low 20s—at least 20% more than last week’s price. Other investors have mentioned Schwab as an excellent way to play Americans’ new-found thrift: As savings rates rise, the price-cutting firm, with its raft of money-market funds and other alternatives, should be a major beneficiary.
“What’s unrecognized about the story? The sustainability of the asset-gathering mechanism they have in place,” says Bourbeau of ClearBridge. That may not go unrecognized much longer.
The Bottom Line
Discounter and online-broker Charles Schwab is well-positioned to benefit from the confusion within Wall Street’s broker community. And the stock looks pretty cheap too.
Schwab: Lower Returns Ahead
Over the course of his interview with Barron’s Thursday, Charles Schwab spoke mostly about his vision for his company, but he also offered his views on the economy and the markets. Here are the highlights:
- On investor expectations: “We are shifting much more to a managed economy…[with] significant competition for the investment dollar from the government. Instead of 20% of gross domestic product, government will be 30% to 33%. You have to think in terms of your investment expectations that returns will be substantially less here in the U.S…so you don’t get disappointed.”
- On equity-market returns: “8% to 10% is not realistic today. It probably won’t return for at least four to five years. For the next four to five years, you have to be thinking, on a real basis, of more like 4% to 5%.”
- On inflation: “We’re building a vast reservoir of potential inflation. We hope it’s going to be low, but there’s definitely an argument that it’s going to be substantially higher, closer to 10% per annum, a couple of years out.”
- On international investing: “One benefit is it gives you diversification away from our currency. We are expanding our money supply at a very quick rate. If you’d asked me 20 years ago, I’d say you needed 15% in international investments. I’d say now it’s closer to 40%, in large countries, and a component in emerging markets and fixed income. There are better opportunities for growth in some of these smaller countries.”
- On other types of assets: “The degree of uncertainty is quite high, and the way I deal with it is to make sure I have broad diversification. On bonds, it depends. I never think about that rule that your bond portfolio should equal your age — but that’s a nice rule of thumb. In other asset classes, in many respects, it’s better to invest in companies that are more commodity-based. I’m not a big commodity speculator, as that’s much more volatile, so I use companies like ExxonMobil (XOM) rather than oil futures. The real winner is going to be the government. So for a chance to invest in your government, you can buy some of those five-year Treasuries.”
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