I am very excited about the stock that we are going to talk about today because with inflated asset prices everywhere, our guest might have found a stock that trades at a really attractive price-to-value ratio. The stock is Charles Schwab and to help us analyze that stock, we have Arif Karim with us. Welcome back on the show, Arif.

Arif Karim  1:26  

Hey! Thanks, Stig. I really appreciate that I always get to be on your show. Great to talk to you.

Stig Brodersen  1:31  

We definitely love having you, Arif. Like I said there, we will be talking about Charles Schwab and the ticker is SCHW. It’s one of the cheapest high quality picks out there. We’ll talk about intrinsic value at the end of the episode but first things first, could you please provide an overview of the business?

Arif Karim  1:52  

Charles Schwab has been around for almost 50 years now. It was established and founded by Chuck Schwab. 

Back in the days, in the US at least, brokerages were regulated. Brokerages are still regulated now but commissions were regulated by an agency of the federal government. They were at a high price point. 

Really, at that time, for the average investor to be able to trade stocks, you must pay high commissions because the trading capability was a.) managed by a bunch of people informing the market, and b.) it was bundled with Wall Street research. All that was kind of embedded in the cost of trading. 

Schwab was a guy who wanted to democratize trading for the masses. In order to do that, you had to bring the cost of trading down. That was the founding of the business. 

His whole deal was, “I want to create a better and cheaper way to trade, in the sense that you don’t have to buy the research along with it, if you have your own ideas of what you want to buy yourself.”

He wasn’t able to really get that going until commissions became deregulated. That was called Mayday. It was May 5, 1975, I want to say, but that’s when stock trading commissions became deregulated so they could be at any price point. That was the birth of the discount broker and Schwab was one of the first at that. 

Over the years, what’s happened is the ethos that Schwab brought to the business and founding the business carried on into the culture business. 

Schwab’s whole culture and ethos have been around bringing down the cost of trading, but also asset management and increasing distribution of investment products’ availability to the masses. That’s their focus in the business. 

What that means over time what Schwab has done is it’s the parts of investing in terms of the cost of investing that can be commoditized. They have commoditized and of course, technology is a huge enabler of that by taking away the high cost people and implementing where possible automation and computers to basically reduce that cost of various fees. 

We have trading pools of investment vehicles. Schwab has then carried over that ethos and culture of bringing down commissions to other areas of investment management. Like we all know, ETFs which basically reduced the cost of owning a basket of stocks. Mutual funds used to manage at 1% or 100 basis points or more, down to only 5 to 10 basis points, and on its way to free basically, right?

Those sorts of things Schwab has also worked to basically enable.

I think one of the things that is really attractive to me about Schwab is that over that long term window is their ability to basically move up the value chain and also scale their business model across different types of customers and services. 

They go up the value chain. They commoditize the services in the lower end of the value chain and move up where there’s margin and then basically go in scale that part of the business. Again, they use technology and scale to reduce the cost of that as they keep going further up the value chain. 

The conclusion of that is basically it allows this win-win situation where customers are attracted  to Schwab because it offers the best value for the services they’re offering. It’s high quality service. It’s not the cheapest guy, but it’s not far from the cheapest guy.

However, by paying a little bit more than the cheapest guy, you also get this great value from Schwab in terms of quality of service and the offerings they provide like security and technology. 

They’re never the leader in technology, like Robinhood would be, for example, but they’re usually pretty close behind. I think you get this win-win-win relationship between Schwab the company, Schwab’s customers, and what they’re offering for them. Then over the long term as shareholders. That’s kind of that short version of the history of Schwab and what they do.

Preston Pysh  5:51  

Arif, as you mentioned, Charles Schwab, it’s only been around since the 1970s. Today, they’ve got $4 trillion of assets under management, which is just an unthinkable number. How are they able to achieve that in such a short amount of time?

Arif Karim  6:08  

You delve into the history and look at the means by which they built their business. Their origin was all around trading commissions and being a discount trading broker, right? 

What they did then is they basically worked their way up the value chain. They had millions of retail customers trading on their platform. 

Initially, it was by phone. You still call and talk to somebody and then put a trade through. Then it became an automated telephonic service. I remember this when I started my first account with Schwab back in college. 

You call them and there was an automated service that you used. Then with the internet, you’ve got this web interface that came with it. Over this time, their commissions kept declining and it kept opening up the service to more and more people who became interested in trading stocks. 

Then when they had enough of a customer base, they really had this distribution platform that they could then go back and market to the companies that had products to sell to customers. 

What was applicable to Schwab’s customers were mutual funds. They created this platform called OneSource, where a mutual fund could trade on Schwab’s platform, commission free, which was a big deal at the time because commissions were non-trivial. You could list on their OneSource mutual fund platform by sharing a piece of your *inaudible*. 

The mutual fund would pay Schwab for distribution to retail who saw the ability to trade the mutual funds on OneSource for free. That created this advantage for the mutual funds that could be on the OneSource platform, in terms of getting new customers and increasing the share with those customers, relative to the mutual funds that weren’t on OneSource and you had to pay a commission to trade those mutual funds. 

Then, they acquired a company that allowed them to do options trading. They added that as another investment form that customers could use. These are examples of vertically and moving up the stack of different types of investment vehicles and higher value services. 

Then at that point, they added their own mutual funds. Then when ETFs came in, Schwab also created a set of ETFs. Today, they are some of the lowest cost ETFs, right? 

Schwab doesn’t fight the trend. When the trend hits kind of a tipping point, Schwab just kind of goes all in and makes sure it has the servicing costs at the back end, to enable it to succeed in those new offerings. They’re driving greater value for customers. 

The other thing that they do is they also have this horizontal expansion strategy. What that means is they started first with retail investors, right? So, just individuals that were interested in trading. It started with trading and then later became wealth management and advisory services, which Schwab also offers now. 

In terms of horizontal expansion, what they did is they had this platform that’s been built with the ability to trade at a low cost and the ability to custody assets at a low cost. 

The cost is relatively fixed, right? We’re talking about computers, databases, and things like that. Then, interfaces with other financial services. The whole regulatory and compliance sort of infrastructure, you get to build all these things. They are there in place. You want to distribute the cost of that over as many parties or assets as possible in order to get the lowest expenses per dollar of assets that you manage, basically.

To horizontally expand what they started doing in the 90s, they added an independent registered investment advisory. What you’ve had over time is regulation changed and the realization that incentive structures really matter on how financial professionals service their customers… 

The way you collect fees, how you charge your fees. The fact that investment advisors have relationships with customers over a long period of time and provide them a lot of value has led a lot of investment advisors who work under the traditional wirehouses. These are like Morgan Stanley, Goldman Sachs, UBS, Credit Suisse. They basically cut away from those big banks and start their own businesses, oftentimes bringing a certain number of clients with them who they have close relationships with. 

They change the way they get compensated so that it’s much more client beneficials. In other words, it becomes a win-win situation in the sense that, historically, these investment advisors really were brokers in the past. They would make money by getting you a client to trade. That, of course, presents a bunch of the wrong incentives, in terms of what’s best for the client. 

The right incentive is to say that if the client wins, I win. So in many ways, how that’s manifested into incentives has been, “I collect a fixed fee on the assets under management with my client and I can then provide whatever is best for my clients. My client’s wealth grows, and therefore my fee grows along with them, since it’s a percentage of *inaudible*.” 

It’s not based on this churning of their portfolio, where I get a chunk of the brokerage commissions, which is how it traditionally had been done. 

Anyway, there’s been this trend of entrepreneurship, more and more investment advisors, especially they have more experience and have strong relationships with clients, moving from these integrated platforms to their own independent platforms.

Stig Brodersen  11:25  

Arif, let’s dig a bit deeper into that. In 2018, trade commissions accounted for less than 8% of revenue. Then the year after, Charles Schwab chose to completely eliminate brokerage commissions. I mean, talk about a company cannibalizing itself. So keeping that in mind, how does Charles Schwab make money today? How do you think the company will make money in the future?

Arif Karim  11:52  

It’s interesting. Schwab, like we talked about their genesis, was brokerage commissions. In 2019, they basically eliminated brokerage commissions, which is incredible. 

In many ways, what it attests to is this ability of the company to adapt over time. As we talked about, move up the value chain so that the lower parts of the value chain become commoditized, in a sense that the fact that 8% of revenue in 2019 came from trading commissions was pretty small, relative to where it started, which is 100%. 

This has been a trend over time that the things that can get automated and can get, at the expense of scale, that perspective of declining per transaction costs going to zero via automation. Schwab makes those investments and it drives that commoditization and those lower value services. 

It’s a great example of just what we’ve talked about, which is commoditization of the lower value services that can be automated and cost per transaction reduced. 

Schwab had started with 100% commissions creating revenue, right? Then over time, they’ve expanded into higher value services, while commoditizing the lower value services, which makes it a much more compelling proposition for its customers. Over almost 50 years, they basically brought commissions trading from 100% of revenue down to 8%. 

The trend was clear. Commissions trading revenue is heading toward zero, because it’s done via computers, right? So, both on the customer side in terms of how we manage our accounts, in terms of trading, we self-enter these trades. We don’t call somebody, a trader, to trade for us. There’s no person there. We’re self-servicing. 

However, also on the back end, when you look at those old pictures and videos of the New York Stock Exchange with people yelling and screaming with hand signals and all that, that doesn’t exist. It’s just a bunch of servers now.

Every time you bring computers into any kind of a service, you’re basically reducing dramatically the cost of providing that service. The cost of trading is heading towards zero. They basically kind of preempted what would be a long drawn out sort of asymptomatic and a curve towards zero by just taking it down to zero. 

As I mentioned, it was only 8% of the revenue. They are higher than that on operating margin or operating income, but certainly they were outside factors that drove Schwab to basically take it to zero. 

There’s a company called Interactive Brokers, and I’m sure many of your listeners are also familiar with them. Interactive Brokers is sort of a pure automated trading platform. They introduced a service that was zero commissions and that’s probably the first mainstream type of brokerage service that took their commissions to zero. 

The one that sort of wasn’t mainstream is small, but growing quickly is Robinhood, which has been more of a little bit of a definitely a phenomenon with millennials and younger generations who basically are at first in terms of a lot of the services they consume. 

So Robinhood has been commission-free for a while but they make their money on something called order flow. All the other brokers have some order flow revenue as well that substitutes for commission. 

You’ll see Schwab doesn’t go to zero trading revenue, they do have some order flow. Then options still provide a source of commissions revenue but are very small relative to that equity.

Schwab at least saw the writing on the wall to kind of accelerate this to zero. That hit some of the more traditional “discount brokers” like Ameritrade and E-Trade much more harshly because more of their revenues came from commissions still. 

What this did for Schwab is it created this competitive advantage relative to acquiring new customers in the sense that we’ve talked about the higher value strategies that Schwab has added to its plate of service that offers customers.

So to answer your question about where they make their money now, it’s that they still offer lots of other investment products that they earn a fee on. They still provide a platform for IRAs to custody on, and they make some fees on that. Not directly from the custody but around these  services. 

They offer IRAs. Then they have this sort of very important entity called Schwab Bank, which basically takes the cash that sits in customer accounts and puts it into a sweepstake basically into a bank that’s run by Schwab. 

Just like a regular checking account, they pay some kind of interest on the cash balances that customers have, but then they get to use that to basically float and invest in higher yielding assets. Schwab bank collects the difference in the yield that they receive versus what they pay out to customers depositors. That yield difference is called the net interest margin.

Schwab has built Schwab Bank within its brokerage and asset management business. Interestingly enough, that now accounts for over half its revenue. It is 60%, but it’ll be probably more like 50% range in 2020. Between 50% and 60% of revenue comes from Schwab Bank now. That’s a highly profitable business within Schwab entirely, about 40% of business, between 30% and 40% comes out of their asset management fees business. That’s just advisory services: fees on mutual funds, fees on ETFs, fees on that mutual fund distribution platform I mentioned, OneSource, and other fees like that.

That too, over time, we believe, is also getting commoditized. Basis points of fees that they will collect on any asset base is going to decline that *inaudible* piece of the business. 

Going to kind of roll it all together, I’d say the summary is that what Schwab does is it offers lower and lower explicit fees to the customer. You’re getting all these services and more and more services, more and more choice on Schwab for a lower and lower fee as a customer. That accelerates the flywheel of bringing in new customers and bringing in new assets, which then increases its scale, which further reduces Schwab’s costs because it is a *inaudible* driven platform. The more assets they manage, the lower expense per dollar of assets that they manage, right?

The bigger the scale they get, the more cost advantage they have, the lower they can bring the prices to then bringing even more customers and more assets. It’s this flywheel effect. 

However, they charge what I call an implicit fee, which is an opportunity cost. You could take that cash and yourself buy something else within the platform in the form of a bond or some sort of credit instrument that could be short term or medium term as a way to substitute period cash, but to the extent you leave the cash in there.

Schwab takes that cash. I mean, sort of these are all like accounting buckets, right? The cash still belongs to you, it’s still yours. But just like a bank, it uses that cash you have in your checking account, that cash balance, to then invest for itself in other higher yielding fixed income instruments, that then keeps the benefit of that higher yield for itself for within the form of profit for Schwab. 

However, you, the customer, could always say, “Oh, you know what? I have a 10% cash balance in my account. I’m going to allocate it to some Fixed Income Fund or some treasuries, or whatever it is that I want to put it in.” 

But it’s just that most investors and most clients always have some kind of a cash buffer, if you like to have between trades, or it might be part of your allocation. It might just be for whatever reason, they’ll have cash that they’re not actively putting to work.

Schwab takes advantage of that pool of cash. Of course, cash is available to whoever needs and wants it. However, that pool of cash is redeployed in Schwab Bank where it makes its gain. Like I said, it accounts for 50% to 60% of revenue. That revenue probably has on an incremental basis, like an 80% plus margin to it. 

That becomes an implicit cost to the investor client because I’m not directly paying a fee on this. It’s just cash sitting around that I’ve lost the opportunity. It’s my own fault because I haven’t put it to work. I’ve lost the opportunity to basically invest it somewhere else. However, I very well could and anytime I want. Schwab offers you the tools and the instruments by which you can do that. 

Just one more note is that when Schwab Bank invests in higher yielding credit instruments, while paying you a deposit interest rate, one thing that we like about Schwab Bank is that it’s a very low risk proposition. 

Think about Schwab Bank just like any other bank, right? Most banks take money from depositors. They pay them with a small interest rate and then a low yielding environment, of course. Then they basically take that money and invest it in higher yielding private instruments. 

Now, with higher yields, you get a higher yield for a longer duration. You get higher yield at more risk. You get a higher yield, or maybe smarter, fixed income management kind of thing, or sometimes for more sophisticated or complicated structures. 

One thing that we’ve not really liked about the banking sector is the lack of transparency on their balance sheet. You get some summary statistics, but that really doesn’t tell you about what’s on that balance sheet. That came to a head back during the housing crisis, right?

Just read the summary statistics. By and large, the average investor probably would have said, “Oh, this looks totally fine, safe, and within the limits of the federal financial regulators.” 

What we learned though was that there were a lot of risky instruments in there, and the amount of leverage on the balance sheet couldn’t handle housing falling 10% to 20%, in terms of the value of the house, right? 

Then as a result, what the homeowners behavior ended up being in terms of both their ability to voluntarily or involuntarily sustain their mortgage payments. So there’s a lot of risks that banks bear, as a result of being institutions that provide credit to businesses and consumers. 

What we like about Schwab is that we don’t have to worry about most of them. The vast majority of the balance sheet at the bank is basically invested in low risk federal, the US government-insured products, whether it’s treasuries directly or mortgage-backed securities that are agency mortgage-backed securities that have the implicit support of the US government. Then high grade corporates. That’s a minority of their balance sheet.

What they’re doing over time is doing more in terms of lending money to customers, but of course, backed by the value of the accounts they have. There’s some prudent measures they have there that we think will continue to make the balance sheet very safe. 

So, we don’t worry too much about the credit risk part of it. You’re getting this high margin bank asset within Schwab that sources low cost funds from brokerage accounts, and then invests in relatively safe credit instruments at some very high incremental profit margins.

Preston Pysh  22:37  

Arif, I want to talk more about the business of asset management. A very important key ratio is expenses on client assets or the EOCA. Could you please explain what that is? Then also talk about how Schwab is situated with respect to that key ratio compared to some of the competitors?

Arif Karim  22:57  

This is one of the big advantages of Schwab’s platform is that they have created this platform, as we talked about earlier. We always talk about a spectrum, right? When we talk about it, it’s going to sound like it’s very one sided. 

On the spectrum of costs, you have variable costs, which is at every new client you bring in or every dollar new asset that you bring into manage for the client, your expenses grow in proportion to that. That’s a very variable sort of a business model.

On the other end is a fixed model where you have to build out a platform. Then theoretically, no matter how much money you bring onto the platform, it doesn’t cost you any more to service that money.

 

In that way, you’ve got this scale leverage that comes to their platforms. Kind of in a simplistic version, the more you can bring in, the lower the cost per dollar to manage on your platform. 

Schwab is more than a fixed cost side, in the sense that their costs scale very slowly, relative to the amount of assets they manage. The bigger the scale of assets you mentioned earlier that Schwab manages over $4 trillion in assets for its clients. All those assets sit on this platform that’s relatively fixed costs. 

The more assets you can then bring, the lower the amortization of fixed costs over every dollar of asset. That EOCA, as they call it, the expenses on client assets, reflects that ability to basically have a very low cost basis per dollar of assets being managed for the client. 

Schwab, because of the nature of their platform, and there’s a lot of this culture of low cost, this culture of automating what can be automated. All that kind of brings to bear cost advantage for them relative to their competitors on that measure. 

The importance of that measure is that it gives Schwab more pricing power. Normally, Warren Buffett acolytes, such as ourselves, value investors, we think of pricing power as the ability to raise prices over time, but in this sort of business, pricing power also means it gives you ability to lower prices without damaging your margins. 

If you’re thinking about it from a competitive perspective, if I can lower prices for services for my customers, I can use that as a way to attract them to my platform. But if the cost of my platform is actually declining faster than I’m reducing my prices to the customer, then my margins are growing. That’s a great strategic advantage to have. 

When you look at Schwab’s platform, they are at 16 basis points per dollar in expense of assets managed for clients. In other words, for every dollar of assets that they manage for clients, it costs them now, scale derived,  $4 trillion. For every dollar of line assets they manage, it costs them 16 basis points to custody that dollar of assets. That’s much lower than their direct competitors. Ameritrade is at 27. E-Trade is at 37. *inaudible* and Morgan Stanley Wealth Management are at over 50 basis points, basically. 

This is based on numbers that Schwab has provided. We trust the management there. I put another way to independently verify this, but the point is that they are so much lower than competitors based on the structure of their platform and their culture, that it’s hard for those guys to compete with Schwab in doing that. 

Going back to that idea that pricing power comes from being able to lower your costs faster than you lower the cost of your clients. In other words, the better you can lower your costs to make yourself more efficient, the more value you can provide clients by lowering their cost to operate with you. In the meantime, you can raise your margins as well. That’s kind of that’s hugely powerful flywheel.

Actually we’ve seen this with Amazon Web Services. Before Amazon broke out Amazon Web Services, we were all kind of guessing at what the margins were there, because what we saw from a public perspective was they kept reducing prices for their services. 

However, we didn’t see that while prices were coming down, costs were going down even faster, again, because of Moore’s Law and other technologies of scaling types of initiatives that they had. That made it very hard for new entrants to compete, because they had scale. 

Today, that probably still rings true. There’s only a handful of global cloud providers that can have the scale to have the types of cost structures that Amazon Web Services or Microsoft Azure can have. 

Similarly, in the financial business, you need to have large scale and a platform built on technology to take advantage of the technology curve, in terms of cost reductions in order to compete with Schwab

Stig Brodersen  27:48  

Arif, great that you’re so thorough in your analysis and you include so many different variables. Very interesting to hear about… We often talk about the few key variables that you really need to understand and you need to track those key variables to see who are most competitive in the industry. 

Warren Buffett has said that and Bill Miller, who we had on the show. We have been talking about those two to three… It varies from company to company, but you don’t necessarily need to monitor 1000 different variables to figure out which companies are most competitive. 

Keeping that in mind, could you please outline the competitive landscape of Charles Schwab and perhaps also one or two other key ratios you are looking at to understand the competitiveness of both Charles Schwab and their competitors?

Arif Karim  28:33  

Interestingly, when we talked about expenses on client assets, I mentioned a couple of the competitors that Schwab measures itself against. One of them sort of, historically speaking, you had Schwab being a discount broker. Ameritrade and E-Trade were discount brokers. They were kind of traditional competitors back in the 90s. 

Before that, there were a bunch of other sort of discount broker competitors that have kind of gone by the wayside, because they just didn’t grow fast enough to stay competitive. More and more, Schwab has been going up the value stack as we talked about, which means they compete more and more with traditional investment managers, wealth managers, like Morgan Stanley, UBS, Bank of America, JP Morgan. All these guys have wealth management subsidiaries to them. They may also manage large amounts of client wealth in the hundreds of billions of trillions. 

Schwab’s competitive set has been growing towards the traditional names that we know of, as I mentioned. 

On the other hand, the cost structure they have is much  lower than those guys were more “full service.” They have research teams that publish reports and make recommendations. Whereas Schwab doesn’t offer a whole lot in the way of research, but they offer you a platform to express your own views of wherever you get your research from.

Then a lot of it is Seeking Alpha, reading the news or following things on Twitter, wherever people get their investment ideas from. Increasingly as you know, it’s heading in the direction of passive investing right through ETFs. 

We think the latest numbers in the US is something like half of all assets in the management are now in ETFs. There’s not much research needed for that at all. You’re just buying into the index and letting others do the research for you and price the components of the index for you, basically. You’re riding passively there. 

Having said that, the competitive set are all these a whole host of companies. One of the things that came out of the Schwab basically eliminating missions was that it damaged the business model for some of the traditional competitors like Ameritrade and E-Trade. What we’ve seen is that Schwab is able to take advantage of that situation by acquiring Ameritrade. 

What Ameritrade does for Schwab is it acquired its one of its closest competitors, another roughly $1.5 trillion to its platform. You’re going to see a platform that goes from $4.5 trillion assets, getting to% 6 trillion assets, probably by the end of the merchant acquisition closing. That will, again, further improve its expenses on client assets because you’re going to expand the pool of assets to $6 trillion from $4 trillion. 

What they’ve said is they were going to cut out about $2 billion of costs from the Ameritrade business because there’s a lot of duplication of expenses between the two organizations. Those Ameritrade assets are coming in are incrementally even more profitable. Schwab’s potential was to be higher but today, it’s not higher necessarily, because of other dynamics going on. We can talk about later, which is kind of what’s happening to the net interest margin piece of Schwab. 

Coming back to your question of what types of ratios that we look at in measuring how well Schwab is doing. One, it’s how fast are they growing their AUM. They publish this number called net new assets, which is the organic growth of new assets coming to the Schwab platform. It’s gross assets coming in, minus assets leaving, and the assets could leave because, “I’m retired and I need a part of my assets to live.” It could also be competitive losses, having customers that go from my platform to somewhere else. 

So, net new assets encompasses the gross coming in minus those that leave, and that the net new assets have been growing on the range of about 5% to 7% a year, over the last several years, as a percentage of the base of assets they have. It’s an important measure metric to measure, which is the success Schwab is having and growing. It’s AUM. 

The most basic way to view the intrinsic value growth at Schwab is looking at AUM growth, because that tells you a lot about the health of the business in multiple ways. It tells you what’s happening in that competitive environment. The assets leaving would be the result of competitors attracting customers away. Probably our number one metric is net new assets to look at.

The other thing to look at is this idea that net interest margin, NIM. We talked about Schwab Bank being 50% or 60% of revenue. More than that, in terms of operating profits, as a percentage of operating profits. NIM is the difference between what Schwab earns on the assets that it owns, using customer cash balances. It’s like a float. Less what they pay out to customers, right? 

That tells you about the profitability of the base of assets that they have. The way that breaks that is how much cash are clients holding as a percentage of their AUM. I think currently it’s in the 7% range or so.

The other piece of it is what Schwab is able to earn on that client cash basis. Those metrics are kind of the important metrics we watch and that feeds into what revenue will be, that will feed into what operating margins will be, which of course, boil down to profitability of the firm as well.

Preston Pysh  34:01  

Arif, one of the things that I’ve learned from going out to some of the Berkshire Shareholders’ meetings with Warren Buffett is he always brings up this idea of this silver bullet test to understand the moat of a business in the industry and the key factors of success. 

Just for the audience, I’ll quickly explain what the silver bullet test is. The way that Warren would always pose the question to a company that’s performing really well to go to the CEO, or whoever the key executive was. 

He’d say, “Alright, I give you one silver bullet and you can kill one of your competitors. Who do you shoot?” And so, that’s what the test is for people that are hearing that term and maybe not understanding what it is.

You’ve picked Schwab as your winner on a price-to-value ratio, but which competitor would you give the silver bullet test regarding their price-to-value ratio and why?

Arif Karim  34:54  

That’s a tough question because in many ways, Charles Schwab has been the silver bullet for most of its competitors. In many ways, the silver bullet has more to do with the evolution of the industry. I would probably say new companies up and coming. 

One that we’ve been watching is called Robinhood because at the end of the day, like I said, one of the most important metrics from our perspective for Schwab is net new asset growth. 

Robinhood is very small currently. It’s a private company. It’s a very small business growing very quickly and attracting a lot of attention from young investors. That’s always something we pay attention to because in this day and age, what we’ve seen is that user interface and experience, being a customer, plays a big role in where and who acquires really market share amongst early customers. 

Those early customers eventually become kind of the middle of the customer base,  20 years in terms of wealth management space, as they get into mid-career, as they inherit wealth from their parents, etc. So we always keep an eye towards where our new customers are going and why they are going to where else. 

There’s a lot of buzz around Robinhood. They’ve had great success in attracting young customers. Having said that, the scale of your assets they’re actually gathering is not very big compared to what Schwab does. But it’s one that we kind of keep track. 

So from a silver bullet question perspective, just as Schwab has been perpetually changing the business model for its competitors in terms of how it attacks, the customers that Schwab and its competitors have been trying to attract, I think we worry about who’s the guy on the horizon that may change the rules of business, the rules of client interesting engagement in such a way that would handicap Schwab.

For a while, maybe three years ago or so, there’s a lot of buzz around these robo advisors. I don’t know if you’re familiar with this. There are companies like Wealthfront and Betterment that basically were pulling out costs and asset management in the asset management business. 

If you think about it, from a personal asset, financial advisor perspective. When they sit with the customer, initially, they’ll basically talk about life goals and talk about how much income you have, how much you save, what your needs are going to be over the course of your lifetime. 

You have to pay for retirement, you have to pay for your kids education, maybe pay off your house. How do you work a plan within the realm of what your income and savings are today to get to a point where you can be secure by the time you retire, right? That’s the plan they lay out.

Then, you have an investment plan that’s associated with and then basically, the advisor would charge you 80 basis points or 100 basis points and 1% of say to pretty much reallocate your portfolio every quarter or every year as the weights of different asset classes change. They would kind of do that perpetually. Maybe they touch base with you to see if anything’s changed. Most times, things don’t change a lot. 

So, for most people, their financial plans aren’t that complicated. The changes in allocation of assets within their portfolio are not that complicated.What the robo advisors did is they automated that, right? 

They automate a bunch of that and massively reduce the fee for financial advisors. Basically you sit once with the financial advisor and then a robot takes over, a computer takes over in terms of rebalancing for you. The person is just focused on relationship management, while the computer focuses on portfolio rebalancing.

It dramatically reduced the cost of financial advisory services. That could have been seen as a potential threat to Schwab, kind of indirectly, too, because like I talked about there is a platform with half their assets. IRA is their business model. Half financial advisory, relationships with their clients. There’s some that have very complex relationships they are managing, in terms of the complexity of the financial needs of their clients. Those aren’t going to be replaced by computers anytime soon. 

However, there’s many that have simpler clients, in the sense that their clients don’t have a whole lot of financial complexity in their plan. Those can be automated. 

On the one hand, you saw these venture capital funded robo advisory platforms that potentially going to take away assets from the financial advisory industry, the traditional one.

Schwab was able to acquire a small firm and then build on it. Today I think it might be the biggest robo advisor platform. Actually, in the span of three years. They came in from behind. They were looking to make the right moves. They saw where things were heading. It is just traditional Schwab culture. They saw where things were heading. They saw what the trend was and they either build or buy a small company and then scale it. That’s exactly the robo advisory.

Stig Brodersen  39:54  

I can’t help but think that based on what you said here in this interview, you could argue that Charles Schwab could be a very strategic asset for a company like JP Morgan. What are your thoughts on that and do you attribute a catalyst like being a target for a company like that? Any value whenever you assess the investment thesis?

Arif Karim  40:16  

Yeah, sure. I mean, that’s a great question and it definitely is something that is always on the horizon for any company, with a larger platform and being interested in bringing this really interesting and fast growing platform into the fold. So, after Schwab and Ameritrade merged, like I said, *inaudible* is expected next few days, it’s going to be roughly a $70 billion market cap platform. 

JP Morgan is a $300 billion market cap, I think it would be a very attractive thing for JP Morgan to bring into the fold. Of course, they have to pay a premium for it. I don’t think it’s likely but it’s a possibility that JP Morgan will be attracted to it.

It’s very strategic in the sense that you bring a lot of custody assets to JP Morgan, it would bring scale to JP Morgan’s own asset management business. 

JP Morgan is a traditional banking platform that’s very sophisticated and can offer lots of different products to the generally wealthy clients that Schwab has. 

Let’s take a step back. One thing we haven’t talked about is what’s been happening with the zero rate environment and what impact that’s had on Schwab, which is very important, actually. 

We talked about the Schwab Bank, the banking piece of Schwab, which really is a name spread business and it’s they don’t really do traditional banking, per se. It’s a bank in terms of regulatory structure, but all they do is they take clients cash that they pay, let’s say 10 basis points on that point 1% and invest at 1.5% to 2% in assets that yield that. They keep the spread as part of their profits. 

Someone like JP Morgan does a lot more sophisticated stuff, right? So they might also pay 1% or 10 basis points on depositors cash and they do a whole host of other things like write new loans to businesses. They have a credit card business. They have a car loan business. They have a construction business, and all sorts of different lending businesses where it’s much more sophisticated, but also, of course, brings in credit risk.

Preston Pysh  42:25  

Arif, how do you think about inflation with a company like this, because everyone’s talking as if inflation will never come back? I think that that’s probably not as likely of an outcome as most might suspect. I’m curious what you think about that with respect to this company?

Arif Karim  42:45  

That’s a great question. I want to touch on net interest margin for Schwab. The current interest rate environment, the zero interest rate environment in the US, negatively impacts Schwab dramatically. We’ve seen that in their numbers and they have spent their stock. It was coming down dramatically over the last, call it a year. 

The way that manifests is in net interest margin. Whereas they paid their depositors, 10 basis points, 20 or 30 basis points. What they had been collecting was roughly 2.5 per 250 basis points of their portfolio of fixed income assets. 

In a zero rate environment, what happens is what they can collect starts to collapse. it comes down dramatically. Schwab for Q4 has already said their net interest margin will be in the realm of kind of mid to high 140. So 1.4% to 1.5%, which is down dramatically from 2.4%, just a couple of quarters ago. That, of course, is pure profit that’s lost to your bank and the organization as a whole.

So getting back to your question of inflation. Inflation will be a huge positive for Schwab, in the sense that as inflation increases, at some point and the Fed in the US, the central bank in the US, has talked about taking a more lenient stance towards inflation increases in the near term and medium term, because they want to create that buffer between the zero bound level if they keep hitting. Kind of where they want to take interest rates to be in a normal economic environment. 

What they want is the ability to have interest rates go higher than what they’ve been bound to, which has been sort of in the 1.5-2% range really effectively.  That the next time there’s a recession, they have a greater cushion between whatever the normal rate is at that point and kind of zero bound. So trying to build a cushion.

In order to build that cushion, we want inflation to build higher. Secondarily, I think it is a social mission of letting inflation go a little bit beyond the 2% range that they’ve talked about in the past, which is really considered to be more their upper bound as opposed to average. They’ve talked about now they think that over a long period of time, they want 2% to be the average.

We’ve had such a sustained period of time where we’re under 2%. I think what they’re signaling is that in the medium term, they’re looking for inflation and to let it go beyond 2%, maybe two 3%. Maybe even higher, unknown, right? 

So, to the extent that you had inflation, what you’re going to see yields in the long end of the curve start to go up. That, of course, gives an advantage to Schwab’s NIM. It allows them to invest the cash deposits in their clients at higher and higher interest rates, which would expand the name that Schwab has. That would expand its profitability. That’s one part of it. 

The other part of it is that inflation would also probably help asset prices, too. It’s a bit of a mixed bag, because on the one hand, inflation helps asset prices and companies would be better able to raise prices, under this scenario of overall inflation. 

On the other hand, we know that inflation generally is not good for the discount rate mechanism that feeds into PEs. So, PEs would probably shrink, while earnings and revenues are nominally growing. 

If we just say it’s nominally overall, it’s just a wash between faster growth and lower PE, to the extent that you have asset prices rising, either they don’t rise or they rise. 

Maybe they diminish a little bit, but the AUM portion will also feed into how Schwab reacts because that’s the base on which it collects the NIM to some degree. 

Overall, to answer your question, very shortly, we think that inflation is actually a very positive scenario for Schwab’s business.

Stig Brodersen  46:36  

Thank you for your wonderful analysis of Charles Schwab. I’m just about to say that’s to take a look at the score. By that, I mean, based on your analysis, which intrinsic value per share, would you put on Charles Schwab? Also, which potential return would that imply? Just for reference, as we’re recording here, the stock price is around $37. 

Arif Karim  47:02  

Of course, it always comes down to the meat of the story, which is what’s this thing worth and what kind of return I will earn on this. Like I said, today, we’re in a zero interest rate environment. We assess businesses based on what we think their intrinsic value is over a long period of time. These are businesses that last for a long, long time.

As you know, financials are a cyclical business. Right now, we’re trading in the low end of the cycle, because interest rates are zero and a big driver of Schwab’s earnings are net interest margins. Right now, we are in and heading towards the kind of the low part of the cycle for Schwab, because of the zero interest rate environment that we’re in. 

However, in a normalized environment, which we’re kind of in just in 2018, we expect NIMs to be kind of the older 2% range, kind of a 2.5% to 3% range. When we think about long term normal average around the cycle, our assumption is we think is on the conservative end: Schwab can earn a 2% net interest margin. 

We can do some upside to that for the conservative end, but there’s just been a lot of uncertainty in the last decade and in the next decade to come. It’s just really hard to know what that’s going to look like. 

It’s a very different time period relative to the great financial crisis that we had in 2008 to 2009. That implies a valuation on Schwab, about $70 per share. They’re about to close on this Ameritrade deal, which brings a lot more assets to them, but it also brings very profitable assets. 

Like I said, Ameritrade is estimated to earn I think it’s about $2 billion in operating profits in 2021. This is consensus estimates, so about $2 billion on about $5 billion of revenue. Schwab is talking about expense energy of up to $2 billion. We’re looking at a company that has a 40% operating margin in 2021 that could actually go up to 80% operating margin when it’s part of Schwab. 

It’s a highly creative deal. We think that $70 price is actually Schwab and then bringing in Ameritrade at Schwab’s average kind of normal margins. But in fact, there’s upside to that if they can actually realize the types of synergies on the expense base they’re talking about in Ameritrade.

Then further down the road, there’s revenue synergies, so there’s even further upside. On a conservative basis, we think $70 is a reasonable fair value estimate for Schwab. Today, that represents almost doubling in price. It’s about an 89% increase from today’s prices. 

It’s not going to happen next year. It probably will take some time. I think when you’ll see that realization of the price will be based on when interest rates start to rise again, that the market starts to have a visibility on when normalization occurs.

In the meantime, like I said, the potential for Schwab’s revenue and profits is all embedded in the growth of its asset base, to the extent that Schwab continues to grow that asset base at net new assets coming into Schwab running at 6%. Then the market gains on those assets also add to the scale the assets. We assume something like a 4% or 5% market gain. 

From the current price, you expect Schwab to compound at something like 8-12% a year. Then when interest rates start to normalize, you see a rapid increase in the normalization valuation by the market on Schwab. That might not be for a couple of years from how we understand the Fed is thinking about interest rates.

Stig Brodersen  50:39  

Again, I have to repeat myself and just say that it’s been absolutely amazing having you here on the show. I’m sure that the audience would like to learn more about you and Ensemble Capital. We’ll definitely like to give you the opportunity to give a handoff where they can do that. Where can the audience learn more about you and Ensemble Capital?

Arif Karim  50:59  

Our website is ensemblecapital.com. There’s a bio of me there, but also ways to reach me and my colleagues in research and wealth advisory there as well. We’re also very active on social media. We post blogs where we’re talking about ideas, both high level ideas as well as company specific ideas. It’s a way for us to communicate with clients, peers, and interested folks. So, that blog site is intrinsicinvesting.com. Then, finally, we’re on Twitter. Our handle is @intrinsicINV.

Stig Brodersen  51:28  

Thank you for being so generous with your time, Arif. I’m sure we’ll stay in touch and bring you on soon again. 

Arif Karim  51:35  

Thanks. 

Stig Brodersen  51:37  

Alright guys. So at this point in time of the show, we will play a question from the audience. This question comes from Damian. Here we go.

Damian Helm  51:44  

Hi, Stig and Preston. This is Damian Helm here from Cambridge in the UK. In your recent podcast, you talked about only investing in assets that you know well. I was wondering if you could talk about what you mean to know an asset well, and what is it that you look for in your own understanding that convinces you that you know an asset well enough to be able to invest?

Stig Brodersen  52:07  

Damien, this is such a great question. The cheeky answer is, if you don’t know if you understand it, you don’t. On a more serious note, it is a great question and a question that more investors should ask themselves. 

Too many investors are buying into companies because they read a random article of why the price would soon soar. They never even read the reports for that particular company. They probably don’t even understand the competitive situation. 

I would break it down and ask, do you know how the company and the competitive situation will look like in 10 years? If the answer is no, you don’t know the business well enough. If you don’t know how the company industry will look in 10 years, you cannot project the cash flows and estimate what the stock is worth today. 

How do you know if you bought at a discount, you simply don’t. You need to understand the most important key factors for success in that industry. You will likely notice that in the interviews that we have here on the podcast, I almost always ask about the key factors of success or key variables one way or the other. 

I did that also here in this interview with Arif Karim. Two weeks ago did the same with Jake Taylor. For instance, he said that for insurance companies, you need to track and understand the combined ratio and the investment record. There were those two main key variables you need to understand if you need to compare insurance businesses. 

You just notice how much noise there is whenever you’re investing in the stock. You hear 100 pieces of different news that just all seem important at first glance, but it’s your job to figure out what is important and what is not. 

Say, let me come up with an example. I have a position in Spotify. I follow numbers of paid subscribers closely. I might hear that they signed a deal with XYZ artist for the podcasting business. That is generally not important, regardless of all the press that you might see on that. Quarter on quarter, I need to see the paid subscribers go up. Even more important, I need to see that year on year. It has to be faster than industry, because of the nature of the industry. So far, so good. 

Of course, you also need to compare that to the cost, too. I mean, everyone can get market shares if you have to have unlimited money. The key is that you need to identify what is important, and that is what you need to focus on. Then leave out what is not. It would take too much of your focus and too much off your time. If you can’t do that, you need to continue working until you can identify the factors. Even if you can’t understand the factors, but understand how the business will develop. 

Really, there’s no shame in moving on to the next business. There’s no such thing as a difficult bonus in investing. I personally do not understand most businesses. I really don’t, but I do understand the few that I feel comfortable investing in. I tend to focus on those, and then I try to slowly widen my circle of competence to a few other businesses and industries, when I think I might be able to understand it and if I think there’s a good business case there.

Stay with the businesses that you understand. To sum up, when you understand the key factors of success and understand the key variables, you’re on the right path to understand the value of a stock.

Preston Pysh  55:25  

Damian, I really like this question.  I think I got a better respect for what it is I know and what I don’t know, after having created my own business. Prior to that, when I would invest, I would think that I knew the questions to ask myself, but I rarely did. 

You can read the financial statements. You can do these analyses. You can look at the revenue and you can say, “Oh, it’s growing. So that means it’s good.” Or you can look at the net income and see that it’s growing. You can quickly deduce that that’s a good sign. 

However, what I learned through owning my own business is you understand the various revenue streams that the various assets within your company are making. You understand your expenses. You understand, basically the trend that the business is going and you understand the competitive landscape. 

I would argue that whenever I invest in many companies, I do not have that same level of understanding like I do for my own operational business that I own. The challenge that I’ve posed for myself is that whenever I do buy stock, in a non-operational way, that I try to understand the business from that same vantage point.

How does a person who doesn’t own their own business acquire that knowledge or that skill to be able to do those things? The only thing I can really tell you is to try to break the business down into really kind of what I break it down into maybe three different sections. 

First of all, you have to understand the revenue streams that the various assets are bringing in and the competitive landscape of how they’re going to remain competitive moving forward. Try to understand the expense structure of your business. Where are the expenses growing? Why are they growing? Those types of things. 

Then in general, you just got to understand the direction of the competitive landscape and how much market share the businesses are really kind of taking. That’s how I would challenge a person to try to understand the roots and the core of the company that they’re buying and that they potentially own or whatever the case might be. 

After you understand that is when I think you can start digging in and saying, “Alright, based on all those things and the projection that I think it’s going in the future, this is how much I think it’s worth.”

We talk about all those things but we talk about them in kind of an audit, and don’t really kind of lay it out in a framework or like a methodical way. That’s what I would challenge you to try to do and try to really think as if you personally own the whole business. That’s when you can really say I understand this. 

So Damian for asking such a fantastic question, we’re going to give you a free subscription to TIP Finance. This is going to be more of a tool to do the latter of what I talked about, which is the assessment in the valuations. 

Here’s the other thing that it’ll help you with is finding companies that come up in a very advantageous way based on value filters where you can then dig in deeper and start doing all the analysis of things like what Stig and I were just talking about. 

We are really excited to be able to give you this tool which also helps you manage your correlation inside of your portfolio. So really useful.

If somebody else is listening to this and wants to get your question played on the show, go to asktheinvestors.com. If your question gets played on the show like Damian’s, you’ll get a free subscription to TIP Finance.

Stig Brodersen  59:01  

Alright guys, Preston and I really hope you enjoyed this episode of The Investor’s Podcast. We will see each other again next week.

Outro  59:09  

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