Shares of discount brokerage firm Charles Schwab (NYSE: SCHW) have had a very quiet 12-months. This time last year you could buy them on the New York Stock Exchange for around $44.85 apiece. Today those shares are currently changing hands for around $43.40 each.
At first glance the stagnating stock price bears little resemblance to the performance of the underlying business. In 2017 Schwab cleared nearly $9 billion in annual revenue and $2.3 billion in net profit. This year, analysts expect revenue to come in at over $10 billion and earnings to clear $3.3 billion. Readers will no doubt realize where this apparent discrepancy comes from. Over the course of the past year Schwab’s valuation metrics have contracted sharply. This time last year you had to pay around 27x for every dollar of underlying earnings if you wanted to buy the stock. Today you only have to pay around $17.75.
On the whole that seems a good deal for a large-cap business growing net profits at a double digit clip. Speaking of which, Schwab has tripled its net profit over the past five years and the direction of travel looks to be only going one way. An earnings yield of over 5.5% plus the prospect of a few more years of double digit earnings growth? Sounds good, but there’s a caveat which I’ll mention later on.
I also like how Schwab makes most of its money. A lot of folks would guess that a broker would make its money through trading fees (you know that $5 – $10 commission you pay for every trade). In Schwab’s case these fees actually make up less than a tenth of its annual revenue. In the year 2000 the comparable figure was 25%. The lion’s share (around 53% to be precise) of company profit is made from net interest generated by client cash held in Schwab accounts (back in 2000 the comparable figure for this revenue source was also 25%). In the short-term this should be good for Schwab because interest rates are rising. In the long-run the trend is positive since this revenue source is more stable than commissions; the latter dropping due to fierce competition and electronic trading.
The big downside? These businesses are highly cyclical. I mean owning a brokerage firm during a bear market or recession isn’t going to be much fun. As a guide to how rough things can get check out what happened at the back end of the last decade. In fiscal year 2008 the company posted revenue per share of $4.45 and earnings per share of $1.05. By 2009 those figures had dropped to $3.53 and $0.46 respectively.
Needless to say certain investors lost out big time. If you invested at the 2008 peak -and bear in mind the P/E ratio back then was only 19.5 so it didn’t look crazy expensive – you lost 50% in the space of six months. In fact it didn’t reach its 2008 peak share price again until 2013. That’s basically the rationale behind why I called this a tentative GARP (growth at a reasonable price!) stock. Paying 15x earnings right now seems like a good deal, and probably is if you’ve a long-term outlook, but for the best results I’d be looking to pick this up during the next recession or bear market.