Shares of discount brokerage firm Charles Schwab (SCHW) have had a very quiet twelve months. They currently change hands for somewhere in the $43.40 region – virtually unchanged on the $44.85 per share that folks were paying around 12 months ago. Perhaps annoyingly, the stagnating stock price seems to bear little resemblance to the performance of the underlying business, at least at first glance. I mean, Schwab cleared nearly $9b in annual revenue and $2.3b in net profit last year. This year, analysts expect revenue to come in at over $10b and earnings to clear $3.3b.
Readers will no doubt realize where this apparent discrepancy comes from. Schwab’s valuation has contracted sharply over the course of the past year, falling from 27x earnings to under 18x earnings. On the whole, that seems a good deal for a large-cap business growing net profits at a double-digit clip. 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 topping 5.5% and the prospect of more years of double-digit growth? Yeah, that sounds good, but there’s a caveat which I’ll mention later on.
I also like how Schwab makes most of its profit. A lot of folks would guess that a broker would make its money through trading fees – you know those pesky $5-$10 commissions you pay for every trade. In Schwab’s case, these fees actually make up less than a tenth of annual revenue. That is down from circa 25% back in 2000. 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. The comparable figure for this revenue source was also 25% back in 2000. Now, this should be good for Schwab in the short term because interest rates are rising. In the long-run the trend is also fairly positive since this revenue source is more stable than commissions. Obviously the latter has been dropping due to fierce competition from upstarts as well as electronic trading in general.
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. Check out what happened ten years ago as a guide to how rough things can get. In 2008, the company posted revenue per share of $4.45 and earnings per share of $1.05. Those figures had dropped to $3.53 and $0.46 respectively by 2009.
Suffice to say that certain investors lost out big time. Those investing at the 2008 peak – and bear in mind the PE ratio was only 19.5 back then so it didn’t look crazy expensive – lost 50% in the space of six months. The stock didn’t reach its 2008 peak again until 2013, and that basically sums up 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 have a long-term outlook, but for the best results I’d be looking to pick this up during the next recession or bear market.
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