Thanks to Lehman Bros., Bernie Madoff, Ivan Boesky, Dennis
Kozlowski, Henry Blodget and many others, most investors have had
enough. They simply don't trust
Wall Street
and are convinced that the investing business is rigged for the
benefit of those who know how to circumvent the rules.
That's the only conclusion you can draw after reading up on
the
latest survey
jointly conducted by The University of Chicago and Northwestern
University. They recently discovered that just 16% of Americans
trust the stock
market
.
The fact that the survey's results come AFTER the stock market has
doubled in value during the past three years is truly sobering. You
can only imagine what investor sentiment would look like if the
market fell 10% or 20% this year, or another financial executive
was caught with his hands in the honey pot.
Frankly, it's a shame. I'd be a fan of much more regulation of Wall
Street (which explains why
I no longer have the stomach to work for Wall Street
firms
), but I still think investors shouldn't be shunning stocks. With
the right amount of homework and the proper amount of risk
aversion, investors can still make major gains as they build up
retirement nest eggs. In fact, that's basically the entire
philosophy behind my
$100,000 Real-Money Portfolio
.
The fact that 84% of Americans shun stocks is unpleasant news for
online brokerage firms such as
E*Trade (Nasdaq: ETFC)
and
TD Ameritrade (Nasdaq: AMTD)
. These firms must hope for investor trust to return if they are
ever to see a robust rebound in sales and profits.
Even many Wall Street employees have had enough. Wave after wave of
stockbrokers have left the big firms to set up shop on their own,
realizing that acting as an independent financial advisor looks a
lot better to most clients.
But there is a clear investable beneficiary of this trend:
Charles Schwab (Nasdaq: SCHW)
, which has been a virtual magnet for newly-independent financial
advisors. In the past decade, Schwab has seen a huge buildup of new
clients, with some impressive numbers to show for it, as I'll
detail in a moment.
Unfortunately, you wouldn't
spot
this change by looking at Schwab's share price. The company has
historically made solid profits by managing un-invested client
funds in interest-bearing money-market funds. And while the Federal
Reserve has kept rates at rock-bottom lows, Schwab's profits have
barely budged.
As rates start to normalize during the next few years, the stage is
set for Schwab to become a
profit
powerhouse. Although
the Fed
insists that rates will stay low for several more years, this
pledge will be impossible to maintain if the United States is able
to rebound in coming quarters.
A powerful base of assets
The stock-brokerage industry began its tectonic shift in 2004, as
Schwab and TD Ameritrade built up platforms to meet the needs of
financial advisors who wanted to hang out their own shingle. Since
then, these two firms have boosted
assets under management (AUM)
by registered investment advisors (RIAs) at an 8% annual compound
rate. Meanwhile,
AUM
for the traditional firms such as Merrill Lynch, Smith Barney, UBS
and others have been falling at a 3% annual pace. And this trend
shows no sign of letting up.
Part of the shift is intentional. Wall Street firms are
increasingly focusing on the largest accounts, effectively telling
mid-sized accounts to take their business elsewhere. That's why the
$1.2 trillion in assets managed by brokers using Schwab and other
back-office platforms (as of the end of 2010, according to a study
conducted by Cerulli & Associates) is expected to swell to $1.5
trillion by mid-decade.
Schwab, with 56% of the
RIA
market, is the biggest beneficiary. TD Ameritrade, with an 8%
share, is a distant second, while Fidelity has less than 5% of the
market in third place. (Fidelity, with a 24%
market share
, is the leader in managing investment retirement accounts (IRAs)
for individuals, with Schwab and TD Ameritrade controlling 14% and
4%, respectively.)
Yet as noted earlier, many investors avoid playing the market
directly out of mistrust, which is why RIAs are building up assets
at such a steady pace. To put real numbers behind this trend, note
that Schwab's current
asset
base of RIA-controlled assets is at $630 billion and could exceed
$900 billion by 2015, according to Goldman Sachs.
The rate hike scenario
The era of low interest rates can't end soon enough for Schwab. The
company would likely see
earnings per share (
EPS
)
rise by 35% from current levels for every 100 basis point (1.0%)
increase in the federal-funds rate, according to Goldman Sachs, as
profit margins expand on money-market accounts.
To put this in context, Schwab is expected to earn $0.85 to $0.90 a
share in 2013. Let's say the Fed-funds rate is 100 basis points
higher in 2014. Then you'd be looking at $1.20 in
EPS
. A 200 basis point hike would turn out to be $1.50. And a 300
basis point hike likely equates to almost $2 a share in annual
earnings
power.
Right now, Schwab is making life easy on its clients, waving 42
basis points out of the typical 57 basis points that it would
receive on funds parked in money management accounts. As rates
start to rise, Schwab won't need tooffer that giveback. So what is
now roughly $300 million in annual income for Schwab would be
roughly $1 billion in annual income without it. That's almost as
much as Schwab makes in its other three businesses combined: Funds
and ETFs, OneSource fund distribution services and RIA platform
fees.
[block:block=16]Risks to Consider:
Shares
of Schwab won't really start to percolate until investors have a
clearer read on when the Fed will start to hike rates. Any moves
won't likely come before the second half of 2013, but anticipation
of such an event may start to get factored into earnings models for
Schwab later this year.
Action to Take -->
Charles Schwab has historically been seen as a
proxy
for investor interest in stocks. Yet the company's
business model
has steadily morphed, so its interest rates and RIA
asset management
have actually become the key drivers for this business. Schwab has
had great success in putting the right platform in place, having
attracted thousands of RIAs in recent years. It's only a matter of
time before this bigger client base translates into much bigger
profits.
Over the course of 2012, investors should only expect moderate
upside, perhaps in the 20% to 30% range. As noted, this is a
rate-sensitive play. President of the
Federal Reserve Bank
of Minneapolis Narayana Kocherlakota is the only member of the
Fed's Board of Governors that argues for rate hikes to begin as
soon as this year. Yet shares can still rally quite nicely in 2012
if it becomes increasingly apparent that a tightening cycle will
begin in the first half of 2013.
In the longer-term, Schwab has robust potential upside. Applying
profit margins from the middle of the last decade to the current
asset base, Schwab could easily be earning $2 a share by
mid-decade. And if shares ultimately garner a forward multiple of
15 on that figure, then investors are looking at a $30 per share,
or more than 100% upside. To be sure, it would take several years
for that scenario to play out.
[Note:
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-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.