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AMM Dividend Letter #40: The Emoji Guide to Investing & Charles Schwab
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Episode Transcript
Welcome to the third episode of the AMM Dividend Growth Podcast.
In this podcast I breakdown a current position in the AMM Dividend Growth Strategy. This episode is all about Charles Schwab.
I’ll cover why we classify Schwab as a new dividend payer even though it has paid a dividend for quite a while now. I’ll then cover how safe Schwab’s dividend is, the catalysts we see for future dividend growth and price appreciation, the risks to our investment, and our estimate of Schwab’s fair value.
If you want to read the full AMM Dividend Letter about Charles Schwab and to see all the charts that go along with this episode and what you can learn from emojis to make you a better investor, there is a link in the show description. You can also go to amminvest.com/episode3 that is alpha mike mike I N V E S T .com/ episode3 for the show notes and a link to the full letter too.
Before we get on with the rest of the episode show, I need to read you our disclaimer.
Before we get into Charles Schwab let’s take a slight detour into TVs.
The first flat screen TVs cost several thousand dollars and were out of reach for most U.S. consumers. Then the manufacturing process improved, the cost of supplies declined, and increased competition drove the price of flat screen TVs down.
Lower prices led to increased demand and a larger total market for flat screen TVs. What was once a novelty only the rich could afford is now the TV everyone has.
This is the natural progression of competitive markets with indistinguishable products. This is true for brokerages too. But it wasn’t always this way.
Before May 1975 all brokerages charged an agreed upon fixed commission for stock trades. Then regulators abolished the fixed rates. This opened the brokerage business up to new discount brokers like Charles Schwab (“Schwab”).
Schwab focused on providing the best customer service while maintaining the lowest prices.
Technology was and still is a key tool for Schwab to achieve these goals.
Schwab was the first discount broker to use an automated order entry system. This led to the development of real-time stock quotes and they built a News system for the touch-tone phone. Schwab also one of the early pioneers of online trading in the 1990s.
Schwab’s focus on high-quality customer service and low costs helped to drive down trading commissions across the brokerage industry. Like flat screen TVs, the declining commissions increased the total addressable market for Schwab’s services. Commissions and fees were cheap enough for the average person to start investing.
We’re classifying Schwab as new dividend payer. You’re probably asking why since they’ve paid a dividend since 2002.
Because. Between 2008 and 2016 Schwab did not increase its dividend. They held on to their excess capital to meet the Federal Reserve’s requirements for banks. So, the change in business structure and the long time it took Schwab to start raising its dividend again leads us to classify Schwab as a new dividend payer. Is it the best category? Probably not but it doesn’t fit our definition of a dividend stalwart or a special situation. So New Dividend payer it is.
Schwab now meets the Federal Reserve requirement and they are returning excess capital back to shareholders. Since 2016, Schwab has increased its quarterly dividend from $0.06 to $0.17. A 183% increase.
Onto dividend safety.
Schwab’s payout ratio is 27.53% below our 60% limit. Its cash dividend payout is 6.62% which is below our 60% limit too. And Schwab’s debt to equity ratio, backing out interest bearing liabilities (customers’ cash), is 33%.
Schwab’s low payout ratio is what we want to see in a New Dividend Payer. A low payout ratio means Schwab can raise their dividend faster than by earnings growth alone. Schwab raised their dividend at the beginning of this year by 30%.
These are the major catalysts we see for future price appreciation and dividend growth.
Charles Schwab is primarily thought of as an online discount brokerage but Schwab doesn’t generate a lot of revenue from trade commissions.
In their fiscal 2018, 10-K trading commissions accounted for 8% of Schwab’s total revenue. The majority of Schwab’s revenue, 57%, comes from net interest income
Schwab is more a bank than a discount broker now. The majority of its revenue comes from the interest it receives on interest-bearing assets.
Schwab’s cost of funds is very low. Cost of funds is the cost a bank pays to use your cash for their own investment purposes. This is the interest a bank pays you in your savings accounts and on CDs.
They are paying you for the use of your cash for their own investment purposes. Schwab’s fiscal 2018 cost of funds as we calculated it was 0.27%. For comparison, JP Morgan’s 2018 cost of funds on customers deposits were 0.56% again from our own calculations.
When selecting a savings account or CD you likely shop around for the highest interest rates. The cash in a Schwab brokerage account is strategic cash. An investor lets dividends, interest, and deposits buildup as they wait for an investment opportunity. Schwab can pay less for the use of customers’ cash because this cash is immobile.
Schwab’s focus on low costs and high service is designed to attract more assets to its platform. The average cash balance on accounts at Schwab is 10%. The more assets Schwab attracts, the more cash they can sweep onto their balance sheet. More cash means more investments by Schwab in interest-earning assets. Combined with a low cost of funds leads to a wide net interest margin and revenue growth for Schwab.
What also helps Schwab’s net interest revenue is higher interest rates.
The net interest margin is the interest Schwab earns less the interest it pays on customers’ cash.
Schwab primarily invests swept cash into 2 year Treasuries. After the Great Financial Crisis, the yield on the 2-year Treasury fell below 0.5%. Total client assets and interest-bearing assets at Schwab grew during this period but net interest income growth did not keep pace with asset growth because of the low interest rates.
In the last year, the Federal Reserve raised interest rates. When we wrote the dividend letter discussing Schwab, the 2-year treasury was yielding 2.40%. If interest rates continue to rise then Schwab should earn more on its interest-bearing assets and combined with its low cost of funds leads to a wider net interest margin. At the end of 2018, Schwab’s net interest margin was 2.30%.
Higher interest rates and a higher net interest margin will drive Schwab’s Return on Equity higher too. Higher returns on equity lead to excess capital that Schwab can use to increase its dividend.
Schwab is riding two long-term secular growth trends.
The first is the rise of the Registered Investment Advisors or RIAs which I’ll cover in a bit.
The second is the growth of Exchange Traded Funds (ETFs).
Since 2014 there has been a steady flow of money out of mutual funds. In 2016 the money leaving mutual funds outpaced the money coming in, according to data from Advisor Analyst.
The money leaving equity mutual funds is not leaving the stock market. The money is flowing into ETFs (Exchange Traded Funds).
While Schwab wasn’t an early pioneer in the ETF space, they are now one of the leading ETF providers based on assets under management. BlackRock is number 1 with 1.43 trillion in ETF assets. Followed by Vanguard, State Street, Invesco, and then Schwab at number 5 with 123 billion in AUM, according to ETF.com. In the full letter, we have table highlighting the top ten ETF providers if you want to check it out.
ETFs are still in the early stages of their growth.
According to the 2018 Investment Company Fact Book, in 2007 index ETFs had a 6% market share. Now at the end of 2017 index ETFs had a 17% market share in the U.S. for all assets invested in open ended funds.
We expect the percentage of assets in ETFs to continue to grow as assets move out of mutual funds and into ETFs. The current ETF leaders should remain the leaders and attract the most assets.
The appeal of ETFs is their low costs. Instead of the typical 1% management fee in a mutual fund, you can invest in an ETF with a similar strategy for far less. Schwab’s U.S. broad market index ETF has a management fee of 0.03%.
Low management fees do not mean ETFs are not profitable. Most ETFs are based on an index like the S&P 500. Managing the ETF requires a few computers and a handful of people. As compared to a mutual fund and their teams of people. The fixed costs for ETFs are very low and the scalability of an ETF is very high. The more assets in an ETF the more profitable they become.
The other major secular trend for Charles Schwab is the rise of the independent investment advisor, RIAs.
25 years ago Schwab made a key decision to support independent financial advisors. Schwab provided custodial, trading, banking, and technical support to help the developing Independent Investment Advisory business. Today Schwab is the largest custodian for RIAs.
That early decision to help independent investment advisors is paying off handsomely for Charles Schwab. Independent advisory firms are the fastest growing segment as measured by assets in the investment industry. According to Schwab’s February 2018 winter business update, they show the AUM for RIAs growing at a compound annual rate of 11.1%. The total US investable wealth growing at 9.3% and Schwab’s RIA assets growth is compounding at 12.7%
One way to think of Schwab is as a platform company for RIAs.
If Schwab can offer the best RIA custodial experience at the lowest cost it will continue to attract more RIA business. The more RIAs on its platform the more assets held at Schwab. The more Schwab will make with its ETFs, mutual funds, trading commissions, and cash sweeps.
A true platform company means the sum total value of the companies built on it will exceed its own value. The RIA business as a whole will surpass Charles Schwab. But Schwab will keep earning increasing quote economic rent unquote as the RIA business grows.
The big theme for the risks facing Schwab is what we call The Race to Zero. Zero Commissions and zero fees.
Schwab is dedicated to being the low price leader in the brokerage business. But Schwab is not the lowest cost provider right now.
That title goes to Robinhood with $0 commissions. If you don’t know what Robinhood is they are an app based mobile trading platform. They only offer taxable accounts.
JP Morgan recently announced their own commission-free mobile brokerage platform. But it has a catch.
New accounts will get 100 free trades in their first year. If a customer maintains a balance greater than $15,000 they will continue to get 100 free trades per year. If you are a Chase Private Client with an account balance of at least $250,000 you will have unlimited commission-free trades.
JP Morgan can offer commission-free trades because they can make more money selling their other services to an account holder. JP Morgan is obviously a bank and they too can use customer cash to invest in interest-bearing assets.
Robinhood is not a bank. Their plan to make money is twofold. They will sell their order flow to wholesalers.
Robinhood’s second way to make money is through securities lending and margin loans. This is why all Robinhood accounts are taxable. Only taxable accounts are marginable.
If commissions went to zero, Schwab would still have trading revenue. Like Robinhood, Schwab sells its order flow to UBS and they make money with securities lending too.
Unlike Robinhood, Schwab has ETFs, mutual funds, and a banking unit to generate other revenue.
Schwab’s bigger risk is big banks like JP Morgan offering lower commissions to win assets. But this has always been true and it hasn’t had a material effect on Schwab’s asset growth. Schwab’s leading position with RIAs is a bigger factor for asset growth than lower commissions.
The bigger hit to Schwab’s revenue in the race to zero would be from its asset management division.
At the end of 2018, Charles Schwab had $233.4 billion of assets in its proprietary mutual funds and $115 billion of assets in its proprietary ETFs.
The launch of Zero fee ETFs did not surprise anyone paying attention. A zero fee ETF has been predicted for several years. Large ETF providers make money from their total ETF management fees and from lending out their positions in the ETF.
An ETF provider can charge a zero fee on a core asset ETF because the goodwill it generates will attract more assets to its platform. The extra asset are then invested in their other ETFs that do have fees. As the ETF provider scales up, they make more money across their entire ETF platform.
The bigger risk of Zero Fee ETFs is competitors chipping away at Schwab’s asset growth. If too many competitors eat into Schwab’s ability to grow its asset base then our estimate of fair value may be too high.
A big part to our investment thesis is a widening net interest margin which is driven in part by higher short-term interest rates.
If you think predicting the future price of the S&P 500 is hard then try predicting interest rates.
Until December of last year, the market was certain that the Federal Reserve would raise rates further. Then Jay Powell signaled that the Federal Reserve would take a pause on raising rates.
If a recession occurs the Federal Reserve will most likely start cutting rates again taking the yield on the 2-year treasury down with it. If this occurred then Schwab would earn less on its interest-bearing assets pushing our estimate of Schwab’s fair value down.
And that is a good transition into our estimate of fair value.
The revenue drivers for Charles Schwab are total client asset growth, interest-bearing assets as a percentage of total assets, net interest margin, mutual fund and ETF management fees, and Schwab’s Advice Solutions fees.
Charles Schwab has grown its total client assets at a compound annual growth rate of 11.5% over the last 5 years and 8.8% over the last 10 years. We’ll use a 10% growth rate over the next 5 years. We’ll keep interest-bearing assets as a percentage of total assets at 7%. We’ll keep Schwab’s net interest margin at 2.3%
The average fee for mutual fund and ETF assets is 0.25%. As more assets flow into ETFs and zero fee ETFs become common we expect this fee to contract. Our 5 year target fee rate is 0.10%. We’re probably being too conservative here.
The average fee rate for Advice Solutions over the last few years is 0.39%. Schwab recently changed its pricing schedule for its robo-advisor. It switched from an AUM model to a flat fee model. Under the new pricing schedule the flat fee equates to an annual 0.35% fee on an account with $100,000. We’ll use 0.35% as the fee rate going forward.
We’re also keeping trading revenue flat over the next 5 years.
Using these growth assumptions, our 46% pre-tax margin assumption, and a 1% annual growth in shares outstanding our estimate for Schwab’s EPS in 5 years is $3.76. Applying a 21x multiple to these earnings — this is well below Schwab’s long-term average multiple — we get a per share price of $80. Then discounting this price back to today at an 11% (Schwab’s cost of equity) rate we get a fair value price of $48.
We also value Schwab using a residual income model. Financial firms are hard to value using a Free Cash Flow model. Bank debt is not the same as debt for a non-financial firm. Debt for banks is a raw material. It’s like steel for a car manufacturer. Capex for financial firms is almost non-existent. Financial firms invest in human capital and intellectual capital which is not well reflected on the statement of cash flows. Using our expected return on equity of 25%, a cost of equity of 11%, an expected 2019 book value of $23.13 billion, and a persistence factor of 0.75 we get a present value of $50.
In the full letter we have a snapshot of the spreadsheet showing the residual income valuation if you want to take a look.
Both scenarios reflect our base case. With Charles Schwab trading around $43 per share we think the stock is very attractive at current levels given the long-term secular growth trends driving the company forward.
Thank you for listening. If you enjoyed this episode, please subscribe through your favorite podcast player and leave us a rating and review.
If you want to learn more about the AMM Dividend Growth strategy and the benefits of being a client of AMM then please give me a call at 858-755-0909.
If you’re a financial advisor, we offer the AMM Dividend Growth Strategy as a Separately Managed Account too.
Again head to amminvest.com/episode3 for the full show notes, transcript, and a link to download the full AMM Dividend Letter.
Until next time.
