We Study Billionaires - The Investor’s Podcast Network - TIP319: Intrinsic Value Assessment of Charles Schwab w/ Arif Karim (Business Podcast)

Starting point is 00:00:00 You're listening to TIP. On today's show, Stig and I have Arif Karim back on the show to talk about an intrinsic value assessment. After graduating from MIT more than two decades ago, Arif entered the financial investment space, and he's now the senior investment analyst at Ensemble Capital Management. The purpose of these types of shows are to conduct deep dives into individual companies so we can learn about the important aspects of valuation and the competitive nature for businesses in its sector. Today's discussion will be for a deep value pick, and that's Charles Schwartz.

Starting point is 00:00:30 So without further delay, here's our chat with the reef. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to The Investors Podcast. I'm your host, Dick Broderson, and as always, I'm accompanied by my co-host, Preston Pish. I am very excited about the stock that we were talking about today. Because with inflated asset prices everywhere, our guest might have found a stock that trades as a really attractive price-to-value ratio. The stock is Charles Swap, and to help us analyzing that stock, we have Arif Karim with us.

Starting point is 00:01:23 Welcome back on the show, Arif. Hey, thanks, Stig. I really appreciate it. Always get to be on your show and great to talk to you. We definitely love having you. Arif, like I said there, we'll be talking about Charles Swap, and the ticker is S-C-H-W, it's one of the cheapest high-quality picks out there. And we'll talk about the intrinsic value at the end of the episode. But first things first, could you please provide an overview of the business?

Starting point is 00:01:52 So Charles Schwab has been around for, my gosh, almost 50 years now. It was established or founded by Chuck Schwab. Back in the days when, in the U.S., at least, brokerages were regulated. I mean, brokerages are still regulated, but commissions were regulated. by, I guess, an agency of the fellow government. And they were at a high price point. And really, at the time, for the average investor to be able to trade stocks, you paid very high commissions because the trading capability was a manual, a bunch of people, you know,

Starting point is 00:02:24 forming a market. But B, it was bundled with Wall Street research. And so all that was kind of embedded in the cost of trading. And Schwab was a guy who basically wanted to democratize trading for the masses. And in order to do that, you had to bring the cost of trading down. And so that was the founding of the business. His whole deal was, you know, I want to create a better, cheaper way to trade, better in the sense that, you know, you don't have to buy the research along with it

Starting point is 00:02:51 if you have your own ideas of what you want to buy himself. He wasn't able to really get that going until commissions became deregulated. And that was called May Day. I think it was May 5th, 1975, I want to say. But that's when stock trading commissions became deregulated. regulated so they could be at any price point. And so that was the birth of the discount broker. And Schwab was one of the first effect. Over the years, what's happened is the ethos that Schwab brought to the business and founding the business carried on into the culture of the business.

Starting point is 00:03:23 And so Schwab's whole culture and ethos has 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. And so what that's meant is 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 huge enabler of that by taking away the high cost people and implementing where possible automation and computers to basically reduce the cost of various fees. So be it trading, be it pools of investment. investment vehicle. So Schwab has then carried over that ethos and culture of bringing down commissions

Starting point is 00:04:12 to other areas of investment management. And so, like we all know, ETFs, right, which basically reduce the cost of owning a basket of stocks, mutual funds used to manage it, 1% or 100 base points or more, down to only 5 to 10 basis points and on its way to free, basically, right? But those sorts of things Schwab has also worked to basically enable. And I think one of the things is really attractive to me about Schwab sort of 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. As 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

Starting point is 00:04:58 business and then again, use technology and scale to reduce the cost of that as they keep going further up the value chain. And so 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 and it's high-quality service. It's not the cheapest guy, but it's not far from the cheapest guy, but by paying a little bit more than the cheapest guy, you also get this great value from Schwab in terms of quality of service, the offerings they provide, security, technology. So they're never the leader in technology, like a Robin Hood would be, for example, but they're usually pretty close behind. And I think you get this win, win, win relationship between Schwab

Starting point is 00:05:39 the company, Schwab's customers and what they're offering for them, and then over the long term as shareholders. So that's kind of a short version of kind of the history of Schwab, kind of what they do. So, Arif, as you mentioned, Charles Schwab, it's only been around since the 1970s. And 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? If you delve into kind of the history of it and look at the means by which they built their business, their origin was all around trading commissions, being a discount trading broker, right? But what they did then is they basically worked their way up the value chain.

Starting point is 00:06:21 So they had millions of retail customers, right, trading on their platform. And initially it was, you know, by phone, you still called and talked to somebody and then put your trade-through. And then they became an automated telephonic service. And I remember this when I started my first account with Schwab back when I was, I think it was in college. You know, you called them and there was an automated service that you used. And then with the internet, you know, you got this web interface that came with it. And so over this time, their commissions kept declining.

Starting point is 00:06:52 And I kept opening up the service to more and more people who became interested in trading stocks. And 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. So what was applicable to Schwab's customers were mutual funds. So they created this platform called One Source, where a mutual fund could trade on Schwab's platform, commission free, which is a big deal at the time because commissions were non-trivial.

Starting point is 00:07:25 And you could list on their One Source mutual fund platform by sharing a piece of your AEOM fee. So the mutual fund would pay Schwab for distribution to retail who saw the ability to trade the mutual funds on one source for fruit. So that created this advantage for the mutual funds that could be on the one source platform in terms of getting new customers and increasing to share with those customers relative to the mutual funds that weren't on one source and you had to pay a commission to trade those mutual funds. Then they, you know, acquire a company They allowed them to do options trading. And so they added that as another investment form that customers could use.

Starting point is 00:08:08 So these are examples of vertically moving up the stack of different types of investment vehicles and higher value services. And then at that point, they added their own mutual funds. And then when ETS came in, Schwab also created a set of ETF funds. Today are some of the lowest cost ETS, right? So Schwab doesn't fight the trend. When the trend hits kind of a tipping point, Schwab just kind of goes all in. and make sure it has the servicing costs at the back end to enable it to succeed in those new

Starting point is 00:08:37 offerings that are driving greater value for customers. The other thing that they do is they also have this horizontal expansion strategy. And what that means is they started first with retail investors, right? So just individuals that were interested in trading. And then, you know, it started with trading and then later became wealth management and advisory services, which Schwab also offers now. But in terms of horizontal expansion, what they did is they have 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.

Starting point is 00:09:06 So the cost is relatively fixed, right? Because we're talking about a lot of computers and databases and things like that. And then interfaces with other financial services and then, you know, the whole regulatory and compliance sort of infrastructure you got to build. So all these things 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. And so to horizontally expand, what they started doing that in the 90s was they added a independent registered investment advisory.

Starting point is 00:09:38 And what you've had over time is as regulation has changed and as the realization that incentive structures really matter on how financial professionals service their customers, the way you collect fees, how you charge for fees, the fact that investment advisors have relationships with the customers over a long period of time that provide them a lot of value has led. A lot of investment advisors who worked under the traditional wirehouses are called. It's like the Morgan Stanley, the Coleman Sachs, you know, UBS, Credit Suisse, basically put away from those big banks and start their own businesses. Oftentimes bringing certain number of clients with them who they have close relationships with, and they change the way they get compensated so that it's much more client beneficial. So in other words, it becomes a win-win situation in the sense that historically, these investment advisors, really, or brokers in the past, would make money by getting

Starting point is 00:10:34 you the client to trade. And 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 client wins, I win. So in many ways, how it's manifested in terms of incentives has been, you know, I collect a fixed fee on the assets under management with my client. And I can then provide whatever is best for my client's wealth grows and therefore my fee grows along with them since it's a percentage of that a um and it's not based on this churning of their portfolio where i get a chunk of the brokerage commissions right which is how it traditionally had been done so anyway there's been this trend of entrepreneurship more and more investment advisors especially to get more experienced and have

Starting point is 00:11:16 strong relations with clients moving from these integrated platforms to kind of their own independent platforms so our if let's dig bit deeper into that. So in 2018, traded commissions accounted for less than 8% of revenue. And then the year after, Charles Swab chose to completely eliminate brokerage commissions. I mean, talk about a company cannibalizing itself. So keeping that in mind, how does Charles Swab make money today? And how do you think the company will make money in the future? It's interesting. Schwab, like we talked about, their genesis was brokerage commissions, right? And in 2019, they basically eliminated brokerage commissions, which is incredible. In many ways, you know, what it attests to is this ability of the company to

Starting point is 00:12:07 adapt over time. And as we talked about, you know, move up the value chains, that the lower parts of the value chain become commoditized. So in a sense, the fact that 8% of revenue in 2019 that came from trading commissions was pretty small relative to where it started, which is 100%. And so this has a trend over time that the things that can get automated and can get expenses scaled from the perspective of declining per transaction cost going to zero via automation. Schwab makes those investments and it drives that commoditization in those lower value services. It's a great example of just what we've talked about, which is kind of this commoditization of the lower value services that can be automated and cost per transaction reduced. So Schwab had started.

Starting point is 00:12:54 started with 100% commissions trading revenue, right? And then over time, they've expanded into higher value services while commoditize the lower value services, which makes it a much more compelling proposition for its customers. So over, you know, almost 50 years, they basically brought commissions trading from 100% of revenue down to 8%. And the trend was clear. Commission's trading revenue was heading towards 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,

Starting point is 00:13:27 we self-enter these trades. We don't call somebody a trader to trade for us. So there's no person there. We're self-servicing. But also on the back end, you know, when you look at those old pictures and videos of the New York Stock Exchange with people yelling and screaming with the hand signals and all that, that doesn't exist. It's just a bunch of servers now, right? Every time you bring computers into any kind of a service, you're basically reducing dramatically. the cost of providing that service.

Starting point is 00:13:53 So the cost of trading that heading towards zero, they basically kind of preempted, you know, what would be a long, drawn out sort of asymptotic kind of curve towards zero by just taking it down to zero. And as you mentioned, it was only 8% of the revenue. And, you know, a bit higher than that on operating margin or operating income. But certainly there were outside factors that drove Schwab to basically take it to zero. There's a company called Interactive Brokers,

Starting point is 00:14:20 I'm sure many of your listeners are also familiar with. Interactive brokers is sort of a pure automated trading platform, and 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, it's small but growing quickly, is Robin Hood, which has been more of a, it's definitely been a phenomenal with millennials, you know, and younger generations who basically are at first in terms of

Starting point is 00:14:55 a lot of the services they consume. And so Robin has been commissioned free for a while, but they make their money up something called order flow. All the other brokers too have some order flow revenue as well that substitutes for commissions. So you'll see Schwab doesn't go to zero trading revenue. They do have some order to flow. And then options still provide a source of commission's revenue, but very small relative to the equities. Schwab, you know, at least saw the writing on the wall. They kind of accelerated this to zero. And that hit some of the more traditional, quote, discount brokers like Ameritrade and E-Trade,

Starting point is 00:15:29 much more harshly because much more of their revenues came from commission still. But 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 Shubb has added to its plate of services that offers customers. So to answer your question about where do they make their money now, it's that they still offer lots of other investment products that they earn an AUM fee on. They still provide a platform for RAs, you know, to custody on and they make some fees on that. They're not directly from the custody, but fees around services they offer RAs. And 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 sweeps it basically into a bank that's run by Schwab. And just like a regular checking account,

Starting point is 00:16:23 they pay some kind of interest on the cash balances that customers have, but then they get to use that basically float and invest it in higher yielding assets that 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. So Schwab has built Schwab Bank within in its brokerage and asset management business. And interestingly enough, that now accounts for over half its revenue. It was 60%, but it'll be probably more like 50% range in 2020. But between 50% and 60% of revenue comes from Schwab Bank now.

Starting point is 00:17:02 And that's a highly, highly profitable business within Schwab entirety. About 40% of business, between 30 and 40% comes out of their asset management fees business. And that's just advisory services. It's fees on mutual funds. It's fees on ETFs. fees on that mutual fund distribution platform I mentioned, one source. So it's other fees like that. And that, too, over time, we believe, is also getting commoditized that basis points of fees

Starting point is 00:17:28 that they will collect on any asset base is going to decline for that AOM piece of a business. But when you 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. So you're getting all these services, more and more services, more and more choice on Schwab, for a lower and lower fee as a customer. So that accelerates the flywheel of bringing in new customers, bringing in new assets, which then increases its scale, which further reduces Schwab's costs because its platform is a scale-driven platform.

Starting point is 00:18:02 The more assets they manage, the lower expense per dollar of assets that they manage, right? And so the bigger the scale they get, the more cost advantage they have, the lower they can bring the prices to then bring even more customers and more assets. It's just 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 fraud 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 for a cash.

Starting point is 00:18:31 But to the extent that 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 that you have in your checking account, that cash balance to then invest for itself. in other higher yielding fixed income instruments, that then it keeps the benefit of that higher yield for itself for,

Starting point is 00:18:52 in the form of profit for Schwab. But 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 you want to put it in. But it's just that most investors, most clients, always have some kind of a cash buffer that they like to have, between trades,

Starting point is 00:19:14 or it might be part of it. their allocation, or it might just be, you know, for whatever reason, they'll have cash that they're not actively putting to work. And so Schwab takes advantage of that pool of cash, of course, is cash available to whoever needs it and wants it. But that pool of cash is redeployed in Schwab Bank, where it makes this nimb. So like I said, it accounts for 50 to 60% of revenue. And, you know, that revenue probably has a, you know, on an incremental basis, like an 80% plus margin to it. And so that becomes an implicit cost to the investor. client because I'm not directly paying a fee on this. It's just cash out sitting around that I've

Starting point is 00:19:52 lost the opportunity. And it's my own fault, right? Because I haven't put it to work. I've lost the opportunity to basically invest it somewhere else. But I very well could anytime I want. And 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 Schwabank is that it's a very low risk proposition. So think about Schwabank just like any other bank, right? So most banks, they take money from depositors. They pay them a small interest rate and then in a low yielding environment, of course, right?

Starting point is 00:20:25 And then they basically take that money and invest it in higher yielding, credit instruments. Now, with higher yields, you get a higher yield for a longer duration. You get a higher yield for more risk. You get a higher yield for maybe just smarter, fixed income management kind of thing, right? 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

Starting point is 00:20:54 balance sheet. And that came to a head back to the housing crisis, right? Just read the summary statistics. By and large, the average investor probably would have said, oh, this looks totally fine, and safe, you know, within the limits of the federal financial regulators. But what we learned 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? And 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 risk that banks bear as a result of being institutions that provide credit to businesses and businesses and

Starting point is 00:21:38 consumers. What we like about Schwab is that we don't have to worry about most of them. The vast majority of their balance sheet at the bank is basically invested in low risk federal governments, a U.S. 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 U.S. government and then high-grade corporates, and 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. So there's some prudent measures have there that we think will continue to make the balance sheet very safe. So we don't worry

Starting point is 00:22:18 too much about the credit risk part of it. And so you're getting this high margin bank asset, you know, within Schwab that sources low cost funds from brokerage accounts and then invest in, you know, relatively safe credit instruments. It's a very high incremental profit margin as a result. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord,

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Starting point is 00:26:25 business partner, Shopify, and start hearing, sign up for your $1 per month trial today at Shopify.com slash WSB. Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. So, Reef, I want to talk more about the business of asset management. And a really very important key ratio is expenses on client assets or the EOCA. Could you please explain what that is and then also talk about how Schwab is situated with respect to that key ratio compared to some of the competitors? 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, you know, a spectrum, right? So when we talk about it, it's going to sound like it's very one-sided.

Starting point is 00:27:19 But on the spectrum of costs, you know, you have variable costs, which is that every new client you bring in or every dollar new asset that you bring in to manage for the client, your expenses grow in proportion to that. And 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. And then theoretically, no matter how much money you bring onto the platform, it doesn't cost you any more to service that money. So in that way, you've got the scale levers that comes to that platform.

Starting point is 00:27:49 platforms, kind of in a simplistic version, the more you can bring in, the lower the cost per dollar to manage on your platform. And so Schwab is more on a fixed cost side, the sense that their costs scale very slowly relative to the amount of assets they manage. So the bigger, the scale of assets, you mentioned earlier, that Schwab manages over $4 trillion in assets, right, for its clients. and all those assets sit on this platform that's relatively fixed cost. And so the more assets you can bring, the lower the amortization of that fixed cost over every dollar of asset. And so that Ioka, as they call it, the expenses on client assets reflects that ability

Starting point is 00:28:34 to basically have a very low cost basis per dollar of assets being managed for the client. And 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. And the importance of that measure is that it gives Schwab more pricing power. And normally, Warren Buffett acolytes, such as ourselves, right, 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 the ability of lower prices without damaging your margins. And so if you're thinking about it from a competitive perspective, if I can lower prices

Starting point is 00:29:27 for services for my customer, I can use that as a way to attract them to my platform. But if the cost of my platform is actually declining faster that I'm reducing my prices to the customer, then my margins are growing. And so that's a great strategic advantage to have. And so when you look at Schwab's platform, they're at 16 basis points per dollar in expense of assets managed for clients. So in other words, for every dollar of assets that they manage for clients, it costs them now, you know, at the scale they're at $4 trillion. For every dollar of line assets they managed, it cost them 16 basis points to custody that dollar of assets. And that's much lower than their direct competitors. Ameritrade is at 27, E-trades at 37, B of A and

Starting point is 00:30:21 Morgan Stanley wealth management are at over 50 basis points, basically. And this is based on, you know, numbers that Schwab has provided. We trust the management there. So I have to put a note that we have independently verified this. But the point is that there's 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 and doing that. So going back to that idea that pricing power comes from being able to lower your costs faster than you lower the cost for your clients. So 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. And the meantime, if you can raise your

Starting point is 00:31:00 margins as well, that's kind of, that's hugely powerful flywheel that actually we've seen this with Amazon Web Services do the same. 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. But we didn't see that while prices were coming down, costs were going down even faster. Again, because of Morris Law and, you know, other technology scaling types of initiatives that they had. And that made it very hard for, new entrance to compete with that because they had scale. And today, that probably still rings true. There's only a handful of global cloud providers that can have the scale to have types of

Starting point is 00:31:41 cost structures that similar like Amazon Web Services or Microsoft Azure can have. So similarly in a financial business, you need to have large scale and a platform built on technology to take the technology curve in terms of cost reductions in order to be able to compete with Chihuah. Aref great that you're so thorough in your analysis and you include so many different variables and very interesting to hear about, you know, we often talk about that there are a few key variables that you really need to understand and you need to track those key valuables to see who are most competitive in the industry.

Starting point is 00:32:16 Warren Buffett has said that and Bill Miller, who also had on the show, have been talking about those two to three varies from company to company, but you don't necessarily need to monitor a thousand different variables to figure out. which companies are most competitive. So keeping that in mind, could you please outline the competitive landscape of Charles Swap and perhaps also one or two other key ratios you are looking at to understand the competitiveness of both Chal Swap but also their competitors? So interestingly, you know, 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 the, historically

Starting point is 00:32:53 speaking, you had Schwab being a discount broker, right, Ameritrade in each. trade were discount brokers. So there were kind of traditional competitors, call it back in the 90s, right? And 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 a Morgan Stanley, a UBS, Bank of America, JP Morgan, all these guys have wealth management subsidiaries to them. And they may also manage large, large amounts of client wealth in the hundreds of billions

Starting point is 00:33:32 of trillions. And so Schwab's competitive set has been growing towards kind of the traditional names that we know of, as I mentioned. On the other hand, the cost structure that they have is much lower than those guys who are more, quote, full surface, you know, and that they have research teams that publish report and make recommendations. Whereas Schwab doesn't offer a whole lot in the way of research, but they're not. offer you a platform to express your own views of wherever you get your research from. And

Starting point is 00:34:03 a lot of it is, you know, seeking alpha or reading the news or following things on Twitter, wherever people get their investment ideas from. And increasingly, as you know, it's, it's heading in the direction of passive investing, right, through ETS. I mean, I think the latest number of seeing the U.S. something like half of all assets in the management are now in ETS, right? So 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 elements of the index, the components of the index for you, basically, right? You're writing a passive way there. So having said that, the competitors that are all these whole host of companies. One of the things that came out of the Schwab basically eliminating commissions was that it damaged the business model for some of the traditional competitors like Ameritrade and E-Trade.

Starting point is 00:34:48 And what we've seen is that, you know, Schwab basically was able to take advantage of that situation by acquiring Ameritrade. So what Ameritrade does for Schwab is, you know, acquired its one of its closest competitors, another roughly $1.5 trillion to its platform. And so you're going to see a platform that goes from four, four and a half trillion assets, getting to $6 trillion, probably by the end of the year with the Ameritrade acquisition closing. And so that will, again, further improve its expenses on client assets, right? because you're going to expand the pool of assets to $6 trillion from $4 trillion. And what they've said is they were going to cut out about $2 billion of costs from the Ameritrade business, right?

Starting point is 00:35:32 Because there's a lot of duplication of expenses between the two organizations. And so those Ameritrade assets that 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 having. of the net interest margin piece of Schwab. So coming back to your question of what types of ratios that we look at in measuring how well Schwab is doing?

Starting point is 00:35:59 So one, it's how fast are they growing their AUM, right? And so they publish this number called net new assets, which is the organic growth of new assets coming to the Schwab platform. So it's gross assets coming in minus assets leading. And the assets could leave either because, you know, I'm retired and I eat a part of my assets to live. Or it could be competitive losses. You know, I have a customer that goes from my platform to somewhere else. So net new assets encompasses, you know, the growth is coming in minus those that leave. And then the net new assets has been growing on the range of about

Starting point is 00:36:32 5 to 7% a year over the last several years as a percentage of the base of assets they have. So that's an important metric to measure, which is the success Schwab is having and growing its AUM. So AUM growth, in our view, like the most basic way to view, the intrinsic value growth at Schwab is to look 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 the competitive environment, right? So the assets leaving would be the result of competitors, you know, attracting customers away. Probably our number one metric is net new assets to look at. Now, the other thing to look at is this idea of the net interest margin, NIM, right? So we talked

Starting point is 00:37:14 about Schwab Bank being 50 or 60% of revenue. And more, more than that in terms of operating profits, you know, the percentage of operating profits. NIM is the difference between what Schwab earns on the assets that it owns using customer cash balances, so kind of like float, right, less what they pay out to customers, right? And that tells you about the profitability of the base of assets that they have. And the way that kind of breaks out is there is how much cash or clients holding as a percentage of their AUM, right? and I think currently it's in the 7% range or so. And the other piece of it is what is that Schwab is able to earn on that client cash basis.

Starting point is 00:38:01 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 then. So, Reef, 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. And, you know, just for the audience, I'll quickly explain what the silver bullet test is. And the way that Warren would always pose the question to a company that's performing really well, so he'd go to the CEO or whoever the key executive was and he'd say, all right, I give you one silver bullet and you can kill one of your competitors. Who do you shoot?

Starting point is 00:38:46 and so that's what the test is for people that are here in that term and maybe not understanding what it is, but you've picked Schwab as your winner on a price to value ratio, but which competitor would you give the silver bullet test to regarding their price to value ratio and why? 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. and I would say probably new companies up and coming. One that we've been watching is one called Robin Hood.

Starting point is 00:39:21 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. And Robin Hood, very small currently, you know, it's a private company. It's very small, but it's been growing very quickly and attracting a lot of attention from young investors. And 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 who acquires early market share amongst

Starting point is 00:39:55 early customers. Those early customers eventually become kind of the middle of the customer base in 20 years in terms of wealth management space, right? As they get into kind of mid-career, as they inherit wealth from their parents, et cetera, out, right? So we always keep an eye towards where are new customers going and why are they going to somewhere else? And so there's a lot of buzz around Robin Hood. They've had great success in attracting young customers. Having said that, the scale of their assets they're actually gathering is not very big compared to what Schwab does, but it's one that we kind of keep track out.

Starting point is 00:40:31 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 interest and engagement in such a way that would handicap Schwab. For a while, you know, this was maybe three years ago or so. You know, there's a lot of buzz around the robo advisors. I don't know if you're familiar with this, but, you know, there are companies like

Starting point is 00:41:06 Wealthfront and Betterment that basically were pulling out costs. in asset management in the asset management business, if you think about it, you know, from a personal asset financial advisor perspective, when they sit with a customer, initially, they'll basically talk about life goals and talk about, you know, how much income you have, how much you save, what your needs are going to be over your course of your lifetime. You know, 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 like what your income and savings are today

Starting point is 00:41:37 to get to a point where you can be secure, you know, by the time you're recovering. tire, right? That's a plan they'll lay out. And then, you know, you have an investment plan that's associated with. And then basically, the advisor would charge you 80 basis points or 100 basis points, 1%, let's say, right, to pretty much reallocate your portfolio every quarter or every year, you know, as the weights of different asset costs change in there, right? And they would kind of do that perpetually. Maybe once you're a touch base with you to see if anything's changed, most times things don't change a whole lot. So for most people, their financial plans aren't. that complicated and the changes in allocation of assets, you know, within their portfolio,

Starting point is 00:42:17 isn't that complicated? And so what the robo advisors did is they automated that, right? They automated a bunch of that and massively reduce the fee for financial advisory. And basically, the end of being is, you know, you sit once to be a financial advisor and then a robot takes over, a computer takes over in terms of, you know, rebalancing for you. It's not a person that does that. The person just focused on relationship management while the computer focuses on portfolio rebalancing for you. It's that dramatically reduced the cost of financial advisory services. And so that could have been seen as a potential threat to Schwab, kind of indirectly, too,

Starting point is 00:42:52 because like I talked about, their RA platform is half their assets. And RIAs, their business model, right, is that have financial advisory relationships with their clients. and there's some that have very complex relationships are managing in terms of the complexity of the financial needs of their clients and those aren't going to be replaced by computers anytime soon. But there's many that have simpler clients, right,

Starting point is 00:43:18 in the sense that their clients don't have a whole lot of financial complexity in their plan. And those can be automated. And so on the one hand, you saw these venture capital-funded robo advisory platforms that potentially were going to take away assets from the financial advisory industry, the traditional one. But Schwab was able to acquire a small firm and then build on it.

Starting point is 00:43:41 And today is, I think it might be the biggest Robo Advisor platform today, actually, in the span of three years. So they came in from behind. They were able to make the right moves. They saw where she was heading. And it's just traditional Schwab culture, right? They saw what she was heading. They saw what the trend was.

Starting point is 00:43:58 and they either build or buy a small company and then scale it. And that's what exactly did, Robo Advisory. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. Vanta automates your compliance process

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Starting point is 00:47:28 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? Yeah, sure. I mean, that's a great question. And it definitely is something that is always on the horizon for any company, right? Would a larger platform be interested in bringing this really interesting fast-coring platform, you know, under them, bring them into the fold? So after Schwab and Ameri Trade merge, like I said, it's expected next few days. You're going to be talking about a, you know, roughly $70 billion market cap platform.

Starting point is 00:48:18 J.P. Morgan is a $300 billion market cap. I think it would be a very attractive thing for J.P. Morgan to bring into the full. Of course, they have to create a premium for it. I don't think it's likely, but it's a possibility that somebody like a J.P. Morgan will be attracted. I mean, it's very strategic in the sense that, you know, would bring a lot of custody assets to J.P. Morgan. It would bring scale to J.P. Morgan's own asset management business and JPMorgan 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,

Starting point is 00:49:02 what impact that's had on Schwab, which is very important actually. So we talked about the Schwab bank, the banking piece of Schwab, which really is a nimb spread business. right. They don't really do a whole lot of banking, traditional bank 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 take 10 basis points on. So that's 0.1%. And they invested at 1.5% to 2% in assets that yield that. And they keep the spread, right, as part of their profits. Someone like a JP Morgan does a lot more sophisticated stuff. So they might also pay 0.1% or 10 basis points on depositors cash. And then they do a whole host of other things.

Starting point is 00:49:43 You know, they write new loans to businesses. They have credit card business. They have car loan business. They have a construction business, you know, all sorts of different, you know, lending businesses where it's much more sophisticated, but also, of course, brings in credit risk. So, Reef, 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.

Starting point is 00:50:12 as most might suspect. But I'm curious how you think about that with respect to this company. That's a great question. And I want to touch on net interest margin for Schwab. So the current interest rate environment, zero interest rate environment in the U.S. negatively impacts Schwab dramatically. And we've seen that in their numbers and we've spent their stock coming down dramatically over the last call a year.

Starting point is 00:50:36 And the way that manifests self is the net interest margin. So whereas they paid their depositors and basis points, for 20 or 30 basis points, what they had been collecting was, you know, roughly two and a half, 250 basis points off their portfolio of fixed income assets. In a zero rate environment, what happens is what they can collect starts to collapse, right? 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%.

Starting point is 00:51:12 4% just a couple of quarters ago. And that, of course, is pure profit that's lost to their bank, right? And the organization as a whole. And so getting back to your question of inflation, inflation would be a huge positive for Schwab in the sense that as inflation increases at some point, and, you know, the Fed in the U.S., the central bank here in the U.S., has talked about taking a more lenient stance towards inflation increases in the near-term medium term because they want to create that buffer between the zero bound level, if they keep hitting and kind of where they want to take interest

Starting point is 00:51:47 rates to be in a normal economic environment. What they want is the ability to have interest rates to go higher than kind of what they've been bound to, which has been sort of in a one and a half to two percent range, really effectively, so 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 cushion. In order to build a cushion, they want inflation to build higher. Secondarily, I think, you know, is that kind of social mission of letting inflation kind of go

Starting point is 00:52:20 a little bit beyond kind of 2% range they've talked about in the past, which they've really considered to be more their upper bound as opposed to average. They've talked about now, you know, the thing that over a long period of time, they want 2% to be average. We've had such a sustained period of time where it was under 2% that it's, I think, what they're signaling is that in the medium term, they're looking for inflation to let it go beyond 2%, maybe to 3%, maybe even higher, unknown, right? So to the extent that you get inflation, what you're going to see is you're going to see yields and the long end of the curve start to go

Starting point is 00:52:53 up. And that, of course, gives an advantage to Schwab's NIM. It allows them to invest the cash deposits from their clients at higher and higher interest rates, which would expand the NIM that Schwab has, and that would expand its profitability. So that's one part of it. The other part of it is that inflation would also probably help asset prices too. And so it's a bit of a mixed bag because on the one hand, inflation would help asset prices and that companies would be better able to raise prices, right, under the scenario of overall inflation. On the other hand, we know that inflation generally is not good for the discount rate mechanism

Starting point is 00:53:31 that feeds into PEs, right? So PEs would probably shrink while earnings and revenues are nominally growing. So if we just say it's nominally overall, it's just a wash, you know, between faster growth and lower PEs, 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 NIM to some degree. So overall, to answer your question, you know, very short briefly, we think that inflation is actually a very positive scenario for Schwab's business. Thank you for your wonderful analysis of child swap. And I'm just about to say, let's take a look at this score. And by that, I mean, based on your analysis,

Starting point is 00:54:21 which intrinsic value per share would you put on child swap and also which potential return would that imply? And just for reference, as we're recording here, the stock price is around $37. Of course, it always comes down to the meat of the, the meat of the story, which is, you know, what's this thing worth and what kind of return can I earn on this? So 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

Starting point is 00:54:52 of time. These are businesses that last for a long one of time, right? And so, as you know, financials are a cyclical business. So right now, we're trading in the low end of the cycle because interest rates are zero, right? And a big driver of Schwab's earnings are net interest margins. But right now, we are in and heading towards, you know, kind of the low part of the cycle for Schwab because of the zero interest rate environment that we're in. But in a normalized environment, which we're kind of in, right, just in 2018, we expect NIMS to be, you know, kind of in the over 2% range, kind of a 2% to 3% range. So when we think about long-term normal average around the cycle, our assumption, we think is on a conservative end, is that Schwab can

Starting point is 00:55:36 earn a 2% net interest margin. We think there's some upside to that. We're too conservative, 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 prior to the great financial crisis that we had in 2008, 2009. And that implies a valuation on Schwab of 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 a very profitable asset. Like I said, you know, Meritrade 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.

Starting point is 00:56:19 Schwab has talked about expense energy of up to $2 billion. So we're looking at a company that has a 40% operative of Ameritrade. This is that has a 40% operating margin in 2021 that could actually go up to 80% operating margin when it's part of Schwab. And so it's a highly accretive deal. And so 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 an expense base that they're talking about at Ameritrade. And then further down the road, there's revenue synergies.

Starting point is 00:56:57 So there's even further upside. So on a conservative basis, we think $70 is a reasonable clear value estimate for Schwab. And so today, you know, that represents, you know, almost doubling in price, right? So it's got 89% increase from today's prices. But, you know, it's not going to happen next year. It probably will take some time. But 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

Starting point is 00:57:26 occurs. But in the meantime, like I said, the potential for Schwab's revenue and profits is all embedded in the growth of its asset base. And so the extent that Schwab continues to grow that asset base at net new assets coming into Schwab running at 6%. And then the market gains on those assets also add to the scale of the assets. So, you know, we assume something like a four or five percent, you know, market gains. So from the current price, we expect Schwab to compound at something like 8 to 10 to 12

Starting point is 00:57:59 percent a year. And then when interest interest starts to normalize, you see that rapid. increase in the normalization valuation by the market on Schwab. But that might not be for a couple of years from how we understand the Fed is thinking about interest rates. Again, I have to repeat myself and just say it's been absolutely amazing having you here on the show or if I'm sure that the audience would like to learn more about you and Ensemble Capital and we'll definitely like to give you the opportunity to give a handoff where they can do

Starting point is 00:58:27 that. Where can the audience learn more about you and Ensemble Capital? We've got our website, 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. So we post blogs where we're talking about, you know, ideas, both high-level ideas as well as company-specific ideas.

Starting point is 00:58:48 It's a way for us to communicate with clients and also just peers and interested folks that are interested in talking to us. So that blog site is interesting investing.com. And then finally, we're on Twitter. Our handle is intrinsic, I-N-V. Thank you for being so generous with your time, Arif. I'm sure we'll stay in touch and bring you on soon again. Thanks, Steve.

Starting point is 00:59:10 All right, guys, so at this point in time, the show, we'll play a question from your audience, and this question comes from Damien. Here we go. Hi, Stig and Preston. This is Damien 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

Starting point is 00:59:37 well enough to be able to invest? Okay, thank you. So, Damien, this is such a great question, and the cheeky answer is, if you don't know if you understand it, you don't. But 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, and they never even read any reports for that particular company, and they probably don't even understand the competitive situation. So I would break it down and ask, do you know how the company and the competitive situation will look like in 10 years?

Starting point is 01:00:19 If the answer is no, you don't know the business well enough. And if you don't know how the company and industry will look like in 10 years, you can't project the cash flows and estimate what the stock is worth today. So how do you know if you buy it at a discount? You simply don't. And you need to understand the most important key factors for success in that industry. You likely notice that in the interviews that we have here in the podcast, I almost always ask about the key factors of success or key variables one way or the other.

Starting point is 01:00:49 I did that also here in this interview with RF Karim. Two weeks ago, I did the same with Dick Taylor. And for instance, he said that for insurance companies, you need to track and understand combined ratio and the investment record. Like, there was those two main key variables you need to understand if you need to compare insurance businesses. And you'll just notice how much noise there is whenever you're investing in the stock. You hear 100 pieces different news that just all seems important at first glance.

Starting point is 01:01:16 But it's your job to figure out what is important and what is not. Say, let me come up with an example. have a position in Spotify. So I follow the numbers of paid subscribers closely. And I might hear that they signed a deal with XYC artists for the podcasting business. That is generally not important regardless of all the press that you might see on that. Quarter over quarter, I need to see the page subscribers go up. And even more important, I need to see that year over year. And it has to be faster than the industry because of the nature of that industry. And so far so good. And of course, You also need to compare that to the cost too.

Starting point is 01:01:52 I mean, everyone can get a market share if they have unlimited money. But the key is that you need to identify what is important. And that is what you need to focus on. And then leave out what is not. It would take too much of your focus and too much of your time. And if you can't do that, you need to continue working until you can identify the factors. And even if you can't understand the factors, but don't understand how the business will develop. Really, there's no shame in moving on to the next business.

Starting point is 01:02:20 There is no such thing as a difficulty bonus in investing. You know, I personally do not understand most businesses. Really don't, but I do understand the few that I feel comfortable investing in, and I tend to focus on those. And then I try to slowly widen my several commitments to a few other businesses and industries, whenever I think I might be able to understand it and if I think there's a good business case there. But really, stay with the businesses that you understand. So to sum up, when you understand the key factors of success and understand the key variables, you are on the right path to understand and thereby also value a stock.

Starting point is 01:02:58 So Damien, I really like this question. And 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. And 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 analysis. You can look at the revenue and you can say,

Starting point is 01:03:26 oh, it's growing. So that means it's good. Or you can look at the net income and see that it's growing. And you can quickly deduce that that's a good sign. But what I learned through owning my own business is you understand the various revenue streams that the various assets within your company are making. And you understand your expenses. You understand basically the trend that the business is going and you understand the competitive landscape.

Starting point is 01:03:53 And 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. And the challenge that I've posed for myself is that whenever I do buy stock in a non-operational way, that I try to un-operational way, that I try to understand the business from that same vantage point. Now, how does a person who doesn't own their own business acquire that knowledge or that skill to be able to do those things? And the only thing that I can really tell you is to try to break the business down into really kind of what's, I break it down in the maybe three different sections. First of all, you got 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?

Starting point is 01:04:50 Why are they growing? Those types of things. And then in general, you just got to understand the direction of the competitive landscape and how much market share the business is really kind of taking. And so 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 whenever I think you can start digging in and saying, all right, based on all those things and the projection that I think it's going in the future,

Starting point is 01:05:22 this is how much I think it's worth. And that's typically what we talk about all those things, but we talk about them and kind of odd end and don't really kind of lay it out in a framework or like a methodical way. But that's what I would challenge you to try to do and try to really think as if you as if you personally own the whole business, that's when you can really say, I understand this. So Damien, 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,

Starting point is 01:05:58 which is the assessment and the valuations. And 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 like what Stig and I were just talking about. So really excited to be able to give you this tool. It also helps you manage your correlation inside of your portfolio. So really useful. If somebody else listening to this wants to get your question played on the show, go to Ask the Investors.com. And if your question gets played on the show like Damien's, you'll get a free subscription to TIP Finance. All right, guys, Preston, I really hope you enjoyed this episode of The Investors podcast. We will see each other.

Starting point is 01:06:40 again next week. Thank you for listening to TIP. To access our show notes, courses or forums, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decisions consult a professional. This show is

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We Study Billionaires - The Investor’s Podcast Network - TIP319: Intrinsic Value Assessment of Charles Schwab w/ Arif Karim (Business Podcast)

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