Retail investors have flooded the market with record gusto during the pandemic. According to The Wall Street Journal, the three largest online brokers have recorded record numbers of new funded accounts.
While the general public, starved of live sports, has turned to gambling on the stock market instead, discount brokerages are having their day in the sun. But the forgotten one in all this frenzy might be the original discount brokerage house: Charles Schwab (SCHW 0.07%).
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How do discount brokerages make money?
How does a company whose primary advertised service is a trading platform make money when it charges $0 for every trade?
The answer lies in what's required to use the platform: A trading account. Traditionally, retail investors set up a trading account with their desired brokerage, determine the best strategy to achieve their long-term financial goals, and get to work implementing said strategy. Part of this strategy usually results in some amount of cash sitting idle in the account. That's where the brokerages make money -- net interest. Brokerages like Schwab earn most of their trading revenue by investing cash reserves in relatively riskless bonds, like U.S. Treasuries, earning small percentage gains on each investment but, in aggregate, a whole lot of money.
Before the pandemic, discount brokerages were in a war to achieve scale. Sustained low interest rates put pressure on earnings so, instead of making more money on each investment, the brokerages set out to find scale. Schwab acquired TD Ameritrade, Morgan Stanley bought E*Trade, and Robinhood raised more and more money to throw into its own marketing plans.
Then came COVID-19.
This year's day-trading phenomenon has been a boon for customer acquisition for many brokerages. And more customers mean more net interest.
Schwab has been impressive
While COVID-19 will have many implications for the future of the brokerage business, signs are that the increase in users can only help. While Schwab's stock took a dip in March, it is now marching its way back to pre-pandemic highs.
What's particularly enticing about Schwab is its 13.2% return on equity (ROE), beating E*Trade's 2019 ROE of 11.1%. Brokerages are notoriously highly leveraged businesses with low asset turnover, but this is a function of their model: The investments that generate Schwab's net interest income must be extremely low-risk, which limits their upside. Despite slightly lower net interest income in this year's first quarter than in last year's ($1.57 billion versus $1.68 billion), Schwab has grown net interest revenue in each of the past three years, with a 12% jump from 2018 to 2019.
Despite these numbers, Schwab's profit margin is impressive. Considering its size, earning around 33% on sales for 2018 and 2019 signals strong and disciplined management. If there is a rush of new investors to the Schwab book, these numbers indicate that Chuck will certainly capitalize.
Brokerages that offer a more robust suite of services could see the most benefit as this new wave of DIY investors returns to work and finds less time to trade actively. Schwab has made a name for itself over the past 45 years managing client assets, and offers services -- like financial advisory and money management -- that might allow the day traders to become long-term investors. And don't forget: Schwab also owns its own bank to offer lending services to its many brokerage and advisory clients.
Long-term considerations for discount brokerages
Low interest rates for the foreseeable future should be a concern for discount brokerages and net interest income will likely be underwhelming. But in the case of discount brokerages, size matters. And Schwab, with its whopping $4.04 trillion in client assets, can still produce sizable returns despite fewer opportunities.
The biggest question is: What will happen to this new wave of investors as they return to the office and their normally hectic lives? Will they stick to it or become discouraged when their day-trading returns inevitably underwhelm? Some will certainly quit, but others may get smart. Long-term strategies based on sound fundamentals are the best way to produce risk-aligned returns for both institutions and individual investors. From failure comes learning, and Schwab could be the discount brokerage poised to capitalize on this pandemic day-trading boom.
