Charles Schwab (SCHW 0.67%) recently took a hit when Bank of America issued a rare double downgrade on the stock, from buy to underperform. The stock dropped as investors weighed its recent earnings and some updated comments about its future.
One factor playing a part in the downgrade is a phenomenon known as "client cash sorting." And a slower pace of interest rate hikes during the year could hurt the broker -- which is more sensitive to changes in interest rates than others in the industry. Following its recent sell-off, is Charles Schwab worth buying?
The double downgrade comes as Charles Schwab's balance sheet shrinks
Bank of America analyst Craig Siegenthaler double-downgraded Charles Schwab and lowered its price target from $92 to $75. He said that client cash sorting contributed to the downgrade.
Client cash sorting involves clients moving funds into other assets (usually outside of Schwab) to take advantage of higher interest rates. Clients look to take advantage of attractive yields on certificates of deposit (CDs) or money market funds. As a result, Schwab's balance sheet shrank by $115 billion, or down 17%, from the year before.
Management has discussed this cash-sorting phenomenon in the past, noting that it resulted in a 20% reduction in sweep cash balances from 2015 to 2019 when the Fed started tightening. Schwab uses the cash it "sweeps" from client accounts to invest and earn interest. This can be a low-cost funding source since these deposits earn little interest relative to money market funds or treasury bills.
As its balance sheet shrank, Schwab boosted liquidity by limiting new portfolio investments to build available cash and used short-term funding sources such as Federal Home Loan Bank Advances and retail certificates of deposit.
These headwinds will weigh on the business in the short term
Siegenthaler thinks this cash sorting will continue at an elevated pace in the first half of the year, which could put more pressure on interest-earning assets and deposits at Schwab.
One thing Schwab investors should pay attention to is interest rates. Some CDs are paying over 4% interest today. Markets expect the Federal Reserve to raise interest rates a couple more times in the first quarter, which will give customers time to lock in even higher rates on those alternative investments.
This cash-sorting could result in funds flowing out of customers' Schwab accounts, reducing the company's balance sheet. Even if customers move funds into Schwab's own money market funds, the cost of deposits for Schwab will increase, causing a narrowing in the margin between the interest it earns on its investments and the interest paid out on customer accounts. Given higher interest rates are likely to come, Schwab could deal a shrinking balance sheet and shrinking margins for at least one or two more quarters.
US 1-Year CD Rate data by YCharts
Another factor in the double downgrade is Charles Schwab's sensitivity to interest rates. This year, it has benefited from higher interest rates. During the year, its net interest income increased by $2.6 billion, which was the primary reason Schwab's revenue grew by $2.2 billion.
Is it a buy?
Charles Schwab will likely have a tough first half of 2023. According to CME Group's FedWatch Tool, markets are pricing in a 0.25% increase in interest rates during each of the Fed's March, May, and June meetings, followed by a pause in rate hikes.
A slowing pace of interest rate increases with a declining balance sheet could mean slower (or even negative) revenue growth for Schwab in the first half of the year, which thrived when the Fed aggressively hiked rates last year.
While Schwab is a steady company, I'm avoiding the stock for now as its business faces headwinds in the near term. If you're looking for a good brokerage stock that isn't as sensitive to interest rates and is growing at a nice rate, Interactive Brokers Group is one solid alternative to consider.
