Brokerage stocks can be a solid addition to a diversified portfolio because they tend to produce revenue no matter the broader economic conditions. These companies clearly benefit when the economy is growing because that growth leads to increased investing activity. But they also can benefit during times of market volatility, as that volatility often leads to increased trading activity as well.
Charles Schwab (SCHW 0.13%) and Interactive Brokers (IBKR -1.01%) are two brokerage stocks that can make an excellent addition to your portfolio today. they have a proven ability to produce income from the fees they collect on equity trades and from the interest income they receive for managing various loans and other services.
With the market back in a growth mode this month, these two brokerages stand to benefit even more. Here's why.
1. Charles Schwab
Charles Schwab provides customers with financial advisory, asset and wealth management, banking, and brokerage services. In 2019, Schwab acquired TD Ameritrade in an all-stock transaction that valued the broker at $26 billion. The acquisition was a significant move by Schwab, adding 12 million client accounts and $1.3 trillion in client assets.
Schwab struggled to maintain customer deposits throughout the Federal Reserve's interest rate-hiking campaign despite the acquisition. Since last year, the Fed began raising its benchmark interest rate from near-zero to an upper limit of 5.5%.
Schwab was slow to adjust to higher interest rates, and customers began pulling funds from their Schwab bank accounts to chase higher interest rates elsewhere, like in savings accounts or money market funds. The company calls this "client cash sorting" and had previously dealt with this during the Fed's previous rate hiking cycle between 2015 and 2019. Last year the company saw deposits decline by $115 billion, or 17% of its total deposit base.
The deposit outflows resulted in a double downgrade by one analyst earlier this year. Then the failure of SVB Financial's Silicon Valley Bank in March had investors on edge, and they began to scrutinize financial firms that were seeing deposit outflows. Schwab stock took a short-term hit as a result, but it has since alleviated some of those fears. In the second quarter, Schwab's deposits declined 6% year over year, and the trends point to optimism that the outflows will slow down.
Data source: Charles Schwab. Chart by author.
The trends also suggest things will improve from here. The Federal Reserve slowed its pace of interest rate increases, pausing them in June and raising them another 0.25% in July. Market participants predict this could be the last rate increase for a few months. According to CME Group's FedWatch Tool, markets predict the Fed will hold interest rates where they are until the first quarter of next year. Some market watchers are even suggesting a potential cut in interest rates as 2024 progresses.
SCHW PE Ratio data by YCharts
Schwab stock has historically traded at a premium to peers because of its limited credit exposure and stellar profit margins. Worries about interest rates have the stock currently trading below its 10-year average price-to-sales ratio (P/S) and price-to-earnings ratio (P/E).
Charles Schwab did a solid job of navigating a challenging environment. With conditions improving and a relatively low valuation to its historical average, the broker looks like a solid value stock to buy today.
2. Interactive Brokers
While Charles Schwab has struggled to maintain client fund levels, Interactive Brokers has excelled. Interactive Brokers operates the largest electronic trading platform in the U.S. (based on daily average revenue trades). It brokers just about everything, including stocks, options, futures, futures options, foreign exchanges, bonds, mutual funds, and some cryptocurrencies.
An advantage it has over competitors is that Interactive Brokers pays clients some of the highest interest rates in the industry on uninvested cash held in accounts (the current rate is 4.58%). Over the past year, its total accounts have grown 19%, while customer equity has risen 24%.
In addition to higher interest rates, Interactive Brokers offers some of the lowest commissions in the industry. Many of Interactive Brokers' senior managers have a background in software engineering and focus on automating as much of its trading platform as possible. As a result, Interactive Brokers has high profit margins while paying higher interest rates and charging lower fees than competitors.
IBKR PE Ratio data by YCharts
Interactive Brokers has achieved impressive growth. Since 2017, its clear customer accounts have grown from 483,000 to 2.29 million, a 374% increase. This, coupled with its high profit margins, has led to impressive growth for the broker over the last several years. Not only that, but the company trades at a reasonable valuation, with its P/E ratios trading below its 10-year average, making it another excellent brokerage stock to buy today.
