A good value in the financial markets often comes with problems for the company. Otherwise, investing would be easy and everybody would win. Charles Schwab (SCHW 0.13%) certainly has its share of problems, but a case could be made that Schwab's issues are temporary, or at least not as severe as the share price would have implied this year.
Fortunately, when delving into Schwab's specific problems, prospective investors won't need to time the end to higher-for-longer interest rate policy. They'll only have to assume that it will end at some point and that its ripple effects won't shake Schwab's foundations for too much longer.
More customers, more problems
Attentive investors knew that Schwab would suffer some growing pains after it acquired TD Ameritrade in 2020. Apparently, Charles Schwab CEO Walt Bettinger knew it, too.
"While expected deal-related attrition has temporarily weighed on net new asset flows, our underlying growth recipe remains very much intact," Bettinger said last month after a particularly trying quarter for the company. He added: "To date we have executed this conversion with a level and accuracy that I have not seen in any conversion."
Bettinger's confidence shouldn't be accepted uncritically. Schwab has undoubtedly experienced some customer attrition amid the TD Ameritrade change-over; the company's total net new assets slumped from $114 billion in third-quarter 2022 to $72 billion in second-quarter 2023, and then to $48.2 billion in 2023's Q3.
On the other hand, Schwab has already transitioned the "vast majority" (per a Barron's report) of the TD Ameritrade clients and advisors to Schwab's own platform. It also seems intuitively probable that truly disgruntled TD Ameritrade-to-Schwab clients and advisors would have left by now if they had found a better option.
Schwab's cash-sorting problem
While the TD Ameritrade transition has certainly caused friction for Charles Schwab, the most pressing and persistent issue may be higher-for-longer interest rates. A knock-on effect of elevated interest rates is a phenomenon known as cash sorting, wherein banking customers withdraw funds from relatively low-interest brokerage and banking accounts (which are Schwab's bread and butter) and into higher-yielding assets such as money market accounts.
Cash sorting helps to explain why Schwab's net interest revenue declined 24% year over year to $2.2 billion in Q3 2023. It can also account, to a certain extent, for Schwab's 16% net revenue decrease to $4.6 billion, as well as for the stock's overall sluggishness in 2023.
Of course, a stock going down isn't the same thing as a good value. However, if Schwab stock hadn't gone down as much as it did, the company's GAAP trailing 12-month price-to-earnings (P/E) ratio wouldn't likely have retreated to 18.4, versus Schwab's five-year average P/E ratio of 21.4.
Granted, the sector median P/E ratio is 9.5, so one can't rely solely on this metric to build a value-investment case for Schwab stock. It's only one piece of a larger puzzle -- and when you put the puzzle together, it should display a message that says, "This, too, shall pass."
Take JPMorgan analyst Kenneth B. Worthington, for example. He cited cash sorting as the "key factor in determining Schwab's near-term earning power," but nonetheless assigned an "overweight" rating and a December 2024 price target of $92 to Schwab stock.
That implies significant upside from the current share price, so evidently Worthington isn't wringing his hands too hard over Schwab's cash-sorting issue. Perhaps in an ultra-efficient market, the fallout from higher-for-longer rate policy and cash sorting have already been priced in, and then some. Isn't that how good values come to be, after all?
Extracting value from the crisis
In any case, it's not as if Charles Schwab is just sitting around, waiting for the Federal Reserve to back off from its rate-hiking policy. Not long ago, the company announced imminent layoffs in order to cut costs. This won't put the employees in a great mood for the holidays, but at least the shareholders can appreciate the attempt to firm up Schwab's bottom line.
And when the perceived crisis eventually passes, Schwab should emerge a brokerage behemoth with the added clients from TD Ameritrade. So, buying Schwab stock now isn't only a bet that the company provides a good value. It's also a wager on central-bank policy fluctuating through hawkish and dovish cycles, as it always has and likely always will.
