The current elevated interest rate environment has hit some finance stocks especially hard, and Charles Schwab (SCHW 0.13%) is among them. The stock peaked in early 2022, right before the Federal Reserve began raising rates in a bid to get inflation back under control. Since then, shares have declined 31%.
The investment services firm has struggled with a deposit outflow, which it has historically utilized as a low-cost funding source for its business. More recently, deposit outflows have slowed, and the prospect of falling interest rates would be a welcome development for Charles Schwab. However, is that enough to make the stock a buy? Here's what you should consider first.
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Charles Schwab's deposit outflow situation
Charles Schwab provides various financial services for customers, including banking, asset and wealth management, and brokerage services. The company focuses on a low-cost, customer-centric approach to doing business. It has historically been a strong-performing financial stock thanks to its prudent approach to credit and efficient operations.
One essential part of its efficient business model is its deposits. These deposits have served as a low-cost funding base for the company and have been crucial to its longer-term success. However, rapidly rising interest rates, like those we experienced throughout 2022, have weighed heavily on Schwab's business.
Many of Schwab's deposits are in clients' savings accounts and are balances they have yet to invest. However, rising interest rates have led its clients to move deposits from lower-yielding accounts into higher-yielding alternatives, such as high-yield savings or money market funds.
From August 2022 to March 2023, Schwab lost $45.2 billion in deposits, averaging a pace of $5.6 billion per month. This "client cash-sorting" phenomenon resulted in a double-downgrade by analysts at Bank of America in early 2022, and this occurred well before any banking turmoil stemming from the failure of Silicon Valley Bank (SVB Financial's subsidiary) and other regional banks.
One positive sign for investors is that the pace of Schwab's deposit outflows is moderating. From June through December, the company's deposits continue to decline, although at a slower pace of $1.1 billion per month.
Schwab has done a good job navigating challenging market conditions
Despite falling deposits, Schwab continues to do well in accumulating client assets and incorporating its acquisition of TD Ameritrade. In 2023, the company added $306 billion in core net new assets, including $43 billion in December alone. Total client assets are now $8.5 trillion, up from $7 trillion the year before, thanks to inflows and positive market returns. This growing asset base is vital to Schwab's long-term growth and increasing its management and administration fees, which were raised 12.8% during the year.
Schwab will likely continue dealing with client cash-sorting until the Federal Reserve decreases its benchmark interest rate. According to the CME FedWatch Tool, the market is pricing in four interest rate cuts for the year.Schwab would welcome these rate cuts. Higher rates have weighed on its net interest revenue, which fell 11.7% year over year.
According to management, lower interest rates could alleviate cash-sorting woes and help it improve its net interest margin to 3% by the end of 2025. However, that assumes that inflation continues to get closer to the Federal Reserve's 2% target.
Value investors may find Schwab stock appealing
Charles Schwab stock presents an attractive investment opportunity for value investors. Its price-to-earnings (P/E) ratio of 25.3 is right at its 10-year average. However, its forward P/E ratio, based on next year's earnings, is 18.6 and reflects that analysts expect earnings growth from the financial services company over the next year.
SCHW PE Ratio data by YCharts
Charles Schwab stock could continue to experience volatility as interest rates stay elevated. Markets had priced in March rate cuts for several months, but continuing hot economic data has pushed those expectations back to June. However, Schwab's cheap valuation and potential tailwinds from falling interest rates make it a solid stock to buy today and add to as the year progresses.
