⚡ Highlights:
Amid a rout in financials, SCHW has been a particular victim, losing 24% of its value last week.
Social media discussion of possible insolvency highlights the extent to which panic has taken hold.
Past dips in SCHW have always been opportunities; this seems no exception.
A wonderful franchise with growth potential is available at a hugely attractive multiple.
On October 1, 2019, discount broker Charles Schwab SCHW 0.00%↑ announced that it was eliminating commissions on stocks and exchange-traded funds. Investors responded by swiftly selling off Schwab stock. In three sessions, SCHW declined 15%.
But the selling made little sense. By 2018, commissions accounted for less than 7% of the firm’s revenue. The company had already cut its rate to $4.95 the year before. The rise of Robinhood HOOD 0.00%↑ (which, we’d later learn, ended 2019 with over $14 billion in assets under custody) meant any investor paying any attention already knew commissions were going to zero.
That 15% decline proved to be a buying opportunity. Including dividends, SCHW has returned 75% since, nearly double the 40% gain in the S&P 500 Total Return Index.
In fact, as recently as Wednesday, the total return in SCHW was over 100%. But between trading on Thursday and Friday, shares dropped 23%. The catalyst, of course, has been the failure of Silicon Valley Bank SIVB 0.00%↑ , a failure which has raised a number of concerns among other American financial institutions.
This sell-off, too, looks like a buying opportunity.
Taking A Step Back
Our thesis here is that the sell-off in SCHW last week was unjustified. Like any investing thesis, there’s a risk that we’re simply wrong: that we’re underestimating the risks that drove the selling in the stock, or that we are not fully grasping Schwab’s exposure to a potentially volatile situation.
But that kind of thesis carries another risk as well: that the price and the business weren’t all that great before the sell-off. Put another way, even an unjustified sell-off can lead to (roughly speaking) a justified price.
We’d argue strenuously that such a risk doesn’t really apply here. Simply put, Charles Schwab is an outstanding business. Over three decades leading up to the pandemic, its return on equity averaged about 20% (it was 18% last year). Assets under management were $96 billion at the end of 1993, and more than $7 trillion at the end of 2022. That’s nearly three decades of ~16% annualized growth. Not coincidentally, SCHW including dividends has returned more than 15% annualized over 30 years (per data from YCharts).
To be sure, the 2020 acquisitions of USAA’s brokerage operations and, more importantly, Ameritrade both contributed to that increase in AUM. But organic growth (via both customer acquisition and the increase in existing assets) has been impressive; net new asset growth has been in the mid-single-digits annually for the past 10-plus years. More broadly, we’d argue that this has been one of the great American businesses since its founding a little over five decades ago.
Meanwhile, it’s not as if SCHW’s valuation was particularly onerous at Wednesday’s close of $76. At Friday’s close below $59, it looks particularly attractive. Shares now trade at just under 18x adjusted EPS for 2021, and 15x the print for 2022. Given ROE and huge profit margins, both multiples are more than acceptable. That’s particularly true because, as we’ll discuss later, for one key reason neither figure seems to fully reflect the company’s earnings power.
If we are understanding the situation properly, it’s one in which all sorts of Warren Buffett quotes apply. Schwab is a wonderful franchise now available at a more-than-fair valuation. That valuation is available to those willing to be greedy when others are being fearful.
Of course, that’s only true if we are understanding the situation properly. Many investors clearly believe that we’re not.
The Read-Through From SVB
There’s still some debate as to precisely why Silicon Valley Bank failed. We’ll leave the particulars of that debate to the thousands of newly-discovered banking analysts on Twitter.
But one clear cause (and obviously there were more than one) was the duration mismatch between deposits (ie, liabilities), and assets. Every bank has this mismatch — they “lend long and borrow short” — but SVB was an outlier in the space:
source: JPMorgan research via Lake Cornelia Research Management on Twitter
SVB had a huge portion of its assets in fixed-rate, instead of floating-rate, securities. Per the Financial Times (h/t Matt Levine at Bloomberg), the proportion of 56% fixed was roughly double that of other American banks.
Those fixed-rate investments represented a massive bet on interest rates. The bet lost as the Federal Reserve began to hike last year. As Marc Rubinstein noted on his Substack, Net Interest, the balance sheet impact was severe:
So big was this drawdown that on a marked-to-market basis, Silicon Valley Bank was technically insolvent at the end of September. Its $15.9 billion of HTM [held to maturity] mark-to-market losses completely subsumed the $11.8 billion of tangible common equity that supported the bank’s balance sheet.
At some point, those unrealized losses began to spook customers, who (apparently with a push from venture capitalists in the area) went to pull their deposits. SVB had no way out. It appears based on current (and admittedly imperfect) information that even liquidating its bond portfolio would not have raised the necessary cash to cover withdrawal requests.
That mismatch unsurprisingly has led to the question of “who’s next?” Yes, SVB had an unusually high proportion of fixed-rate assets. But in a zero-interest rate environment, nearly every financial institution was trying to take on at least some duration risk in exchange for some kind of yield.
Presumably, some (or even most) of those institutions have their own versions of the same math problem cited by Rubinstein. Adjust their reported tangible equity for unrealized losses in their HTM portfolios, and the equity cushion becomes thin or nonexistent.
Before SVB, that math perhaps wasn’t seen as such a threat. Banks with positive equity surely still had enough flexibility to pay out the withdrawals that were needed. Over time, the HTM portfolio would run off, with the cash at maturity then being reinvested at higher rates. Those long-dated bonds — in some cases yielding less than 2%1 — might hurt profits and ROE until maturity, but (to oversimplify) it was a problem that would eventually work itself out.
But after SVB, that’s not the interpretation:
source: finviz.com
Investors have fled regional banks in particular, and are on the lookout for the ‘next’ SVB.
Is Schwab Insolvent?
A few investors have even pointed to Schwab. On Substack right now is a post claiming that “$SCHW Is Next!”, which claims that “$SCHW is no better than $SIVB”. Over on Twitter, the following table has made the rounds:
source: Twitter
So too have claims of declining deposits and plunging tangible book value.
Some of these claims are driven by errors. The chart above, for instance, appears to calculate equity value only for the banking subsidiary. Other analyses have double-counted unrealized losses from HTM and AFS (available for sale) portfolios. Others stem from not understanding that Charles Schwab isn’t actually a bank (it owns a bank, but that’s not quite the same thing) and thus, for instance, a lower deposit balance doesn’t mean a shrinking asset base.
But the problem is not the math — it’s the conclusion. On paper, you can make a credible argument that Schwab’s equity, post-Q1 will be negative (it probably isn’t, though it might be). In terms of responding to that fact, however, we’d quote Triumph the Insult Comic Dog from one of his funniest sketches. “The correct answer is: who gives a sh—?”
There’s not going to be a run on the bank at Charles Schwab. Securities held through the brokerage are segregated. Cash in a brokerage account has a very different purpose for investors than does cash in a checking account. Cash at Schwab is also insured via the SIPC (Securities Investor Protection Corporation) up to $250,000; supplemental insurance via Schwab takes the figure up to $1.15 million. And as the chart above from JP Morgan highlights, SVB had not just a portfolio overweight fixed-rate securities, but a deposit base heavily overweight corporate accounts. Those accounts were mostly not insured (most corporates are going to have accounts over the $250,000 cap; we’ve seen figures that Federal Deposit Insurance Corporation insurance covered ~3% of the total base), making the bank far more susceptible to a run.
Schwab has $50 billion-plus in borrowing capacity from the Federal Home Loan Bank (per figures from the 10-K). It can sell near-term maturities; it can collateralize additional borrowings even with underwater securities. And in the absolute worst-case scenario, we’d wager that Charles Schwab (and here we mean Mr. Charles Schwab) could probably call Mr. Buffett in Omaha and get an infusion of cash for preferred stock to boost both the balance sheet and investor confidence. (Who would a Schwab customer trust more than Buffett?)
That wouldn’t be an ideal situation for shareholders, certainly. Buffett drives a hard bargain in times of crisis. But that’s an option only required in the absolute worst-case scenario. The thin odds of it even being considered simply lend further credence to the idea that the risk of a Schwab failure is overblown, to put it mildly.
We’d add one more point: right now, every investor is taking the risk of Schwab blowing up. There is no world in which Schwab fails and the S&P is down 10% or even 20% from current levels. If SVB truly is a contagion event from which a straight line is drawn to Schwab, that in turn suggests an absolute collapse in the American financial system.
And in that scenario, U.S. equities crash hard, as they did in 2008-09. Investors willing to take the risk of being net long anything post-SVB might as well take that risk in SCHW, where at least the rewards are both significant and directly correlated to the firm’s true strength.
Why Are You Talking About Twitter?
At this point, an appropriate rebuttal might be that “SCHW did not drop 24% last week because of social media.” That’s no doubt true. But social media discussion and sentiment likely had some effect, particularly in terms of trading on Friday.
After all, it's worth remembering that we’ve recently seen swirling rumors on social media significantly impact a financial stock. Back in October, Credit Suisse CS 0.00%↑ plunged, and its credit default spreads widened materially, sparked apparently by posts on Reddit and Twitter. (To be fair, CS has indeed proven to be a terrible investment since, but that’s been the case for more than a decade now and for reasons that go far beyond its solvency.)
More broadly, the frenzy on Twitter around SVB, Schwab, and other financials is just one sign of a market losing its bearings. There are other signs that the panic has become ridiculous.
Q2 Holdings QTWO 0.00%↑, for example, is a provider of software to regional banks and credit unions that enables online and virtual banking. Its stock fell 15% — in line with the sector it serves — on Thursday and Friday. Are we to believe that 15% of regional banks are simply going out of business? That their balance sheets are so impaired they won’t have the funds to upgrade their digital platforms2?
On Friday, I played merger arbitrage tourist and took a position in Sumo Logic SUMO 0.00%↑, a company that is being acquired by private equity. On Friday, the merger spread nearly tripled (and was up ~5x at one point), apparently because that company at one point had a revolving facility with SVB. As I detailed (on Twitter), the widening spread appears to make close to zero sense.
The idea that panic is at play here is further supported by the simple fact that the nature of Schwab’s balance sheet and fundamentals were already well-known to the market for some time. Here’s how a Value Investors Club article recommending SCHW framed a decline in the stock ahead of publication [emphasis ours]:
[SCHW has fallen] primarily to investor concerns regarding the future path of short term interest rates and client cash “sorting,” the dynamic by which some clients choose to optimize the interest earned on their excess cash by moving…[to]…money market funds, CDs or Treasuries. Additionally, investors have been concerned about a shareholders’ equity decline due to unrealized, mark-to-market value reductions on the fixed-income government securities that the company holds and classifies as “available for sale.”
The article was published on July 29th.
Cash Sorting Versus NIM
Those concerns highlighted in July certainly have merit, and are worth addressing. Cash sorting presents a particular risk.
The core of Schwab’s business model comes from interest on customer accounts. Just over half of 2022 revenue came from net interest revenue. Schwab pays little or no interest on cash sitting in customer accounts; it generates interest by “sweeping” those funds into its banking subsidaries, and captures the spread (its net interest margin). This is why the move to commission-free trading did little to dent results, and in fact was a strategic masterstroke (as it damaged the ability of commission-intensive rivals like Ameritrade and E*Trade to generate their own revenue).
At a time of near-zero yields even on Treasuries, there was much less incentive for customers to put in the work to move cash around to capture yield. In 2023, however, with yields in money markets and T-bills at 4%-plus, customers are moving unused cash out.
Again, this was known. Bank deposits shrunk 17% in 2022, which management attributed to cash sorting. The bear case, as the VIC author rightly noted, is that such behavior will continue, further reducing bank deposit levels, NIM, and profit.
But as interest rates have risen, Schwab management has repeatedly said that sorting continues to follow historical trends. (Schwab customers can also push cash into a Schwab money market fund; those funds are far less profitable, but Schwab at least keeps some revenue that way.) In the Winter Business Update in late January, management said the trend was heading toward an “equilibrium.” At some point for each customer, the value of added interest is negated by the opportunity cost of not actually having cash in a brokerage account to invest.
What cash sorting is, essentially, is a result of interest rates rising too fast. We don’t necessarily mean that in a moral sense, or in a “this is all the Fed’s fault” sense, but rather in terms of the Schwab business model. Like SVB, Schwab bought too many fixed-rate securities. Those fixed rates are well below market. Schwab customers, however, can go get market rates on their assets via money markets or T-bills. In other words, Schwab customers can get higher interest rates much faster than Schwab itself can. And so they are.
Eventually, the rates can Schwab can earn and offer will be more in balance. And if you take the mid-term view, it’s important to remember that higher interest rates are an enormous tailwind for Schwab earnings. Net interest margin — essentially, the spread between interest paid to customers on their cash and interest earned by Schwab by investing that cash — in 2022 was 1.78%3. The figure in 2006 was 3.92%, and it was 4.33% the following year. Then the financial crisis hit, the Fed funds rate spent ten-plus years at or near zero, and spreads were constrained by the upper bound of what Schwab actually could earn in the market in AA/AAA assets.
In a normalized rate environment, that upper bound is rising, which means the spread should as well:
source: Schwab presentation, January 2023
As cash sorting moderates, the remaining interest-earning base is going to generate significantly more profit for Schwab. The 3% target in 2025 is more than double the 2021 figure of 1.44%. After all, the terrible paper that Schwab bought last year is going to mature and be reinvested at sharply higher rates, allowing the firm to play catch-up.
Even with the current portfolio, and with cash sorting increasing, in 2022 net interest margin still increased, and net interest revenue jumped 33%. The path to a potential 3-handle suggests, with reasonable asset growth, consistent double-digit earnings growth even at the current forward curve. The Street certainly is modeling as much: consensus EPS for 2025 sits at $6.51, giving the stock a 9x forward P/E.
Of course, analysts aren’t always right, and with JPMorgan recommending SIVB right to the bitter end, skepticism would be forgiven. But the broad point holds: higher rates are good for Schwab.
To that end, one possible logical explanation for the weakness in the stock is that SVB actually lowers rate expectations. The argument is that Fed will need to respond to potential weakness at other banks by cutting rates, and thus undercutting the path for Schwab (and others) to higher NIM.
We’re rather skeptical of that analysis (though we also by no means are expert Fed forecasters). But at this point, it also doesn’t break the case. Unless the Fed heads back to zero, from a multi-year perspective the 2022 and 2021 results are not peak earnings. Barring an absolute Fed U-turn, from an NIM perspective, they’re closer to the trough.
And again, SCHW is at 15x 2022 EPS and 18x 2021, with incremental synergies from Ameritrade on the way as well. Fed easing at some point already is priced in. Growth is not. When this panic subsides, at some point the market is going to focus on those facts.
When The Smoke Clears
We do believe the panic will subside. That is not going to happen immediately: SCHW almost certainly has more volatility ahead. News about SVB on Sunday will impact Schwab stock; so will the market’s perception of that news.
But we remain highly skeptical that SVB is a canary in the coal mine, or that contagion is set to spread across the banking sector. Again, that bank was a significant outlier in terms of its deposit base and its bond portfolio. The argument that it is the first of many such failures ignores that hugely important fact. And that has created a number of opportunities.
SCHW is not the only one of those opportunities. Regional banks on the whole look intriguing. There might be a case for QTWO, and there are likely a couple we’re missing.
But to our eye, Schwab seems like the best opportunity for one simple reason: it’s far and away the best business being sold off in this panic. Short-term pressure on the price is the catalyst, but it’s the long-term outlook that truly makes SCHW worth buying.
As of this writing, Vince Martin is long SUMO. He plans to initiate a position in SCHW at Monday’s open.
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SVB’s HTM portfolio in 2022 had a weighted average yield of 1.66%.
If you’re asking why we’re not recommending QTWO instead of SCHW, we direct you to our point up top. The sell-off seems unjustified, but valuation after the sell-off is not particularly enticing.
NIM is calculated as net interest income divided by income-earning assets.
Thank you for your excellent analysis. You have given teeth to my gut feeling: failure by Schwab is an asymptotic event. I just hope I can buy in the mid-$50s: if a bailout is announced before the market opens, Schwab will open up $10.
Thank you for the heads up on a great opportunity. I aggressively sold puts at massive premiums in the first 30 minutes of mayhem today, and it's looking like I will be buying them back at much lower prices. And if I get exercised and have to buy SCHW in the low 40s, I'm fine with that, too.