After more than a 130% rally since the March 23 lows of last year, at the current price of $66 per share, we believe Charles Schwab Stock (NYSE: SCHW) is trading above its near-term potential. Charles Schwab, the largest brokerage firm in the U.S. (after the TD Ameritrade acquisition), has seen its stock rally from $29 to $66 off the March 2020 bottom compared to the S&P which moved around 75% – the stock is leading the broader markets by a huge margin and has gained 96% over the last twelve months. The retail investing giant has outperformed the consensus estimates for both revenues and earnings in its recently released fourth-quarter results – the first earnings after the TD Ameritrade merger. It was mainly driven by higher trading activity and the addition of 15.8 million new clients, which led to a 13% growth in net interest income coupled with a 6x jump in trading revenues. This has boosted investor confidence in SCHW’s stock.
Charles Schwab’s stock has surpassed the level it was at before the drop in February 2020 due to the coronavirus outbreak becoming a pandemic. While the merger with TD Ameritrade has benefited its valuation, the current level seems a bit expensive. As, in reality, higher trading activity will likely normalize with the recovery in the economy.
While the company’s total revenues rose around 15% from $10.1 billion in 2018 to about $11.7 billion in 2020, it translated into a 9% decrease in the net income figure. The difference in growth numbers is mainly due to a jump in operating expenses as a % of revenues from 55% in 2018 to 63.2% in 2020.
The company has seen steady growth in revenue over 2018-2020, and its P/E multiple has increased. We believe the stock is overpriced and is likely to see some downside after the recent growth and the potential weakness from a recession-driven by the Covid outbreak. Our dashboard What Factors Drove 60% Change In Charles Schwab Stock Between 2018-End And Now? has the underlying numbers.
Charles Schwab’s P/E multiple has changed from just below 17x in FY 2018 to around 25x in FY 2020. While the company’s P/E is close to 31x now, there is a downside when the current P/E is compared to levels seen in the past years – P/E multiple of around 25x at the end of 2020.
So Where Is The Stock Headed?
Charles Schwab completed the acquisition of TD Ameritrade at the start of October 2020, creating a company with approximately $6 trillion in client assets across 28 million brokerage accounts. The figures further improved to $6.69 trillion in client assets and 29.6 million brokerage accounts by the end of 2020 – up by 66% and 140% respectively on a year-on-year basis. Although SCHW reported positive growth in the full year 2020 revenues, it was the fourth-quarter results that made all the difference. The company’s net interest income, which constitutes more than 50% of the total revenues, improved in the fourth quarter. However, it was due to the growth in interest-earning assets driven by higher client-asset inflows and TD Ameritrade acquisition, partially offset by a drop in net interest margin due to interest rate headwinds. Additionally, growth in its fourth-quarter trading revenues was mainly due to the recent acquisition and higher trading activity in the market due to the impact of the Covid-19 crisis. That said, the higher client activity levels in the market are likely to normalize with the recovery in the economy, negatively impacting both client-asset inflows and trading volumes. Further, the investment yields are still below the pre-Covid-19 levels and recovery is likely to take some time. While Charles Schwab revenues are expected to grow in FY2021, both the above factors will likely hurt its growth rate. Overall, we believe the Charles Schwab stock can see some negative movement in the short term.
The actual recovery and its timing hinge on the broader containment of the coronavirus spread. Our dashboard Trends In U.S. Covid-19 Cases provides an overview of how the pandemic has been spreading in the U.S. and contrasts with trends in Brazil and Russia. Following the Fed stimulus — which set a floor on fear — the market has been willing to “look through” the current weak period and take a longer-term view. With investors focusing their attention on 2021 results, the valuations become important in finding value. Though market sentiment can be fickle, and evidence of an uptick in new cases could spook investors once again.
Although Charles Schwab Stock may not be currently attractive, 2020 has created many pricing discontinuities which can offer attractive trading opportunities. For example, you’ll be surprised how the stock valuation for Apple vs. Emergent Biosolutions shows a disconnect with their relative operational growth. You can find many such discontinuous pairs here.