What Makes The Charles Schwab Corporation (SCHW) a Safe Investment in the Current Environment?

“We bought shares in The Charles Schwab Corporation (NYSE:SCHW) as they declined meaningfully in March. Schwab is the premier asset-gathering franchise in the brokerage industry, with particular strength in the advisory market. As one of the top two players in the retail side of the market, it has the scale economies to be a low-cost provider and compete with newcomers intent on industry disruption. In the advisory segment, where it serves independent advisors, it delivers the gold standard in service and product breadth. We believe its moat is wide, and it should grow at a healthy pace for the foreseeable future.

As part of its brokerage model, Schwab operates a meaningfully sized bank, where its brokerage clients maintain deposits as part of their cash management. With over $300 billion in deposits and $500 billion in assets, if it were an independent bank, it would be one of the largest in the country. As interest rates have risen, many clients have been moving cash from low-yield bank accounts to higher-yielding alternatives, such as money-market funds. The industry calls this process cash “sorting.” For Schwab, cash sorting began about 18 months ago, and a large part of its recent stock price drop can be attributed to investor concerns that this process may accelerate. The difference for Schwab, compared to all other banks, is that when depositors pull money out, they are mostly just moving it over to other parts of Schwab! Thus, unlike traditional banks, Schwab doesn’t lose assets in the sorting dynamic. In fact, like U.S. Bancorp, Schwab appears to be a net beneficiary from the recent mini-panic in that new asset inflows have picked up as individuals flee to safety.

This dynamic does cause some disruption at the bank entity, though, as client cash remains within Schwab’s total but is no longer available as deposits to fund the bank’s securities portfolio. We think Schwab has more than sufficient liquidity to deal with this. The realistic worst-case outcome is that total earnings are moderately suppressed for a period as funding costs go up, and Schwab earns less profit for every dollar invested in deposit alternatives, as compared to what it earns per dollar deposited in the bank. Despite this headwind, we believe that as long as Schwab can grow total investment assets under its umbrella over time, its earning power should also grow.”