Zero Rates Offer Chance to Buy Charles Schwab (NYSE: SCHW) at a Discount

Charles Schwab (NYSE: SCHW) stock has underperformed the broader market considerably over the past 2+ years. After pushing $60 a share in May 2018, shares have been trending down since.

The coronavirus pandemic has been tough on Schwab, as it led to the Fed cutting rates to zero. The introduction of zero-commission trades means that Schwab now relies more heavily than ever on net interest income.

But with it’s TTM P/E now sitting below 15 and a strong operational outlook, this may be an opportunity for investors to get Schwab shares on sale. A deal in November 2019 to buy TD Ameritrade (NASDAQ: AMTD) was the biggest in a string of moves meant to position Schwab well moving forward.

TD Ameritrade Deal

Schwab agreed to buy TD Ameritrade for $26 billion – all in stock. Back when it was announced, Schwab stock responded by moving up 8%, showing that market participants were happy with the deal.

The chief reason for that optimism was the expectation of lower operational costs due to redundant operations. Schwab expects to save up to $2 billion.

At the end of Q1 2020, Schwab had client assets of $3.5 trillion. The TD Ameritrade deal will add more than $1 trillion to that number. And those numbers are likely even higher when you consider the market’s rise since the end of Q1.

In addition to the TD Ameritrade deal, Schwab made two more moves meant to position it for prosperity in a changing landscape.

Fractional Shares and Zero-Commission Trades

Schwab has shown a commitment to leading – or quickly following – on brokerage industry trends.

Schwab was the first major brokerage to announce, in October 2019, that it would be offering fractional shares. The move was meant to appeal to young investors, who often don’t have the money to invest in full shares of some of the most popular companies. For example, one share of Amazon (NASDAQ: AMZN) stock goes for more than $2,600. Besides solving the issue of high-priced shares, the move also addresses the widespread preference to invest small amounts over time – or dollar-cost averaging. Fractional shares are a godsend for people that want to invest something like $50 per week.

The decision to move to zero-commission trades was a tough one, but it had to be done.

After Robinhood launched its platform in 2013, offering free equity trades, other platforms have sprouted up with commission-free structures. The writing was on the wall that commission-free was here to stay by late 2019.

Schwab followed suit and slashed trading commissions to zero in October 2019. TD Ameritrade, ETrade (NASDAQ: ETFC), and Fidelity quickly did the same.

Making this move a month prior to the TD Ameritrade acquisition was no coincidence; Schwab essentially pulled the rug out from under one of its biggest competitors, and then scooped it up for the synergies.

But with zero-commission trades, how does Schwab make money?

Interest Rates

The move to commission-free trades and subsequent purchase of TD Ameritrade showed that Schwab is doubling down on its net interest margin business. This practice of taking client cash balances and lending them out for higher yields accounts for around 60% of Schwab’s revenue.

However, this reliance on interest margins leaves Schwab very susceptible to moves by the Fed. According to Barclays, short-term rates moving up or down 25 basis points represent a revenue delta of $75 million to $175 million for Schwab.

With interest rates at zero, it’s clear that Schwab could be in for tough times ahead.

However, here are three reasons for optimism:

1. Interest rates were lowered in response to the coronavirus pandemic. How long the pandemic will hinder the economy is anyone’s guess, but 6-12 months from now, things should be a lot better. It’s unlikely the Fed keeps interest rates low for years in response to the pandemic.
2. Schwab has a strong business that is likely to hold up in times of distress and prosper during the best of times.
3. The stock’s low valuation gives investors limited downside in the event of a lean year or two, and high upside in the case of a favorable move in interest rates.

Technicals

As mentioned earlier, Schwab shares have dipped considerably over the past two years. If you’re looking for a nice entry point, a retest of the May lows around $32 would be appealing. Conversely, a breakout above $45 would be intriguing, as it would represent a 3+ month high and a break above the 200-day moving average.

A Tough Value to Beat

Interest rates will likely be a big headwind for the next 6-12 months. And the chart isn’t exactly a thing of beauty.

But Schwab shares are one of the best values in the market. It’s rare to find a healthy and strong business for this price after a decade + secular bull market. Schwab shares deserve your consideration and could pay off handsomely over the next 2-3 years.