This article is excerpted from Tom Yeung’s Profit & Protection newsletter. To make sure you don’t miss any of Tom’s picks, subscribe to his mailing list here.
Markets Turn Tail… Again
When Once Upon a Time in America was released in 1984, the late Roger Ebert called it “an absolute masterwork of cinema.” The film would go on to win multiple awards and remains a fan favorite on my family’s movie list.
There’s just one little problem:
The full version is almost 4 hours long.
As riveting as the “epic poem of violence and greed” can be, I often sit through the movie feeling as if it’ll never end.
Investors watching the markets can relate. Last week, the S&P 500 recovered 6%, just to drop again this week. Short-term traders might call it a dead cat bounce while longer-term investors would call it a gratuitously long “masterwork” by the Fed.
And we aren’t even at intermission yet. With interest rates still on track to rise at least another 150 basis points, investors need to switch tactics and buy stocks that benefit from rising rates.
So today, we will consider which of the nine financial stocks listed in Tuesday’s newsletter deserves a spot on the core Profit & Protection buy list.
The “Sleeper” Stock That’s Outperforming Robinhood
On Tuesday, I introduced the nine top financial firms of the quantitative Profit & Protection stock-picking system.
- Selective Insurance (NASDAQ:SIGI). A+
- W R Berkley (NYSE:WRB). A+
- Everest Re (NYSE:RE). A+
- PNC Financial Services (NYSE:PNC). A+
- Allstate (NYSE:ALL). A
- JPMorgan Chase (NYSE:JPM). A
- Charles Schwab (NYSE:SCHW). A-
- Northern Trust (NASDAQ:NTRS). B+
- US Bank (NYSE:USB) B+
These picks were chosen with a twist:
They aren’t the fastest-growing firms.
The financial industry has a unique capacity for self-destruction. Over the past decade, financial firms in the fastest growth quintile actually underperformed the middle quintile by nearly 5% annually.
Want to show supernormal loan portfolio growth? How about offering personal loans with zero collateral requirements? You can be sure there’ll be a line out the door by mid-morning.
Need more brokerage customers? Try allowing any investor to open an options trading account, as Robinhood (NASDAQ:HOOD) did before FINRA intervened.
These unsavory practices eventually come back to haunt. Poor underwriting standards drove Lehman Brothers and Bear Stearns out of business in 2008. And Robinhood’s exposure to risky bets would have bankrupted the brokerage in 2021 had they failed to secure an emergency $1 billion lifeline.
Meanwhile, high-performing financial firms tend to avoid such shenanigans. These companies understand that badly collateralized loans can bankrupt even the mightiest of players, settling on middling-speed growth in exchange for increased stability.
It’s a strategy that works. Conservatively run financials from First Republic Bank (NYSE:FRC) to RLI Insurance (NYSE:RLI) tend to outperform risk-takers like Citigroup (NYSE:C); RLI has returned 27,000% since 1982.
And among the top 9 financial firms that my quantitative system has chosen, one stands out as a hidden bet on America’s rising rates.
Charles Schwab (SCHW)
At first glance, Charles Schwab might seem like an ordinary brokerage business. The company is second to BlackRock (NYSE:BLK) by assets under management and recently acquired TD Ameritrade in a $26 billion deal.
Its stock price has also fallen in lockstep with other exchange-focused firms. Since January, SCHW shares have fallen 25%, mirroring the 24% losses at Nasdaq (NASDAQ:NDAQ) and the 28% decline at the Intercontinental Exchange (NYSE:ICE).
But Schwab wouldn’t make the core Profit & Protection list as a pure-play brokerage business. After all, that’s an industry that tends to suffer when interest rates rise and investors stop trading.
Instead, Charles Schwab makes the list because it’s quietly become one of America’s largest and best-run banks.
When customers deposit money with Schwab, only 95 cents of every dollar is invested on average, as is the case with most brokerages. Investors tend to keep the remaining 5 cents in cash for liquidity.
But these small amounts eventually add up. Today, Charles Schwab controls $450 billion in cash deposits. If it were a commercial bank, Schwab would now be the eighth-largest in the U.S.
That has also changed the brokerage’s business model. The company now generates around half of its revenues from interest income, significantly more than JPMorgan’s 40% and on par with Bank of America’s (NYSE:BAC) 47%. Revenues earned from trading fees have become almost secondary. And as rates continue to rise, Schwab’s bottom line will only increase over time.
America’s Hidden Bank
Banking businesses are a special breed when it comes to rising rates. Instead of suffering at the hands of a hawkish fed, banks (and non-health insurance firms) benefit from earning more interest on customer deposits.
In other words, rising rates help banks earn greater Net Interest Margins (NIM).
But interest rates can’t rise too quickly. Banks are a natural representation of the sectors they serve, and the recessions caused by over-tightening will translate into bad loans. Capital One Financial (NYSE:COF) has already fallen 40% since last August for its high exposure to credit card debt while Ally Bank (NYSE:ALLY) suffered the same over auto loans.
An investment in Charles Schwab solves both problems at once:
Net Interest Margin. According to the firm’s interest rate simulations, every 1% increase in interest rates will boost NIM revenue by 14.1%.
Sector Risk. Nearly 90% of Schwab’s assets are held in securities guaranteed by either the U.S. government or U.S. government-sponsored enterprises. The firm has very low risk of accruing bad loans.
Cheap(er) Valuations Than Usual
Most investors still consider Schwab a brokerage business. Shares are down 35% since February and trade a full standard deviation below their historic price-to-book valuation.
That gives smart investors a window of opportunity to buy a high-quality company on the cheap. Rising interest rates will boost Schwab’s revenue without causing additional costs.
Analysts at Morningstar also highlight Schwab’s quality.
“In our opinion, the company’s balance sheet is sound, its capital investment decisions are exemplary, and its capital return strategy is appropriate,” Analyst Michael Wong notes. Additionally, “Charles Schwab’s merger with TD Ameritrade not only creates an industry leader in the retail brokerage space, it creates a leader in the overall financial sector.”
The firm’s profitable, wide-moat business will increase its book value over time. And investors with the patience to hold Schwab will the be ones to benefit.
What’s Charles Schwab Worth?
Schwab represents one of the lowest risk, lowest return picks on the core Profit & Protection list. Valuations based on comparable price-to-book ratios give Schwab a $73 fair value, a mere 15% upside. Adding in a growth premium raises fair value to $85, a 35% premium.
Investors with greater risk tolerances have plenty of other choices. SoFi (NASDAQ:SOFI) is now trading at all-time lows. It’s now a buyout target with 2x to 3x return potential and is one of my favorite speculative picks.
Meanwhile, Robinhood itself could get acquired by the end of the summer for $15 to $20, a significant premium to its current $9 price.
These can make phenomenal investments for those looking for a gamble. But for those looking for a slow-and-steady way to beat rising rates, Charles Schwab offers a business model that’s hard to beat.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.