Own Shares of this Stable, Iconic Brokerage for the Long Haul

Wednesday, May 12, 2010 - 4:25pm

by Frederick M. Steier

There is a company that has long been one of the top holdings in the mutual funds of legendary asset manager Ron Baron. I wondered why Mr. Baron has, for so long, put so much faith in this entity. I did some research and discovered the answer was literally encapsulated in a person's face.

Some companies have a signature item or logo. Other companies rely simply on word of mouth. However, a few of the world's top companies rely on a person. It's difficult using a real person as a company's calling card because that person has to project everything the company stands for, and if something goes wrong, that same person must be able to take the heat.

Charles Schwab (Nasdaq: SCHW) is the literal face of his eponymous company. He is his own brand. It is this brand, its reputation and its financial success that has convinced Mr. Baron to keep Schwab as a top holding for so many years. Charles Schwab himself clearly represents something to people. His face, his tone of voice and his reputation suggest strength, elegance, affluence and most of all, stability.

Using its stable reputation and targeted marketing, Schwab wisely focuses on earning a customer's trust. When it comes to money, particularly in this environment, the last thing an investor wants to worry about is whether he's parked his assets in a potentially insolvent brokerage house. The company debuted a new marketing strategy in 2004, the "Talk to Chuck!" campaign, which was designed to further the trust people had in the company by projecting an image of accessibility. It paid off. The Journal of Financial Advertising voted it the Best Brokerage Ad Campaign and Best in Show for Financial Services Advertising.

Why spend so much time understanding the company image? Because it's the key to understanding how Schwab operates internally, as well. That way, we can determine, if the company is good enough for Ron Baron, is it good enough for the average investor?

Stability is a very good reason investors should take a look at Schwab. During the global credit crisis, nobody heard a peep out of the company. That's because it had not put itself in a bad position by holding exotic securities and debt that nearly cratered peers like E-Trade Financial Corporation (Nasdaq: ETFC). The company's $1.3 trillion asset base is rock solid.

However, those same exotic securities were sold by Schwab to clients. As a result, Schwab did struggle a bit with trust in the summer of 2009, when New York Attorney General Andrew Cuomo sued Schwab for civil fraud over the selling of auction-rate securities to clients. These short-term illiquid debt instruments resulted in billions of losses for clients. Schwab put the blame on the creators of the securities, saying, "Schwab brokers, while trained to levels beyond industry standards, could not be expected to foresee and disclose market risks that even regulators and market experts did not foresee." The case has not been settled, although Schwab settled a similar one with the federal government for $200 million in April. This is serious stuff, and it might sink a lesser brand. Instead, Schwab's client and asset base continues to increase. This past quarter the company added 230,000 new clients and its exchange-traded fund (ETF) advisory services took in $500 million in new client assets.

That kind of Teflon branding says a lot about Schwab.

Financially, Schwab is in a very strong position. Revenue was off -12% this quarter, as Schwab moved to compete with other discount brokerages by changing from a tiered commission structure to a flat fee for online trading. However, trading euphoria has returned to the markets, resulting in a +48% increase in margin loans as investors returned to their leveraging ways to take advantage of the overall market upswing. Operating margins have been increasing since 2003, due to strict cost controls put in place.

Schwab generated $1.3 billion in free cash flow in 2009, a trend that continued into 2010. It sits on $26 billion in cash and $37 billion in other investments, allowing it to generate income from other sources besides client advice and brokerage services. Schwab earns more on interest-bearing investments than it pays in liabilities, so if interest rates rise as many expect, that will only benefit the company.

We have entered a new era of market volatility, and that is unlikely to change. People should, and will, seek out stability. Charles Schwab is the very face of stability. This is a long-term buy-and-hold stock, just like Ron Baron believes. At current prices near $18.00, the stock sits well below its all-time high of $42, and below the pre-2008 crash high of $24.00. It's a good entry point.

Frederick M. Steier does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.