Investors Distrust Wall Street -- And that's Great News For This Stock

Thanks to Lehman Bros., Bernie Madoff, Ivan Boesky, Dennis Kozlowski, Henry Blodget and many others, most investors have had enough. They simply don't trust Wall Street and are convinced that the investing business is rigged for the benefit of those who know how to circumvent the rules.
 
That's the only conclusion you can draw after reading up on the latest survey jointly conducted by The University of Chicago and Northwestern University. They recently discovered that just 16% of Americans trust the stock market.
 
The fact that the survey's results come AFTER the stock market has doubled in value during the past three years is truly sobering. You can only imagine what investor sentiment would look like if the market fell 10% or 20% this year, or another financial executive was caught with his hands in the honey pot.

Frankly, it's a shame. I'd be a fan of much more regulation of Wall Street (which explains why I no longer have the stomach to work for Wall Street firms), but I still think investors shouldn't be shunning stocks. With the right amount of homework and the proper amount of risk aversion, investors can still make major gains as they build up retirement nest eggs.
 
The fact that 84% of Americans shun stocks is unpleasant news for online brokerage firms such as E*Trade (Nasdaq: ETFC) and TD Ameritrade (Nasdaq: AMTD). These firms must hope for investor trust to return if they are ever to see a robust rebound in sales and profits.
 
Even many Wall Street employees have had enough. Wave after wave of stockbrokers have left the big firms to set up shop on their own, realizing that acting as an independent financial advisor looks a lot better to most clients.
 
But there is a clear investable beneficiary of this trend: Charles Schwab (Nasdaq: SCHW), which has been a virtual magnet for newly-independent financial advisors. In the past decade, Schwab has seen a huge buildup of new clients, with some impressive numbers to show for it, as I'll detail in a moment.
 
Unfortunately, you wouldn't spot this change by looking at Schwab's share price. The company has historically made solid profits by managing un-invested client funds in interest-bearing money-market funds. And while the Federal Reserve has kept rates at rock-bottom lows, Schwab's profits have barely budged.


As rates start to normalize during the next few years, the stage is set for Schwab to become a profit powerhouse. Although the Fed insists that rates will stay low for several more years, this pledge will be impossible to maintain if the United States is able to rebound in coming quarters.

A powerful base of assets

The stock-brokerage industry began its tectonic shift in 2004, as Schwab and TD Ameritrade built up platforms to meet the needs of financial advisors who wanted to hang out their own shingle. Since then, these two firms have boosted assets under management (AUM) by registered investment advisors (RIAs) at an 8% annual compound rate. Meanwhile, AUM for the traditional firms such as Merrill Lynch, Smith Barney, UBS and others have been falling at a 3% annual pace. And this trend shows no sign of letting up.
 
Part of the shift is intentional. Wall Street firms are increasingly focusing on the largest accounts, effectively telling mid-sized accounts to take their business elsewhere. That's why the $1.2 trillion in assets managed by brokers using Schwab and other back-office platforms (as of the end of 2010, according to a study conducted by Cerulli & Associates) is expected to swell to $1.5 trillion by mid-decade.
 
Schwab, with 56% of the RIA market, is the biggest beneficiary. TD Ameritrade, with an 8% share, is a distant second, while Fidelity has less than 5% of the market in third place. (Fidelity, with a 24% market share, is the leader in managing investment retirement accounts (IRAs) for individuals, with Schwab and TD Ameritrade controlling 14% and 4%, respectively.)
 
Yet as noted earlier, many investors avoid playing the market directly out of mistrust, which is why RIAs are building up assets at such a steady pace. To put real numbers behind this trend, note that Schwab's current asset base of RIA-controlled assets is at $630 billion and could exceed $900 billion by 2015, according to Goldman Sachs.
 
The rate hike scenario

The era of low interest rates can't end soon enough for Schwab. The company would likely see earnings per share (EPS) rise by 35% from current levels for every 100 basis point (1.0%) increase in the federal-funds rate, according to Goldman Sachs, as profit margins expand on money-market accounts.
 
To put this in context, Schwab is expected to earn $0.85 to $0.90 a share in 2013. Let's say the Fed-funds rate is 100 basis points higher in 2014. Then you'd be looking at $1.20 in EPS. A 200 basis point hike would turn out to be $1.50. And a 300 basis point hike likely equates to almost $2 a share in annual earnings power.
 
Right now, Schwab is making life easy on its clients, waving 42 basis points out of the typical 57 basis points that it would receive on funds parked in money management accounts. As rates start to rise, Schwab won't need to offer that giveback. So what is now roughly $300 million in annual income for Schwab would be roughly $1 billion in annual income without it. That's almost as much as Schwab makes in its other three businesses combined: Funds and ETFs, OneSource fund distribution services and RIA platform fees.

Risks to Consider: Shares of Schwab won't really start to percolate until investors have a clearer read on when the Fed will start to hike rates. Any moves won't likely come before the second half of 2013, but anticipation of such an event may start to get factored into earnings models for Schwab later this year.
 
Action to Take --> Charles Schwab has historically been seen as a proxy for investor interest in stocks. Yet the company's business model has steadily morphed, so its interest rates and RIA asset management have actually become the key drivers for this business. Schwab has had great success in putting the right platform in place, having attracted thousands of RIAs in recent years. It's only a matter of time before this bigger client base translates into much bigger profits.

By David Sterman