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You're listening to Teip on today's show, Stig and I have a Reef Karim back on the show to talk about an intrinsic value assessment. After graduating from MIT more than two decades ago, a reef entered the financial investment space and he's now the senior investment analyst at Ensemble Capital Management. The purpose of these types of shows are to conduct deep dives into individual companies so we can learn about the important aspects of valuation and the competitive nature for businesses in its sector.


Today's discussion will be for a deep value pick, and that's Charles Schwab. So without further delay, here's our chat with AREIF.


You are listening to the investor's podcast where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to the Investors podcast, I'm your host, brought us in, and as always, I'm accompanied by my co-host, Preston Pish. I am very excited about the stock that we were talking about today, because with inflated asset prices everywhere, our guest might have found a stock. The trade is really attractive price to value ratio.


The stock is swap. And to help us analyzing that stock, we have R.F. Karrine with us. Welcome back on the show, Ariff.


Hey, thanks. I really appreciate it. Always good to be on your show and great to talk to you. We definitely love having you around like a set there. We'll be talking about Charles Schwab and the ticker is CAGW. It's one of the cheapest high quality picks out there. And we'll talk about the intrinsic value at the end of the episode. But first things first, could you please provide an overview of the business? So Charles Schwab has been around for, gosh, almost 50 years now.


It was established or founded by Chuck Schwab back in the days when in the US at least brokerages were regulated. Brokerages are still regulated by commissions, were regulated by, I guess, an agency, the federal government, and they were at a high price point. And really at the time, for the average investor to be able to trade stocks, you paid very high commissions because the trading capability was a manual's bunch of people forming the market, but B, it was bundled with Wall Street research.


And so all of that was kind of embedded in the cost of trading. And Schwab was a guy who basically wanted to democratize trading for the masses and do that, you had to bring the cost of trading down. And so that was the founding of the business. The whole deal was, you know, I want to create a better, cheaper way to trade better in the sense that you don't have to buy the research along with it if you have your own ideas, what you want to buy.


And so he wasn't able to really get that going until commissions became deregulated. And that was called May Day, because May 5th, nineteen seventy five, I want to say. But that's when stock trading commissions became deregulated so they could be at any price point. And so that was the birth of the discount broker. And Schwab was one of the first at that over the years. What's happened is the ethos that Schwab brought to the business in founding the business carried on into the culture business.


And so Schwab's whole culture and ethos has been around bringing down the cost of trading, but also asset management and increasing distribution of investment products availability to the masses. That's their focus in the business. And so what that's meant is over time, what Schwab has done is it's the parts of investing in terms of the cost of investing that can be commodities. They had commodities. And of course, technology is a huge enabler of that. By taking away the high cost people and implementing, where possible, automation and computers to basically reduce the cost of various fees.


So we are trading at pools of investment vehicles. So Schwab is then carried over that ethos and culture of bringing down commissions to other areas of investment management. And so we all know ETFs. Right, which basically reduce the cost of owning a basket of stocks, mutual funds used to manage it one percent or 100 basis points or more, down to only five to 10 basis points and on its way to free basically. Right. But those sorts of things.


Schwab is also work to basically enable. I think one of the things is really attractive to me about Schwab sort of over the long term window is their ability to basically move up the value chain. They also scale their business model across different types of customers and services as they go up the value chain, they commodities the services in the lower end of the value chain and move up where there's margin and then basically go in scale that part of the business and then again, use technology and scale to reduce the cost of that as they keep going further up the value chain.


And so the conclusion of that is basically it allows this Win-Win situation where customers are attracted Schwab because it offers the best value for the services they're offering. And it's high quality service. It's the cheapest guy, but it's not far from the cheapest guy. But by paying a little bit more than the cheapest guy, you also get this great value from Schwab in terms of quality service, the offerings they provide, security, technology. So they're never the leader in technology like a Robin Hood would be, for example.


But they're usually pretty close behind. And I think you get this win win win relationship between Schwab, the company, Schwab's customers and what they're offering for them and then over the long term as shareholders. So that's kind of the short version of kind of a history of Schwab, kind of what they do.


So, as you mentioned, Charles Schwab, it's only been around since the 1970s. And today they've got four trillion dollars of assets under management, which is just an unthinkable number. How how are they able to achieve that in such a short amount of time? You delve into the history of it and look at the means by which they built their business, their origin was all around trading commissions being a discount trading broker. Right. But what they did then is they basically worked their way up the value chain.


So they had millions of retail customers. Right. Trading on their platform. And literally it was by phone. You still call and talk to somebody and put your trade through. And then it became an automated telephonic service. And I remember this when I started my first account with Schwab back when I was in college, you called it, and there was an automated service that you used. And then with the Internet, you got this web interface that came with it.


And so over this time, their commissions kept declining and I kept opening up the service to more and more people who became interested in trading stocks. And then when they had enough of a customer base, they really had this distribution platform that they could then go back and market to the companies that had products to sell to customers. So what was applicable to Schwab's customers were mutual funds. So they created this platform called OneSource, where a mutual fund could trade on Shrub's platform commission free, which is a big deal at the time because commissions were a nontrivial and you could list on their one source mutual fund platform by sharing a piece of your fee.


So Mutual Fund would pay Schwab for distribution to retail, who saw the ability to trade the mutual funds on one source for free. So that created this advantage for the mutual funds that could be on the one source platform in terms of getting new customers and increasing the share with those customers relative to the mutual funds that weren't on one source. And you had to pay a commission to trade those mutual funds when they acquired a company that allow them to do options trading.


And so they added that as another investment form that customers could use. So these are examples of vertically moving up the stack of different types of investment vehicles and higher value services. And then at that point, they added their own mutual funds. And then when ETFs came in, Schwab also said ETFs today are some of the lowest cost ETFs. So Schwab doesn't fight the trend when the trend hits kind of a tipping point, Schwab just kind of goes all in and make sure it has the servicing costs at the back end to enable it to succeed in those new offerings, driving greater value for customers.


The other thing that they do is they also have this horizontal expansion strategy. And what that means is they started first with retail investors rights of just individuals that were interested in trading and then start with trading and then later became Wealth Management Advisory Services, which Schwab also offers now. But in terms of horizontal expansion, what they did is they had this platform that would built with the ability to trade at a low cost and the ability to custardy assets at a low cost.


So the cost is relatively fixed. I love computers, data, things like that, and then interfaces with other financial services. And then the whole regulatory compliance sort of infrastructure builds. All these things are there in place. You want to distribute the cost of that over as many parties or assets as possible in order to get the lowest expenses per dollar of assets that you manage, basically. And so to horizontally expand what they started doing that in the 90s was they added a independent registered investment advisory.


And what you paid over time is as regulation has changed and as the realization that incentive structures really matter, how financial professionals service their customers, the way you collect fees, how you charge for fees, the fact that investment advisers have relationships with the customers over a long period of time, it provides them a lot of value, has led a lot of investment advisers who work under the traditional Waterhouses or colleges like the Morgan Stanley, Goldman Sachs, UBS, Credit Suisse basically got away from those big banks and start their own businesses, oftentimes bringing a certain number of clients with them who they have close relationships with, and they change the way they get compensated so that it's much more client beneficial.


In other words, it becomes a win win situation in the sense that historically these investment advisers really are brokers in the past would make money by getting you the client to trade. And that, of course, presents a bunch of the wrong incentives in terms of what's best for the client, the right incentives to say that if client wins, I win. So in many ways, how that's manifested in terms of incentives has been, you know, I collect a fixed fee on the assets under management with my client, and I can then provide whatever is best for my client, my clients.


Wealth grows and therefore my fee grows along with them, since it's a perception that it's not based on this churning of their portfolio where I get a. The brokerage commissions, right, which is how it traditionally had done so anyway, there's been this trend of entrepreneurship, more and more investment advisors, especially the more experienced and have strong relationships with clients moving from these integrated platforms to their own independent platforms. So let's dig a bit deeper into that. So in twenty eighteen, trade commissions accounted for less than eight percent of revenue.


And then the year after, Charles Schwab chose to completely eliminate brokerage commissions. I mean, talk about a company cannibalizing itself. So keeping that in mind, how does Charles Schwab make money today? And how do you think the company will make money in the future? It's interesting, Schwab, like we talked about, their genesis was brokerage commissions, right, and in twenty nineteen they basically eliminated brokerage commissions, which is incredible in many ways to attest to is the stability of the company to adapt over time.


And as we talked about, move up the value chains that the lower part of the value chain become commodities. So in a sense, the fact that eight percent of revenue and twenty nine, four trading commissions was pretty small relative to where it started, which is one hundred percent. And so this has been a trend over time that the things that can get automated and can get expensive scales, the perspective of declining per transaction costs going to zero via automation.


Schwab makes those investments and it drives that commoditization in those lower value services. It's a great example of just what we've talked about, which is kind of commoditization of the lower value services that can be automated and cost per transaction reduced. So Schwab had started with one hundred percent, which is trading revenue. Right. And then over time, they've expanded into higher value services while commodities the lower value services, which makes it a much more compelling proposition for its customers.


So over almost 50 years, they basically brought commissions trading from one hundred percent of revenue down to eight percent. And the trend was clear. Commissions trading revenue was heading toward zero because the computers. Right. So both on the customer side in terms of how we manage our accounts, in terms of trading, we self enter these trades. We don't call somebody a trader to trade for us. So there's no person there. We're self servicing. But also on the back end, when you look at those old pictures and videos of the New York Stock Exchange with people yelling and screaming with a hand signals and all that, that doesn't exist.


It's just a bunch of servers now, right? Every time you bring computers into any kind of a service, you're basically reducing dramatically the cost of providing that service. So the cost of trading is heading toward zero.


They basically kind of preempted what would be a long, drawn out sort of asymptotic curve towards zero by just taking it down to zero. And as you mentioned, it was only eight percent of the revenue and a bit higher than that on operating margin or operating income. But certainly there were outside factors that drove Schwab to basically take it to zero. There's a company called Interactive Brokers. I'm sure many of your listeners are also familiar with interactive brokers, is sort of a pure automated trading platform.


And they introduce a service that was zero commissions. And that's probably the means. The first mainstream type of brokerage service that took their commissions to zero, the one that sort of wasn't mainstream is small, but growing quickly as Robin Hood, which has been more than a little bit of a it's just been a phenomenon in millennials and younger generations who basically are at first in terms of lot of the services they consume. And so Robinett has been commission free for a while, but they make their money up.


So they think order flow, all the other brokers to have some order flow revenue as well that substitutes for commissions. So you'll see Schwab doesn't go to zero trading revenue. They do have some sort of low. And then options still provide a source of commissions revenue, but very small relative to the equities. SCHWAB We saw the writing on the wall.


They kind of accelerated this to zero and that some of the more traditional, quote, discount brokers like Ameritrade and ETrade much more harshly because much more of their revenues came from commissions still. But what this did for Schwab is it created this competitive advantage relative to acquiring new customers in the sense that we've talked about the higher value strategies that Travis added to its plate of service that offers customers. So to answer your question about where do they make their money now, it's that they still offer lots of other investment products that they earn and a fee on.


They still provide a platform for Arias that the custodian and they make some fees on that and not directly from the custody fees around services. They offer IRAs. And then they have this sort of very important entity called Schwab Bank, which basically takes the cash that sits in customer accounts and puts it into a sweep's it basically into a bank that's run by Schwab. And just like a regular checking account, they pay some kind of interest on the cash balances that customers have.


But then they get to use that basically float and invest it in higher yielding assets that Schwab Bank collects the difference in the yield that they receive versus what they pay out to customers. Depositors that yield difference is called the net interest margin. So Schwab has built Schwab Bank within its brokerage and asset management business and. Arrestingly enough that now accounts for over half its revenue is 60 percent, but paid more like 50 percent range in 20 20. But between 50 and 60 percent of revenue comes from Swanbank now.


And that's a highly, highly profitable business. Within Schwab entirety, about 40 percent of business between 30 and 40 percent comes out of their asset management fees business. And that's just advisory services, its fees on mutual funds, its fees on ETFs, fees on that mutual fund distribution platform. I mentioned one source, six other fees like that. And that to over time, we believe, is also getting commodities that basis points of fees that they will collect on any asset base is going to decline.


But a piece of a business, you kind of roll it all together. I'd say the summary is that what Schwab does is it offers lower and lower explicit fees to the customer. So you're getting all of these services, more and more services, more and more choice on Schwab for a lower and lower fee as a customer. So that accelerates the flywheel of bringing in new customers, bringing in new assets, which then increases scale, which further reduces Schwab's costs because its platform is a scale driven platform, the more assets they manage, the lower expense per dollar of assets that they manage.


Right. And so the bigger the scale they get, the more cost advantage they have, the lower they can bring the prices to then bring in even more customers, more assets. This is flywheel effect. However, they charge what I call an implicit fee, which is an opportunity cost. You could take that cash and yourself buy something else within the platform in the form of a bond or some sort of credit instrument that could be short term or medium term as a way to substitute for cash.


But to the extent you leave the cash in there, Schwab takes that cash. I mean, sort of these are all like accounting buckets of cash that belongs to you. It's still yours. But just like a bank, it uses that cash that you have in your checking account, the cash balance to then invest for itself in other higher yielding fixed income instruments, that then it keeps the benefit of that higher yield for itself in the form of profit for Schwab.


But you, the customer, could always say, oh, you know what, I have a 10 percent cash balance in my account. I'm going to allocate it to some fixed income fund or some treasuries or whatever it is you want to put it in. But it's just that most investors, most clients always have some kind of a cash buffer, if you like, to have the between trades, or it might be part of their allocation or it might just be for whatever reason, they'll have cash if they're not actively putting to work.


It's a Schwab takes advantage of that pool of cash course's cash available to whoever needs it and wants it. But that pool of cash is redeployed in Schwab Bank where it makes it. So, like I said, it accounts for 50 to 60 percent of revenue and that revenue probably has a on an incremental basis like 80 percent plus margin to it. And so that becomes an implicit cost to the investor client because I'm not directly paying a fee on this.


It's just cash sitting around that I've lost the opportunity and it's my own fault because I haven't put it to work. I've lost the opportunity to basically invest it somewhere else, but I very well could end any time I want. And Schwab offers you the tools and the instruments by which you can do that.


Just one more note is that when Schwab Bank invests in higher yielding credit instruments while paying you a deposit interest rate, one thing that we like about your bank is that it's a very low risk proposition. So think about Schwab Bank, just like any other bank, right? So most banks, they take money from depositors. They pay them a small interest rate and then a low yielding environment, of course. Right. And then they basically take that money and invest it in higher yielding instruments.


Now, with higher yields, you get a higher yield for a longer duration. You get higher, more risk. You get a higher yield for maybe a smarter fixed income management kind of thing. Right. Or sometimes for more sophisticated or complicated structures. One thing that we have not really liked about the banking sector is the lack of transparency on the balance sheet. You get some summary statistics, but that really doesn't tell you about what's on the balance sheet.


And that came to a head back in the housing crisis. I just read the summary statistics. By and large, the average investor probably would have said, oh, this looks totally fine, safe within the limits of the federal financial regulators. But what we learned was that there are a lot of risky instruments in there and the amount of leverage on the balance sheet couldn't handle housing falling 10 to 20 percent in terms of the value of the house. Right.


And then as a result, what the homeowners behavior ended up being in terms of both their ability to voluntarily or involuntarily sustain their mortgage payments. So there's a lot of risk that banks bear as a result of being institutions that provide credit to businesses and consumers. What we like about Schwab is that we don't have to worry about most, that the vast majority, their balance sheet at the bank is basically invested in low risk federal governments, a US government insured products, whether it's treasuries or.


Equity or mortgage backed securities that are agency mortgage backed securities that have implicit support of the US government and then high grade corporates, and that's a minority of their balance sheet. What they're doing over time is doing more in terms of lending money to customers, but, of course, backed by the value of the accounts.


So there's some prudent measures have there that we think will continue to make the balance sheet very safe. So we don't worry too much about the credit risk part of it. And so you're getting this high margin bank asset within Schwab that sources low cost funds from brokerage accounts and then invest in relatively safe credit instruments at some very high incremental profit margins.


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Twenty twenty. I'm sure you'll really enjoy listening to these episodes. So I want to talk more about the business of asset management and a really a very important key issue is expenses on client assets or the EOKA. Could you please explain what that is and then also talk about how Schwab is situated with respect to that key ratio compared to some of the competitors?


This is one of the big advantages of Schwab's platform, is that they have created a platform, as we talked about earlier.


We always talk about spectrum, right? So when we talk about it, it's going to sound like it's very one sided. But on the spectrum, of course, you have variable costs, which is that every new client you bring in or every dollar of new asset that you bring in to manage for the client, your expenses grow in proportion to that. And that's a very variable sort of a business model. On the other end is a fixed model where you have to build out a platform.


And then theoretically, no matter how much money you bring onto the platform, it doesn't cost you any more to service that money. So that way you get the scale leverage that comes to that platform is kind of in a simplistic version. The more you can bring in, the lower the cost per dollar to manage on your platform. And so Schwab is more the fixed cost side that their costs scale very slowly relative to the amount of assets they manage.


And so the bigger the scale of assets. You mentioned earlier that Schwab managed over four trillion dollars in assets. Right. For its clients. And all those assets sit on this platform that's relatively fixed cost. And so the more assets you can bring, the lower the amortization of that fixed cost over every dollar of assets. And so that Yocha, as they call it, the expenses on client assets, reflects that ability to basically have a very low cost basis per dollar of assets being managed for the client and Schwab because of the nature of their platform.


And there's a lot of this culture of low cost culture automating what can be automated. All that kind of brings to bear cost advantage for them relative to their competitors on that measure and the importance that measures that it gives Schwab more pricing power and normally Warren Buffett acolytes such as ourselves. Right value investors. We think of pricing power as the ability to raise prices over time. But in this sort of business, pricing power also means it gives the ability to lower prices without damaging your margins.


And so if you're thinking about it from a competitive perspective, if I can lower prices for services for my customers, I can use that as a way to attract them to my platform. But if the cost of my platform is actually declining faster than I'm reducing my prices to customer, then my margins are growing. And that's a great strategic advantage to have. And so when you look at Schwab's platform, they're at sixteen basis points per dollar and expect of assets managed for clients, in other words, for every dollar of assets that they manage for client.


It costs them now, Skillshare added, four trillion for every dollar of assets they manage, it cost them 16 basis points to custardy that dollar of assets, and that's much lower than their direct competitors. Ameritrade is at twenty seven trades at thirty seven B of A and Morgan Stanley wealth management are at over 50 basis points, basically. And this is based on numbers at Schwab is provided. We trust the management there. So know that we have can verify this.


But the point is that there's so much lower than competitors based on the structure, their platform and their culture, that it's hard for those guys to compete with Schwab and do that. So going back to that idea that pricing power comes from being able to lower your costs faster than you, lower the cost for your clients, in other words, the better you can lower your costs to make yourself more efficient, the more value you can provide clients by lowering their cost to operate with you.


In the meantime, you can raise your margins as well. That's kind of that's hugely powerful flywheel that actually we've seen this with. Amazon Web Services do the same before Amazon broke out Amazon Web Services. We were all kind of guessing it what the margins were there, because what we saw from a public perspective was they kept reducing prices for their services. But we didn't see that while prices were coming down, costs were going down even faster than because of Moore's Law and other technology scaling initiatives that they had.


And that made it very hard for new entrants to compete with them because they had scale. And today that probably still rings true. There's only a handful of global cloud providers that can have the scale to have types of cost structures that some Amazon Web services or Microsoft is going to have. So similarly, in the financial business, you need to have large scale and a platform built on technology to take the technology curve in terms of cost reductions in order to be able to compete with 12.


R.F. great that you're so thorough in your analysis and you could see so many different variables and very interesting to hear about. We often talk about that there were a few key variables that you really need to understand and you need to track those key variables to see who are most competitive in the industry. Warren Buffett has said that. And Bill Miller, we also heard on the show, have been talking about those two to three varies from company to company. But you don't necessarily need to monitor a thousand different variables to figure out which companies are most competitive.


So keeping that in mind, could you please outline the competitive landscape of Charles Schwab and perhaps also one or two other key ratios you are looking at to understand the competitiveness of both Charles Schwab but also their competitors?


So interestingly, when we talked about expenses and assets, I mentioned a couple of competitors that Schwab measures itself against one of them sort of historically speaking, you had Schwab being a discount broker, right? Ameritrade and ETrade were discount brokers. So they were kind of traditional competitors, call it back in the 90s. Right. And before that, there were a bunch of other sort of discount broker competitors that kind of gone by the wayside because they just didn't grow fast enough to stay competitive.


More and more, Schwab has been going up the value that we talked about, which means they compete more and more with traditional investment managers, wealth managers like Morgan Stanley, UBS, Bank of America, J.P. Morgan, all of these guys, a wealth management subsidiary to them. And they may also manage large, large amounts of client wealth in the hundreds of billions of trillions. And so Schwab's competitive set has been growing towards kind of the traditional names that we know of.


As I mentioned. On the other hand, the cost structure that they have much lower than those guys were more FULL-SERVICE, that they have research teams that publish reports and make recommendations. And whereas Schwab doesn't offer a whole lot in the way of research, but they offer you a platform to express your own views of where you get your research from. And then a lot of it is seeking Alpha or reading the news or following things on Twitter wherever people get their investment ideas from.


And increasingly, as you know, it's heading in the direction of passive investing right through ETFs. We think the latest networks in the US, something like half of all assets under management, are now in ETFs. Right. So there's not much research needed for that at all. You're just buying into the index and letting others do the research for you and price the elements of the index components of the index for you, basically. Right? You're right.


Absolutely there is. Having said that, the competitive set are all these whole host of companies. One of the things that came out of the Schwab basically eliminate missions with that damaged the business model for some of the traditional competitors like Ameritrade and ETrade. And we've seen is that Schwab basically was able to take advantage of that situation by acquiring Ameritrade. So what Ameritrade does for Schwab is acquired. It's one of its closest competitors, another roughly one and a half trillion to its platform.


And so you're going to see a platform that goes from for four and a half trillion assets getting to six trillion assets probably by the end of the year with the Ameritrade acquisition closing. And so that will, again, further improve its expenses on client assets because you're going to expand the pool of assets to six trillion from four trillion. And what they've said is they were going to cut out about two billion of costs from the Ameritrade business. Right. Because there's a lot of duplication of expenses between the two organizations.


And so those Ameritrade assets are coming in, are incrementally even more profitable. Schwab's potential was to be higher, but today it's not higher necessarily because of other dynamics going on. We can talk about later, which is how it's having to a net interest margin piece of Schwab. So come back to your question of what types of ratios that we look at in measuring how well Schwab is doing. So one, it's how fast are they going there? A um, right.


And so they publish this number called net new assets, which is the organic growth of new assets coming to the Schwab platform. So gross assets coming in, minus assets leaving. And the assets could be either because, you know, I'm retired and I eat a part of my assets to live or could be competitive losses, have a customer that goes from my platform to somewhere else. So net new assets encompasses the growth coming in minus those that leave.


And then the net new assets has been growing on the range of about five to seven percent a year over the last several years as a percentage of the base of assets they have. So that's an important measure metric to measure, which is the success Schwab is having and growing. It's a, um, so, um, growth, in our view. The most basic way to view the intrinsic value growth at Schwab is to look at Asian growth, because that tells you a lot about the health of the business in multiple ways.


It tells you what's happening. Competitive environment, right, so the assets leaving would be the result of competitors attracting customers away. Probably our number one metric is net new assets to look at. The other thing to look at is this idea of the net interest margin NIM. So we talked about Schwab Bank being 50 or 60 percent of revenue and more than that in terms of operating profits as a percentage of operating profits. NIM is the difference between what Schwab earns on the assets that it owns using customer cash balances so less what they pay out to customers.


Right. And that tells you about the profitability of the base of assets that they have and the way that kind of breaks. That is there is how much cash or clients holding as a percentage of their, um. Right. And I think currently in the seven percent range or so. And the other piece of it is what is that Schwab is able to earn on that cash basis? Those metrics are kind of important metrics we watch and that feeds into what revenue will be, that will feed into what operating margins will be, which of course, boils down to profitability, the firm as well that.


So if one of the things that I've learned from going out to some of the Berkshire shareholders meetings with Warren Buffett is he always brings up this idea of this silver bullet test to understand the moat of a business in the industry and the key factors of success. And, you know, just for the audience. I'll quickly explain what the silver bullet test is and the way that Warren would always pose the question to a company that's performing really well. So you go to the to the CEO or whoever the key executive was, and he'd say, all right, I give you one silver bullet and you can kill one of your competitors.


Who do you shoot? And so that's that's what the test is for people that are here in that term and maybe not understanding what it is. But you've picked Schwab as your winner on a price to value ratio. But which competitor would you give the silver bullet test to regarding their price to value ratio and why? That's a tough question because in many ways, Charles Schwab has been the silver bullet for most of its competitors, in many ways, the silver bullet has more to do with the evolution of the industry.


And I would say probably new companies are becoming one that we've been watching is one called Robin Hood. At the end of the day, like I said, one of the most important metrics from our perspective for Schwab is net new asset growth and Robin Hood very small. Currently, it's a private company. It's very small base and growing very quickly, attracting a lot of attention from young investors.


And that's always something we pay attention to, because in this day and age, what we've seen is that user interface and experience, being a customer plays a big role in where and who acquires early market share amongst early customers. Those early customers eventually become the middle of the customer base. Twenty years in terms of wealth management space, right. As they get a career as they inherited wealth from their parents, et cetera. Right. So we always keep an eye towards where our new customers going and why are they going to grow.


And so there's a lot of buzz around Robin Hood. They've had great success in attracting young customers. Having said that, the scale of their assets they're actually gathering is not very big compared to what Schwab does, but it's one that we kind of keep track. So from a silver bullet question perspective, just as Schwab has been perpetually changing the business model for its competitors in terms of how to tax the customers that Schwab and its competitors have been trying to attract.


I think we worry about who's the guy on the horizon that may change the rules of business, the rules of client interest and engagement in such a way that would handicap Schwab for a while. This is maybe three years ago or so. You know, there's a lot of buzz around these robo advisors. I don't know if you're familiar with this, but there are companies like Wealth, Front and Betterment that basically we're pulling out costs and asset management in the asset management business.


If you think about it from a personal financial advisor perspective, when they see with the customer initially, they'll basically talk about life goals and talk about how much income you have, how much you save, what your needs are going to be over the course of your lifetime. You have to pay for retirement. You have to pay for your kid's education, maybe pay off your house. How do you work a plan within the realm of what your income and savings are today to get to a point where you can be secure by the time you retire?


Right. That's a plan they lay out and then you have an investment plan that's associated with. And then basically the advisor would charge you the basis points or one hundred basis points, one percent, let's say, to pretty much reallocate your portfolio every quarter, every year as the weights of different asset classes change in their right. And they would kind of do that perpetually. Maybe once your touch base with your savings changed. Most times things don't change a whole lot.


So for most people, their financial plans aren't that complicated and the changes in allocation of assets within their portfolio isn't that complicated. And so what the robo advisors did is they automated that they automate a bunch of that and massively reduce the fee for financial advisor. And basically they end up being, as you know, you sit wants to be a financial adviser and then a robot takes over, a computer takes over. In terms of rebalancing for you, it's not a person that the person just focused on relationship management while the computer focuses on portfolio rebalancing for you, is that dramatically reduce the cost of financial advisory services?


And so that could have been seen as a potential threat to Schwab, kind of indirectly, too, because like I talked about, there are a platform is half their assets and all ideas, their business model. Right. Is that financial advisory relationships, the clients and there's some that have very complex relationships are managing in terms of the complexity of the financial needs of their clients. And those aren't going to be replaced by computers anytime soon. But there's many that have similar clients, right, in the sense that their clients don't have a whole lot of financial complexity in their plan and those can be automated.


And so on the one hand, you saw these venture capital funded robo advisory platforms that potentially are going to take away assets from this financial advisory industry, the traditional one. But Schwab was able to acquire a small firm and then build on it.


And today is I think it might be the biggest robo advisor platform today, actually in the span of three years. So they came in from behind. They were able to make the right moves. They saw where the industry was heading as traditional Schwab culture. I saw she was heading. I saw what the trend was. And they either build or buy a small company and scale it. And that's exactly the advisory. I can't help but think that based on what you said here in this interview, you could argue that Charles, while could be a very chittick asset for a company like J.P. Morgan, what are your thoughts on that?


And do you attribute a catalyst like being a target for a company like that, any value whenever you assess the investment thesis? Yeah, sure, I mean, that's a great question, and it definitely is something that is always on the horizon for any company with a larger platform, be interested in bringing this really interesting, fast growing platform, know bring them into the fold. So after Schwab and Ameritrade merge, like I said, I expect expected next few days, it's going to be talking about roughly 70 billion dollar market cap for JPMorgan is a three hundred billion dollar market cap.


I think it would be a very attractive thing for JP Morgan to bring into the fold. Of course, they have to pay premium for it. I don't think it's likely, but it's a possibility that somebody like JP Morgan will be attractive.


And it's very strategic in the sense that it would bring a lot of assets to JP Morgan. It would bring scale to JP Morgan's own asset management business. And JP Morgan is traditional banking platform that's very sophisticated and can offer lots of different products to the generally wealthy clients that Schwab has. Let's take a step back. One thing we have talked about is what's been happening with the zero rate environment, what impact it's had on Schwab, which is very important, actually.


So we talk about that Schwab Bank, the banking piece of Schwab, which really is a name spread business. Right. And they don't really do a whole lot of banking. Traditional bankers say it's a bank in terms of regulatory structure, but all they do is they take clients cash that they pay, let's say, 10 basis points on six point one percent, and they invest it at one and a half to two percent in assets that you'll get.


And they keep the spread right as part of their profits. Someone like JP Morgan does a lot more sophisticated stuff. Right. So they might also pay one percent or 10 basis points on depositors cash. Right.


And then they do a whole host of other things to write new loans to businesses. They have credit card business. They have a car loan business, they have a construction business, all sorts of different lending businesses where it's much more sophisticated, but also, of course, brings in credit risk.


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All right, back to the show. So how do you think about inflation with a company like this, because everyone's talking as if inflation will never come back? I think that that's probably not as likely of an outcome as most might suspect. But I'm curious how you think about that with respect to this company. That's a great question and I want to touch on net interest margin for Schwab, so the current interest rate environment, zero interest rate environment in the US negatively impact Schwab dramatically.


And we've seen that in their numbers and then their stock. Right. Coming down dramatically over the last year. And the way that manifests itself is in net interest margin. So whereas they pay the depositors 10 basis points or 20 or 30 basis points, which they had been collecting was roughly two and a half or two and a 50 basis points off their portfolio of fixed income assets in a zero rate environment. What happens is what they can collect starts to collapse, comes down dramatically.


Schwab for Q4 has already set their net interest margin will be in the realm of kind of mid to high one forty so one point four to one point five percent, which is down dramatically from two point four percent just a couple of quarters ago. And that, of course, is pure profit that's lost to their bank. Right. And the organization as a whole.


And so getting back to your question of inflation, inflation be huge positive for Schwab in the sense that as inflation increases at some point and the Fed in the US, the central bank in the US has talked about taking a more lenient stance towards inflation, increases in the near to medium term because they want to create that buffer between the zero bound level if they keep hitting and kind of where they want to take interest rates to be in a normal economic environment.


What they want is the ability that interest rates to go higher than kind of what they've been bound to, which has been sort of one and a half to two percent range really effectively, so that the next time there's a recession, they have a greater cushion between whatever the normal rate is at that point and zero about trying to build a cushion in order to build a cushion. They want inflation to build higher. Secondarily, I think is a social mission of letting inflation kind of go a little bit beyond the two percent range they've talked about in the past, which they've really considered to be more their upper bound as opposed to average.


They've talked about now think that over a long period of time they want to present to the average. We've had such a sustained period of time where was under two percent that it's I think what they're signaling is that in the medium term, they're looking for inflation to go beyond two percent, maybe to three percent, maybe even higher. An unknown. Right. So to the extent that you had inflation, what you're going to see is going to see yields and along the curve start to go up.


And that, of course, gives an advantage to Schwab's and then it allows them to invest the cash deposits in their clients at higher and higher interest rates, which should expand the name the Schwab has, and that would expand its profitability. So that's one part of it. The other part of it is that inflation would also probably help asset prices, too. And so it's a bit of a mixed bag because on the one hand, inflation, asset prices in that companies would be better able to raise prices right under the scenario of overall inflation.


On the other hand, we know that inflation generally is not good for the discount rate mechanism that feeds into peace. So it would probably shrink while earnings and revenues are nominally growing. So if we just say it's nominally overall, it's just a wash between faster growth and lower PEs, to the extent that you have asset prices rising, know they don't rise or they rise, maybe they diminish a little bit. But the competition will also feed into how Schwab reacts, because that's the base on which to some degree.


So overall, to answer your question very briefly, we think that inflation is actually a very positive scenario for Schwab's business.


Thank you for your wonderful analysis of Charles Schwab, and I'm just about to say that's take a look at this score. And by that I mean, based on your analysis, which intrinsic value per share would you put on Charles Schwab and also which potential return with that imply? And just for reference, as we're recording here, the stock price is around thirty seven dollars.


Of course, it always comes down to the meat of the story, which is what's this thing worth and what kind of return I earn on this. So like I said today, we're in a zero interest rate environment. We assess businesses based on what we think their intrinsic value is over a long period of time. These are businesses that last for a long, long time. Right. And so, as you know, financials are a cyclical business. So right now we're trading in the low end of the cycle because interest rates are zero.


Right. And a big driver of Schwab's earnings are net interest margins. But right now we are in and heading towards the low part of the cycle for Schwab because of the zero interest rate environment that we're in. But in a normalized environment, which we were kind of in, just in twenty eighteen, we expect names to be kind of the over two percent range, kind of a two and a half to three percent range. So when we think about long term, normal average around the cycle, our assumption we think is on a conservative end is that Schwab can earn a two percent net interest margin.


We think there's some upside to that. We're too conservative, but there's just been a lot of uncertainty in the last decade and in the next decade to come. It's just really hard to know. What that's going to look like is a very different time period relative to prior to the great financial crisis that we had in 2008, 2009. And that implies a valuation on Schwab, about 70 dollars per share.


They're about to close on this Ameritrade deal, which brings a lot more assets to them. But it also brings up very profitable assets. Like I said, the Ameritrade is estimated to earn I think it's about two billion dollars in operating profits in twenty twenty one. This is a consensus estimate. So to about two billion dollars and about five billion of revenue. Schwab has talked about expense, synergy of up to two billion dollars. So we're looking at a company that has a 40 percent operating Ameritrade.


This is that is a 40 percent operating margin. Twenty twenty one that could actually go up to 80 percent operating margin when it's part of Schwab. And so it's a highly accretive deal. And so we think that seventy dollar price is actually Schwab and then bringing in Ameritrade at Schwab's average kind normal margins. But in fact, there's upside to that. If they can actually realize the types of synergies on the expense base they're talking about at Ameritrade. And then further down the road, there's revenue synergies that is even further upside.


So on a conservative basis, we think seventy dollars is a reasonable value estimate for Schwab. And so today that represents almost doubling in price. It's eighty nine percent increase from today's prices, but it's not going to happen next year. It probably will take some time. But I think when you'll see that realization of the price will be based on when interest rates start to rise again, that the market starts to have a visibility on when normalization occurs. But in the meantime, like I said, the potential for Schwab's revenue and profits is all embedded in the growth of its asset base.


As to the extent that Schwab continues to grow that asset base, a net new assets coming into Schwab running at six percent and then the market gains on those assets also add to the scale of the assets. So we assume something like a four or five percent market gains. So from the current price, we expect Schwab to compound at something like eight to 10 to 12 percent a year. And then when interest rates are actually normalized, you see that rapid increase in the normalization valuation by the market on Schwab.


But that might not be for a couple of years from how we understand the Fed is thinking about interest rates. Again, I have to repeat myself and just say it's been absolutely amazing having you here on the show, Ariff, I'm sure that the audience would like to learn more about you and some capital. And we'll definitely like to give you the opportunity to give a hand off where they can do that. Work in the audience. Learn more about you and ensemble capital.


At our website, Ensemble Capital, that there's a bio of me there, but also ways to reach me and my colleagues in research and wealth advisory there as well. We're also very active on social media. So we post blogs where we're talking about ideas, both high level ideas, as well as company specific ideas. It's a way for us to communicate with clients and also just peers and interested folks that are interested in talking to us. So that blogsite is interested in investing dotcom.


And then finally, we're on Twitter. Our handle is intrinsic and the. Thank you for being so generous with your time, Ariff, I'm sure we'll stay in touch and bring you on soon again. All right, guys, so at this point time, the show will play question from the audience and this question comes from Damian. Here we go. High stake and Preston, this is Damien Helm here from Cambridge in the U.K. in your recent podcast, he talked about only investing in assets that you know.


Well, I was wondering if you could talk about what you mean to know an asset. Well, and what is it that you look for in your own understanding that convinces you that you know an asset well enough to be able to invest?


OK, thank you. So, Damien, this is such a great question, and the cheeky answer is, if you don't know, if you understand it, you don't. But on a more serious note, it is a great question and a question that more investors should ask themselves.


Too many investors are buying into companies because the rather random article of why the price would soon soar and they never even read the annual reports or that particular company, and they probably don't even understand the competitive situation. So I would break it down and ask, do you know how the company and the competitive situation will look like in 10 years? If the answer is no, you don't know the business well enough. And if you don't know how the company and industry will look like in 10 years, you can't project the cash flows and estimate what the stock is worth today.


So how do you know if you buy it at a discount, you simply don't. And you need to understand the most important key factors for success in that industry. You will likely notice that in the interviews that we have here in the podcast, I almost always ask about the key factors of success or key variables one way or the other. I did that also here in this interview with R.F. Karim two weeks ago, it did the same Taylor. And for instance, he said that insurance companies, you need to track and understand combined ratio and the investment record like there was those two main key variables you need to understand if you need to compare insurance businesses and you just notice how much noise there is whenever you're investing in stock, you hear 100 pieces different news.


That just all seems important at first glance. But it's your job to figure out what is important and what is not. Say, let me come up with an example. I have a position on Spotify, so I follow the numbers of Pates describers closely. And, um, I hear that they signed the deal with the artist for the podcasting business. That is generally not important, regardless of all the press that you might see on that call core. I need to see the paid subscribers go up.


And even more important, I need to see that video. Yeah, and it has to be faster than industry because of the nature of that industry and so far so good. And of course, you also need to compare that to the cost, too. I mean, everyone can get a mortgage. You have to have unlimited money. But the key is that you need to identify what is important and that is what you need to focus on and then leave out what is not.


It would take too much of your focus and too much of your time.


And if you can't do that, you need to continue working until you can densify the factors. And even if you can't understand the factors but understand how the business will develop, really there's no shame in moving on to the next business. There's no such thing as a difficulty bonus in investing. You know, I personally do not understand. Most businesses really don't. But I do understand the few that I feel comfortable investing in and I tend to focus on those.


And then I try to slowly with my social competence to a few other businesses and industries when I think I might be able to understand it if I think there's a good business case there. But really stay with the businesses that you understand. So to sum up, when you understand the key factors of success and understand the key variables, you are on the right path to understand and therefore also value a stock. So, Damien, I really like this question, and I think I got a better respect for what it is I know and what I don't know, after having created my own business and prior to that, when I would invest, I would think that I knew the questions to ask myself, but I rarely did.


You can you can read the financial statements. You can do these analysis like you can look at the revenue and you can say, oh, it's growing. So that means it's good. Or you can look at the net income and see that it's growing and you can quickly deduce that that's a good sign. But what I learned through owning my own business is you understand the various revenue streams that the various assets within your company are making and you understand your expenses.


You understand basically the trend that the business is going and you understand the competitive landscape. And I would argue that whenever I invest in many companies, I do not have that same level of understanding like I do for my own operational business that I that I own. And the challenge that I've posed for myself is that whenever I do buy stock in a non operational way, that I try to understand the business from that same vantage point. Now, how does a person who doesn't own their own business acquire that knowledge or that skill to be able to do those things?


And the only thing I can really tell you is to try to break the business down into really kind of what I break it down into maybe three different sections.


First of all, you got to understand the revenue streams that the various assets are bringing in and the competitive landscape of of how they're going to remain competitive moving forward. Try to understand the expense structure of your business. Where are the expenses growing? Why are they growing those types of things? And then in general, you just got to understand the direction of the the competitive landscape and how much market share the business is, is really kind of taking. And so that's how I would challenge a person to try to understand the roots in the core of the of the company that they're buying and that they potentially own or whatever the case might be after.


You understand that is whenever I think you can start digging in and saying, all right, based on all those things and the projection that I think it's going in the future, this is how much I think it's worth.


And that's typically what we we talk about all those things, but we talk about them in kind of odd end and don't really kind of lay it out in a framework or like a more methodical way.


But that's what I would challenge you to try to do and try to really think as if you is if you personally own the whole business. That's when you can really say, I understand this. So, Damián, for asking such a fantastic question, we're going to give you a free subscription to tip finance. This is going to be more of a tool to do the latter of what I talked about, which is the assessment in the valuations. And here's the other thing that it'll help you with, is finding companies that come up in a very advantageous way based on value filters, where you can then dig in deeper and start doing all the analysis of, like Wittstock and I were just talking about, so really excited to be able to give you this tool.


It also helps you manage your correlation inside of your poor, inside of your portfolio. So really useful if somebody else listening to this wants to get your question played on the show, go to ask the investors, dotcom. And if your question gets played on the show like Damiens, you'll get a free subscription to tip finance. All right, guys, Preston, I really hope you enjoyed this episode of the Masters podcast. We will see each other again next week.


Thank you for listening to Te IP to access our show.


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