An Insider at This Brokerage Bought $250,000 Worth of Stock

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A Form 4 filed with the SEC has disclosed that Charles Schwab (NYSE: SCHW) Board member Stephen Ellis directly purchased a little less than 12,000 shares of the company’s stock on July 18 at an average price of $21.45 per share. This brought Ellis’ total direct holdings of Charles Schwab to over 16,000 shares and therefore, represents a significant percentage increase in his exposure to the company.

Economic theory states that insiders should prefer diversifying their wealth as opposed to taking on more company-specific risk in this way, unless the insider is particularly confident about the company’s prospects. Studies do, in fact, show a small outperformance effect for stocks bought by insiders (read our analysis of studies on insider transactions).

A closer look at Charles Schwab

In the second quarter of 2013, total revenue increased slightly versus a year earlier. However, earnings were actually down for the quarter even before taking into account the payment of preferred stock dividends, and so, earnings per share fell to $0.18 from $0.20. With the company having experienced essentially flat profits in the first quarter of 2013 from a year ago, net income growth is now negative halfway through the year.

This poor performance on the bottom line should be of concern to Charles Schwab investors: following a 72% increase in the stock price over the last year, it currently trades at 31 times trailing earnings, a valuation at which the market is pricing in high EPS growth over the next several years. Wall Street analysts estimate $0.87 per share in earnings for next year, which would be up 19% from their forecasts for 2013; even then, the forward P/E is 25.

Insider Monkey tracks quarterly 13F filings from hedge funds and other notable investors as part of our work developing investment strategies (for example, we’ve learned that the most popular small cap stocks among hedge funds earn an average excess return of 18 percentage points per year). According to our database, Christopher Hansen’s $2.7 billion hedge fund Valiant Capital owned 3.7 million shares of Charles Schwab as of the end of March (see Hansen's stock picks).

Comparing the company to its peers

The closest peers for Charles Schwab are E*TRADE Financial (NASDAQ: ETFC) and TD Ameritrade (NYSE: AMTD). Markets are optimistic about these companies’ prospects as well, and as a result they, are valued at 21 to 22 times forward earnings estimates. Each of these stocks have also more than doubled the S&P 500’s return over the last year. TD Ameritrade matches Charles Schwab, however, in seeing only modest improvements in both revenue and net income in its most recent quarterly report compared to the same period in the previous fiscal year. The company provides securities brokerage services to individual investors and to institutional clients, including registered investment advisors.

E*TRADE, unlike these two peers, primarily serves retail investors and does it through a variety of websites and software programs. Despite this focus on technology, the company’s recent reports indicate that it has been even worse off, with its recent reports showing a small decline in its net revenue. To some degree, management has been able to cover lower revenue by reducing costs; if an impairment charge is added back in the Q2 numbers, then pre-tax income is up considerably compared to the prior year period.

However, investors should be concerned that increasing earnings entirely through cost cutting is not sustainable and in order for eTrade to justify its valuation (the forward P/E is 24) the company will have to find ways to earn more revenue from its customers. eTrade also carries a good deal of leverage, and partly as a result of that it is highly exposed to movements in the overall market with a beta of 2.4.

Conclusion

It doesn’t seem like a good idea to imitate this insider purchase at Charles Schwab, or buy the other individual investment brokerages. The valuations are quite high, baking in a good deal of expected increases in earnings in the future, and while we aren’t saying that the future will necessarily be weak just because the past has been weak, it certainly seems risky to depend on the fortunes of these companies improving so dramatically in the next few years.

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This article is written by Matt Doiron and edited by Meena Krishnamsetty. They don't own shares in any of the stocks mentioned in this article. The Motley Fool recommends TD Ameritrade. The Motley Fool owns shares of TD Ameritrade. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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