The Next Great Recovery

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Predicting an exact point when an industry will recover is almost always a fools (small f) errand. However, there are certain industries that have a pronounced ebb-and-flow depending on certain conditions. For the last year or so I've been calling a turnaround in the housing industry. Though the housing market has changed a lot in the last few years, one thing is certain: people will always buy houses. My calls on Toll Brothers and Lennar have been some of my best outperform picks on CAPS. That being said, I have my eye on another industry that is ripe for a turnaround: discount brokers.

The discount brokerage business is constantly changing, but the more confidence people have in the stock market, the better discount brokers usually perform. Since the huge drop in the market during the Great Recession, the discount business has been tough. A whole generation of individual investors has been scared of equities, and only a sustained recovery will fix this problem. While 2009 and 2010 were actually very good years for the market, with the S&P marking significant gains by the end of each year, 2011 was rough. The S&P ended up basically flat for 2011, but huge ups and downs led many investors to avoid the market.

This year has seen its share of volatility, but the S&P 500 is still up more than 13%. The problem is that many individuals still feel like the market may be rigged against them, and until this feeling subsides discount brokers will feel the pinch. However, just like the inevitable recovery in housing, brokers will do well again once the individual gains some confidence. The question for investors is which one of the major discount brokers could be the best value?

In my eyes there are essentially four companies that compete in the discount brokerage space: Capital One (NYSE: COF), E*Trade (NASDAQ: ETFC), TD Ameritrade (NYSE: AMTD) and The Charles Schwab Corp. (NYSE: SCHW). Capital One's might seem out of place, but its recent acquisition of ING's Sharebuilder brokerage puts them right in the middle of this competition. Let's look at how the market values each company at the current time.

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>P/E on '12 Earnings</strong></p> </td> <td> <p><strong>Growth Expected</strong></p> </td> <td> <p><strong>PEG</strong></p> </td> </tr> <tr> <td> <p>Capital One</p> </td> <td> <p>9.47</p> </td> <td> <p>9.33%</p> </td> <td> <p>1.02</p> </td> </tr> <tr> <td> <p>E*Trade</p> </td> <td> <p>21.33</p> </td> <td> <p>16.14%</p> </td> <td> <p>1.32</p> </td> </tr> <tr> <td> <p>TD Ameritrade</p> </td> <td> <p>14.92</p> </td> <td> <p>9.92%</p> </td> <td> <p>1.5</p> </td> </tr> <tr> <td> <p>The Charles Schwab Corp.</p> </td> <td> <p>18.7</p> </td> <td> <p>11.38%</p> </td> <td> <p>1.64 </p> </td> </tr> </tbody> </table>

Though Capital One is a more diversified play, the company is much cheaper relative to its growth rate. On the other end of the spectrum, Charles Schwab's history of consistent growth is a contributing factor to that company's higher multiple. (Capital One – 4, E*Trade – 3, TD Ameritrade – 2, Charles Schwab – 1)

One way that I try to determine if future earnings estimates are realistic is by looking at a company's past performance versus estimates. It seems logical if a company has beaten estimates in the past that it may continue this streak in the future. On the opposite side of the coin, I have trouble believing earnings growth projections for companies that miss estimates on a regular basis. Charles Schwab and TD Ameritrade essentially tie for first, with both companies beating estimates on average by about 1% over the last four quarters. Capital One didn't perform as well, with an average miss of nearly 7%. The real laggard of the group is E*Trade, which not only missed estimates 3 times, but each time missed by an average of over 20%. (TD Ameritrade – 3, Charles Schwab – 3, Capital One – 2, E*Trade – 1)

While earnings growth is important, many investors look at free cash flow as a potentially better way to measure what a company can do for its shareholders. Higher free cash flow should indicate the ability to return more to shareholders via dividends, share repurchases, and funds to reinvest for future growth. I always compare each company's free cash flow per $1 of sales to get an apples-to-apples comparison. E*Trade generated $0.52 of free cash flow in its most recent quarter for each $1 of sales. Their closest competitor was Capital One with $0.28 of free cash flow. Finally, Charles Schwab generated $0.26 and TD Ameritrade comes in at $0.23 per $1 of sales. (E*Trade – 4, Capital One – 3, Charles Schwab – 2, TD Ameritrade – 1)

Speaking of cash flow, it is normally a company's free cash flow that pays its dividend. However, just looking at a company's yield isn't enough. What investors want is both a good yield and a relatively low payout ratio as well. With this in mind, Charles Schwab comes out the winner, with the highest yield at 1.86% and a low payout ratio of 22.99%. While TD Ameritrade at 1.53% with a 21.84% payout ratio is attractive, Capital One's extremely low yield of 0.34% isn't enough for most investors to consider. E*Trade comes in last in this comparison because the company pays no dividend. (Charles Schwab – 4, TD Ameritrade – 3, Capital One – 2, E*Trade – 1,)

The final score is: Capital One – 11, Charles Schwab – 10, E*Trade – 9, and TD Ameritrade – 9. Capital One wins by the slimmest margin, and one of the reasons was the company's valuation. The challenge is the company has been missing estimates on average over the last four quarters, which could bring into question its ability to meet growth projections. Charles Schwab could be a good alternate choice. Though the company is relatively more expensive than the rest, it has more consistent earnings performance and pays the highest dividend yield.

If the stock market continues to perform well, individual investors will get more comfortable investing in equities. Though buying these stocks requires patience, investors should consider some exposure to discount brokers to set themselves up for the next great recovery.


MHenage has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend TD AMERITRADE Holding. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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