Is it Time to Sell Brokerages in Favor of Fund Managers?

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

An investor who bought one of the many discount brokerage stocks earlier this year would have seen handsome gains. Indeed, so far, Charles Schwab (NYSE: SCHW) and E*TRADE (NASDAQ: ETFC) are up 55% and 53%, respectively, beating the wider market by 35%. However, I believe that now it could be time to book some gains.

You see, after these recent rallies, these brokerages are looking rather overbought and there is growing trend among retail investors to buy into funds and not individual stocks. Of course, Schwab and E*TRADE will benefit as investors buy into funds and then benefit when investors come to sell these finds when the market eventually crashes. On the other hand, it might be better to look to the fund managers themselves, such as BlackRock (NYSE: BLK) and Invesco (NYSE: IVZ) who have seen smaller gains so far this year and still offer some value.

Indeed, the fund managers have a better long-term thesis for investment as they will collect fees from their funds not matter what, while a drop off in trading could significantly affect the retail brokerages.

There is a valuation gap

Surprisingly, despite the record fund inflows that have been occurring during the past few weeks, there is still a valuation gap between the fund managers and brokers.

<table> <thead></thead> <thead> <tr><th> <p><strong> </strong></p> </th><th> <p><strong>Approx. Price</strong></p> </th><th> <p><strong>P/E</strong></p> </th><th> <p><strong>Forward P/E</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p>BlackRock</p> </td> <td> <p>$285.00</p> </td> <td> <p>18.5</p> </td> <td> <p>17.8</p> </td> </tr> <tr> <td> <p>Invesco</p> </td> <td> <p>$33.10</p> </td> <td> <p>21.2</p> </td> <td> <p>15.8</p> </td> </tr> <tr> <td> <p>Charles Schwab</p> </td> <td> <p>$22.36</p> </td> <td> <p>33.4</p> </td> <td> <p>29.8</p> </td> </tr> <tr> <td> <p>E*TRADE</p> </td> <td> <p>$13.70</p> </td> <td> <p>-27.4</p> </td> <td> <p>27.4</p> </td> </tr> </tbody> </table>

That said, earnings predictions for this year favor the brokers, especially E*TRADE, which is predicted to pull itself from a loss into a profit, although after taking into account lofty valuations, fund manager Invesco appears to be more appealing:

<table> <thead></thead> <thead> <tr><th> <p><strong> </strong></p> </th><th> <p><strong>2012 EPS</strong></p> </th><th> <p><strong>2013E</strong></p> </th><th> <p><strong>Growth</strong></p> </th><th> <p><strong>2014E</strong></p> </th><th> <p><strong>Growth</strong></p> </th><th> <p><strong>PEG</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p>BlackRock</p> </td> <td> <p>$15.40</p> </td> <td> <p>$16.00</p> </td> <td> <p>3.90%</p> </td> <td> <p>$17.10</p> </td> <td> <p>6.88%</p> </td> <td> <p>4.5</p> </td> </tr> <tr> <td> <p>Invesco</p> </td> <td> <p>$1.56</p> </td> <td> <p>$2.10</p> </td> <td> <p>34.62%</p> </td> <td> <p>$2.30</p> </td> <td> <p>9.52%</p> </td> <td> <p>0.6</p> </td> </tr> <tr> <td> <p>Charles Schwab</p> </td> <td> <p>$0.67</p> </td> <td> <p>$0.75</p> </td> <td> <p>11.94%</p> </td> <td> <p>$0.89</p> </td> <td> <p>18.67%</p> </td> <td> <p>2.3</p> </td> </tr> <tr> <td> <p>E*TRADE</p> </td> <td> <p>-$0.50</p> </td> <td> <p>$0.50</p> </td> <td> <p>-</p> </td> <td> <p>$0.60</p> </td> <td> <p>20.00%</p> </td> <td> <p>0.0</p> </td> </tr> </tbody> </table>

It's not just the valuations

Elsewhere, it is not just low valuations that make the fund managers look attractive, Invesco and BlackRock both offer higher dividend payouts than those of the brokers. Invesco, for example, offers investors a 2.7% yield, BlackRock offers a 2.5% yield, meanwhile, Schwab offers a 1.1% payout and E*TRADE offers nothing.

Having said all of that, the outlook for both sectors remains highly dependent on both the economy and Federal Reserve actions, as a rise in interest rates, fall in asset purchases, or deterioration in the economy could quickly send the market into reverse and the fortunes of these asset management companies could change.

Who performs the best?

The only way of telling how these firms will react in uncertain market conditions it to look at the historic performance over a period of uncertainty.

The period between January 2011 and December 2012 was probably one of the most uncertain in recent times as central bank policy remained unclear, debt ceiling and sequestration battles raged, and Europe teetered on the brink of collapse.

So, how did these companies perform?

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Overall, the brokerages appear to be more sensitive to general market uncertainty. Indeed, over the period, BlackRock and Invesco ended with gains of around 10% (5% per year), E*TRADE and Schwab, on the other hand, ended the period with losses and a maximum decline of nearly 60%.

Of course, historical performance is not always an indicator of future performance and some factors need to be taken into account when considering how these companies will perform in the future. As the world's biggest fund managers, BlackRock and Invesco are well placed for future growth, the companies are attracting huge investor inflows and, as I have already mentioned, these companies will continue to attract inflows and fees even during periods of market turbulence. So, they are a good long-term investment play. 

On the other hand, the outlook for E*TRADE and Schwab is slightly more cloudy. Both companies have noted rising earnings over the first half of this year as private investors return to the market, trading more, generating more commission and borrowing to trade on leverage. However, in periods of market turbulence, which may or may not be around the corner, these companies might lose money as investors jump ship. And the more severe the turbulence, the longer it takes for investors to come back, extending losses.

Foolish summary

All in all, discount brokerages have had a good run so far this year, but attractive valuations and stronger cash returns are on offer in the fund managers sector. Invesco and BlackRock offer a better long-term investing outlook as these fund managers will always be collecting income from managing investors' assets while discount brokerages will only profit when there is a positive tone in the market.

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Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool recommends BlackRock. 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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