Rising Interest Rates Will Lift This Stock

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

Interest rates have nowhere to go but up, but the market is pricing securities as though rates will stay at historic lows forever. This presents investors with an opportunity to buy stocks getting hammered by the low interest rates at a bargain price.

When buying a company with the intention of holding onto it for many years, investors should always normalize the financials. In other words, a company earning a meager net interest margin today is going to earn a much higher net interest margin in a more normal interest rate environment. Therefore, investors should evaluate the company based on a higher net interest margin.

Charles Schwab (NYSE: SCHW) is one such company that is getting clobbered by low interest rates. Its net interest income is only slightly higher today than it was in 2008, despite controlling significantly more assets today than it did just a few years ago. But net interest income should rise dramatically alongside interest rates.

Net interest income is only one component of Schwab's earnings. The company also earns revenue from transaction fees for its online brokerage and asset management fees. The company's recent acquisition of optionsXpress positions it to generate more transaction fees.

However, both Schwab's brokerage business and asset management business do much better during less volatile markets. A market crash -- or the general loss of confidence by retail investors -- would be detrimental to all parts of Schwab's business.

Competition

While Schwab has both a brokerage and an asset management business, its primary competitors only have one or the other.

For instance, TD Ameritrade (NYSE: AMTD) is a plain vanilla online broker: it generates revenue from transaction fees and margin loans. It is doing relatively well despite the low interest rate environment, but will still benefit from higher interest rates due to higher margin rates. The company is also dependent on rising equity markets, as most retail investors are more active during a bull market than a bear market.

TD Ameritrade has primarily grown through acquisitions, which is generally not a recipe for long-term success. Management has been a little overzealous at times and has paid fair if not high prices for some past acquisitions.

In addition, the company's client base is less sticky than Schwab's; while Schwab has a large percentage of long-term investors as brokerage clients, TD Ameritrade has a lot more short-term traders which tend to be more fickle. However, Schwab's purchase of optionsXpress adds a number of short-term traders to its client base as well.

While TD Ameritrade competes for Schwab's brokerage clients, T. Rowe Price (NASDAQ: TROW) competes for its asset management clients. T. Rowe Price is one of the largest asset managers in the United States, with $575 billion under management.

TROW's asset management clients are stickier than Schwab's; the majority of its accounts are retirement accounts, which tend to stay with one manager for many decades. In addition, TROW has more high-performing mutual funds than Schwab.

However, TROW's business is extremely concentrated in the U.S. and focuses on equities and balanced equities/bonds portfolios. Not only does it miss out on opportunities to cross-sell a variety of strategies to its clients, but it is overly exposed to U.S. equity markets.

Bottom Line

Relative to most industries, there is not what I would call fierce competition in the brokerage/asset management business right now. If you invest in Schwab, you shouldn't do it because you think it has a better competitive position. The thesis to bet on is that interest rates will rise soon, which will boost Schwab's bottom line. Bernanke has started to jaw-bone about higher rates, so anything could happen between now and 2015.


Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends 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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