Charles Schwab (SCHW): Best bet in 'battered financials'

"We continue to apply our value-oriented principles in selecting new growth stocks as we look for companies with superior profitability and strong balance sheets," says Jim Stack. 

In his InvesTech Market Analyst, he and analyst Bruce Morison explain, "Our latest featured investment, Charles Schwab Corp. (NASDAQ: SCHW), is a prime example and stands out as a conservative way to access to opportunities in the battered financial group."

"We are increasing our equity allocation in stocks that should show strong relative performance in a market upturn.

"We continue, however, to be very selective in terms of quality, as well as downside risk. Over the past 20 years, brokerage/asset management firms have produced more than twice the return of the market following a bear market.

"The Charles Schwab brand is one of the most well-known and trusted names in the financial services industry. Its strategy is to be competitively priced, but more importantly to be positioned as the gold standard in client service and integrity.

"Over the past five years the company has aggressively diversified away from its dependence on trading commissions in favor of fee business in asset management, banking, and advisory services.

"Today, less than 20% of net revenue comes from trading, while the other businesses are producing an enviable and consistent revenue stream that is growing at double-digit rates.

"This sound diversification strategy has generated strong earnings results. On an annualized basis, Schwab’s earnings have grown in excess of 25% per year over the past five years.

"While this explosive growth will be hard to duplicate, sustainable earnings growth is forecast to be in the range of 15%-18%. The company also has a solid balance sheet with long-term debt comprising less than 20% of the firm’s capitalization.

"Our valuation analysis suggests the company’s share price is significantly undervalued as the stock is currently trading near a twelve-year low in terms of valuation metrics.

"The stock is out of favor with investors primarily due to concerns about the volatile equity markets and a lawsuit that has been filed on behalf of Schwab customers who allege they were misled about the safety of a mutual fund that invested in mortgage-backed securities.

"In addition, investors have recently become concerned about the firm’s exposure to auction-rate securities. Regulators are questioning 40 major brokerages about their role in marketing these debt-backed securities, which became illiquid when the auction market dried up.

"In particular, the New York Attorney General is looking at what representations the brokerages made to their customers. Schwab was never an underwriter of the products.  According to the company it only acted as an agent, buying at the request of a client, and never actively marketed the products to its customer base.

"Despite these issues, the success of the firm’s diversification efforts and growing brand name recognition, coupled with its attractive valuation and the industry’s potent performance in post bear market environments, make Schwab a compelling investment for the InvesTech portfolio."