Taking Stock of Schwab : Discounter Scores Again Pitching Mutual Funds

L.A. Times Archives

Aug. 13, 1995 12 AM PT

The financial markets have never lacked for visionaries, people like Charles E. Merrill, who started Merrill Lynch & Co. in 1914. Aided by an unapologetic flair for self-promotion, he built the nation’s biggest brokerage house by catering to the “little guy.”

The 1995 version of Merrill is Charles R. Schwab. With a blend of cutting-edge technology and old-fashioned sales and marketing, Schwab is once again radically altering how Americans of all incomes invest their money.

He pioneered the discount brokerage following the deregulation of stock-trading commissions in 1975, and his San Francisco-based Charles Schwab Corp. remains the nation’s largest discount brokerage.

Now he’s struck gold again, this time in the exploding mutual fund business, a $2.5-trillion market, with 38 million individual investors and 5,600 stock, bond and money-market funds.

In an adroit move to capture more of that business, Schwab developed a unique program in which people can use his firm to invest in 350 outside mutual funds with a single phone call and at no charge.

It’s an idea that seems astonishingly simple, yet one that required Schwab to invest heavily in complicated computer technology to link all the funds. (Schwab won’t disclose how much it spent.)

The effort paid off. The program, Mutual Fund OneSource, and this year’s bull market in stocks, are propelling Schwab’s revenue and profit to record levels. Like all innovations, however, OneSource is being rapidly copied by competitors who keep nipping at Schwab’s heels.

OneSource is also the latest building block in Schwab’s bid to construct the one-stop financial supermarket that many others have tried to build over the years--with generally poor results.

“His success has been extremely good,” said Perrin Long, an analyst with Brown Brothers Harriman & Co. in New York. “Just as a department store doesn’t care whose shoes you buy as long as the store gets the sale, it doesn’t make that much difference to Schwab how people invest their money as long as he gets the business.”

Unveiled in 1992, OneSource allows individuals to invest in mutual funds at no charge. Instead, Schwab collects fees from the funds themselves--about $2.50 for every $1,000 invested. Whether they’re invested in Janus, Strong or Twentieth Century funds, customers can track their funds with one monthly statement from Schwab, and switch among different funds with a phone call.

OneSource has been “a spectacular success,” analyst Guy Moszkowski of Sanford C. Bernstein & Co. in New York wrote in a recent report. In the second quarter of this year alone, investors poured $3 billion into the program.

As a result, Schwab’s total mutual fund assets (the firm markets its own funds as well) soared to $40.4 billion on June 30 from $6 billion just four years ago. And that’s why Schwab’s total customer assets have shot up 200% during the same period to $153 billion.

Schwab now has more than 3 million customers, and is adding about 58,000 new clients every month. That’s less than half the 7 million or so clients of Merrill Lynch, but in several financial categories--such as return on its own investors’ capital--Schwab ranks in the top tier.

Amid efforts in Congress to repeal the Glass-Steagall Act, which separates commercial banking from investment banking and brokerages, Schwab doesn’t hide his glee at the prospect of buying a bank or an insurance firm one day. Then his customers could also buy government-insured certificates of deposit or life insurance policies.

Ending Glass-Steagall “would be very exciting, frankly,” Schwab said in a recent interview in his 28th-floor office in the San Francisco high-rise that bears his name, a building that also features electronic stock tickers inside its elevators.

Banks and insurers “are old institutions” that are “very expensive, have lots of old-fashioned regulations and are mysterious” to the public, Schwab said. To make those services simpler and cheaper is “a big opportunity for a firm like ours.”

How ironic if Schwab were to buy a bank. He sold his firm in 1983 to BankAmerica Corp. for $53 million in bank stock, only to buy it back four years later after BankAmerica’s financial problems dramatically worsened.

The repurchase price: $23 million of equity plus $300 million of debt, which Schwab repaid. It was a typical leveraged buyout, enabling Schwab to effectively buy the firm back for half of his selling price.

For now, though, most of Schwab’s revenue still comes from trading securities, and so the firm remains as vulnerable as the rest of Wall Street to a sustained drop in the markets.

Schwab also is feeling heat from a growing number of rivals. Mutual fund powerhouse Fidelity Investments has its own version of OneSource, called FundsNetwork, which offers 380 outside funds and has amassed $13 billion in assets.

Fidelity also offers discount-brokerage services, and there are several other discount houses, such as Quick & Reilly and Jack White & Co., that often undercut Schwab on trading commissions.

But Schwab shrugs off those concerns, saying that the fierce competition “is wonderful for the consumer.”

Schwab tries to set itself apart by emphasizing its many services, low cost and ease of use. The company’s services include not only OneSource, but 24-hour-a-day trading by telephone or computer (the telephone service offers guidance in English, Spanish, Mandarin and Cantonese), referrals to outside sources for investment advice, no-fee individual retirement accounts, cash-management accounts and investment software for personal computers.

“We demystified the whole aspect of investing,” Schwab said. “We brought it down to the common-man level and took it away from Wall Street.”

That’s hyperbole, of course, but don’t tell that to Schwab’s fans. “They’re a discount broker with Cadillac service,” Peter Morrissey, a Schwab client and legal student, said while checking stock quotes at Schwab’s downtown Los Angeles branch last week.

And the ways that service is delivered illustrate how Schwab uses a medley of old and new features to drum up business. Sure, investors can dial up Schwab via telephone or computer; yet Schwab also has 210 branch offices nationwide for clients who want to talk to real people.

Schwab’s branches (it’s opening 25 more this year) would seem an unnecessary expense at a time when brokerages and mutual funds rely so heavily on computers, toll-free phone numbers and other technology. Also, Schwab’s customers, who at an average age of 47 are about a decade younger than those using traditional full-service firms, are more inclined to handle transactions electronically, analysts said.

But Schwab finds that having an nearby office still counts with investors of any age.

“I like that touch,” Mike Shintaku, a computer specialist and Schwab customer, said as he visited the Los Angeles branch. “I can come down and hop on the [Quotron] machine” to look up prices, he said.

Branches are “critically important to the whole mix,” Schwab said. Customers “like that face-to-face” interaction, he said, noting that 75% of his new accounts are opened in person at branches. “After that, most of the business they conduct is by telephone or personal computer.”

There’s another key to Schwab’s marketing prowess: The firm’s genial 57-year-old chairman and founder. With his boy-next-door looks, modest demeanor and wire-rimmed aviator glasses, Chuck Schwab (everybody calls him Chuck) exudes a bland credibility in the firm’s advertising that induces people to turn their cash over to him.

His low-key, no-haggling personality seems to strike a particularly favorable chord with investors today, when value is the buzzword of personal finance and more Americans make their own investment choices.

Schwab and other discount brokerages now account for 14.5% of the total commissions generated by the brokerage industry, nearly triple their level of a decade ago, according to the Securities Industry Assn.

“People can relate to Schwab,” said Brown Brothers’ Long. “Do you know what Dan Tully looks like at Merrill Lynch? Or Don Marron at PaineWebber?” he asked, referring to those firms’ chief executives.

In his 1994 book “A Piece of the Action: How the Middle Class Joined the Money Class,” Joseph Nocera described how Schwab’s “friendly face” in the ads meant that even though a 25-year-old agent was likely to handle an investor’s call to Schwab’s firm, the call “didn’t feel impersonal.”

“Sure, you were talking to some kid on the other end of a phone line, but he wasn’t your broker,” Nocera wrote. “Your broker was Chuck Schwab.”

Despite a shyness that stems from his long struggle with dyslexia, Schwab reluctantly first appeared in his firm’s newspaper ads in the 1970s. But he stayed in them after seeing how well they worked, and now he also appears routinely on television ads to sell the firm’s services.

The son of a lawyer, Schwab was born in Sacramento and raised in middle-class surroundings in Woodland, Calif., and Santa Barbara. Though he had a mild interest in the stock market while growing up, Schwab was more passionate about playing golf, which he still does at every chance. Nonetheless, he earned an MBA at Stanford University, then started an investment newsletter and a small mutual fund in the 1960s. Both barely survived.

With $100,000 provided by an uncle, Schwab started another investment firm in the early 1970s, which he developed into the discount brokerage in 1975.

It would be easy to say the rest is history, but the twice-married Schwab made his share of mistakes over the next 15 years. He has always admitted to being more concerned with strategy than daily operations, and for years his firm was dogged by haphazard management, insufficient cash reserves and telephone-computer capabilities that always seemed to lag behind the firm’s rapid growth.

That was never more apparent than during the 1987 stock market crash, which almost buried Schwab’s firm. Not only was Schwab woefully unprepared to handle the onslaught of investors’ calls during the crash, the firm also suffered a mighty lapse of oversight: About $13 million of the losses were caused by a single Schwab customer operating through the firm’s tiny Hong Kong branch.

After buying the company back from BankAmerica, Schwab issued a portion of its stock to the public on Sept. 22, 1987--one month before the crash--and raised $123 million. The offering probably saved Schwab, which suffered $22 million in total losses during the crash.

Schwab’s operations are now much more disciplined, analysts said, and the firm has customer-service centers in Phoenix, Denver, Indianapolis and Orlando that back up its branch offices in times of heavy volume.

Of the 5,000 or so stocks that an investor can buy through Schwab, one of the best picks this year would have been its own Charles Schwab Corp.

Responding to the firm’s sizzling performance, its stock has more than doubled in price over the last 12 months, closing at $43.50 Friday in New York Stock Exchange trading. Schwab also plans to hike its dividend 33% on Tuesday, and it plans a 2-for-1 stock split Sept. 1--its fourth split since going public in 1987.

The stock’s rally in turn has added more than $400 million to the personal wealth of Chuck Schwab, who already is one of the richest 400 Americans, according to Forbes magazine. He remains Schwab’s biggest stockholder, with a 22% stake that has a current market value of about $820 million.

How does his firm make its money?

Trade commissions are still the biggest chunk of its business, equal to 51% of total revenue. But the eye-catching growth has come from the fees Schwab earns from servicing its expanding family of mutual funds; those fees were $157 million last year, triple their level of five years ago.

There’s more: As Schwab’s assets grow, so does its ability to earn interest on customers’ cash that’s temporarily idle.

For example: A customer redeems cash from one mutual fund but waits four days before investing in another. In the interim, the redemption proceeds remain on deposit with Schwab, which pays interest on the cash. But Schwab is earning higher interest from investing that cash itself and from making margin loans to its other customers.

The result is that Schwab last year earned an average 2.47 percentage points more in interest than it paid to its customers, which translated into net interest income of $165 million. That’s more than double its level of 1990, because of Schwab’s bulging assets.

But what happens when the stock market tanks again?

That worries Bernstein’s Moszkowski, who wrote that when “a long-term bear market which depresses industrywide activity” hits Schwab, the firm’s “earnings growth could decelerate sharply.”

Yet consider this: In 1994, the markets had a poor year and profits tumbled at many of the full-service brokerages. Schwab, however, posted a 15% gain in earnings on a 10% increase in revenue, and it signed up 736,000 new customers--4% more than in the previous year.

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Discount Broker’s Rapid Growth

Charles Schwab Corp. is best known as the nation’s largest discount broker, but Schwab’s burgeoning mutual-fund programs are also fueling its growth.

REVENUES

In millions of dollars:

1994: $1,065

1993: $965

1992: $750

1991: $570

1990: $387

1989: $346

1988: $267