Charles Schwab: Stock Market Beneficiary

Despite a pullback on October 27, the Dow Jones industrial average is still basking in record-high territory. One way to profit from a strong stock market is to invest in a firm that directly benefits. A prime example of such a company, says Prudential analyst Michael Mayo, is discount brokerage Charles Schwab.

The general thinking: The better the market does, the more apt people are to invest in stocks -- which means more revenues from commissions. A favorable market is also a boon to Schwab's money-management arm because appreciating assets means the company can collect higher fees.

Of course, it's not that simple. The discount brokerage business is super competitive, and price competition is intense -- witness Bank of America's recent announcement that it will offer free trades to brokerage customers who keep at least $25,000 in BofA bank accounts. But Mayo says Schwab's scale and its ability to attract new money give it a big advantage over most of its rivals. "The company seems well on its way at showing strong organic growth that surpasses much of the industry," says Mayo, who upgraded Schwab's shares (symbol SCHW) to "overweight" on October 26.

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Schwab, which invented the discount brokerage business in the 1970s, is also the industry's largest, with $1.3 trillion in client assets. Schwab's services are pricier than those of most competitors and, in fact, the San Francisco-based company looks more and more like a full-service broker, appealing to clients seeking some guidance. The focus on customer service is one reason BofA's free-trade offer doesn't look like a huge threat, says Mayo. He figures that Schwab clients likely value service over rock-bottom commissions. (In our recent survey among brokerages, Schwab ranked high for its broker knowledge, stock research and easy-to-use Web site, though broker responsiveness was sluggish.)

Another plus: Schwab has been reducing its dependence on online trading commissions, revenues from which are notoriously volatile. Only 13% of Schwab's revenues now come from commissions, the lowest of all online brokers, says Mayo. Instead of relying on commissions, Schwab is becoming more dependent on its mutual fund business and investment advisory services. Roughly half of revenues now come from asset-management fees. Randy Shrikishun, an analyst at Value Line Investment Survey, says that although online trading may well pick up by year-end -- thanks to lower prices and increased marketing -- the big growth driver in coming years will be Schwab's expanding asset-management business.

Schwab shares jumped 1.5% on October 27, to $17.81. They are about 4% off their 52-week high, reached in May, and a whopping 66% below their all-time high, set in 1999. The stock sells for about 22 times analysts' 2006 earnings estimate of 80 cents per share and 19 times next year's projections of 93 cents a share. Mayo thinks the stock could hit $23 within the next year and a half.