iFAST and Charles Schwab

Charles Schwab history and development hints at a bright future for iFAST, one of the larger positions in my portfolio.

Both companies sell funds and stocks at a low price and succeeded in gathering more assets and clients.

Take a look at how Charles Schwab has grown over the years.

1. Charles Schwab disrupted the industry by selling stocks at a low commission.
2. Charles Schwab used technology to offer lower prices and increase profit margins.
3. Scope and scale grew with the company selling more products such as unit trusts and a back-end platform for financial advisors.
4. Network effects resulted in a deeper moat and a virtuous cycle as the company’s attractive prices attracted more clients which attracted more suppliers.
5. More transactions with Charles Schwab resulted in clients leaving more cash in their account allowing Charles Schwab to earn net interest income.
6. Net interest income currently makes up more than 50% of Charles Schwab revenue while operating margins have expanded to 45% in 2018 from 19.5% in 1997

This quote from the Ensemble Fund letter explains how net interest income and not trading commissions are a “secret weapon” for Charles Schwab .

In essence, Schwab, the brokerage and advisory company, is able to offer clients great service and great prices on its explicit cost AUM and brokerage services that clients are price sensitive about and winning them over as customers. It then makes its money on the implicit opportunity cost clients bear in the form of uninvested tactical cash balances that are automatically swept into the Bank to drive incremental profit margins and shareholder returns. While the AUM business charges a fee based on the amount of assets managed, the Bank makes a spread of about 200bps between the interest rate it pays on deposits and what it earns investing that client cash in generally safe government and corporate securities. As a result, though assets in the Bank amount to 10-15% of total assets under management, they earn 20x as much as the AUM business on a per customer dollar basis with low incremental cost. The result of this fantastically complementary business are happy customers and happy shareholders.

The similarities between Charles Schwab and iFAST are striking.

1. iFAST disrupted the industry by selling funds at a low commission.
2. iFAST used technology to offer lower prices and increase profit margins.
3. Scope and scale grew with the company selling more products such as stocks, bonds and a back-end platform for financial advisors.
4. Network effects resulted in a deeper moat and a virtuous cycle as the company’s attractive prices attracted more clients which attracted more suppliers.
5. More transactions with iFAST resulted in clients leaving more cash in their account allowing iFAST to earn net interest income.
6. Net interest income made up 6% of iFAST revenue in 2018 while pretax margins have grown from 15% in 2016 to 20.7% in 2018.

The resemblance between iFAST and Charles Schwab ends here because net interest income currently makes up a small part of iFAST revenue. Growing net interest income contributions will be crucial. Net interest income is counter-cyclical (people hold more cash when they are scared) and reduces reliance on volatile unit trust fees. If iFAST can continue attracting more client assets, the company’s net interest income and profit margins should naturally expand as well.

iFAST reports results on 31 October but revenue and net profit trends are likely to be ugly because of volatile markets. Instead, focus on iFAST’s ability to gather assets under administration because that will determine its ability to earn recurring fees. iFAST is trading at 28.9x trailing earnings and 19.1x trailing earnings excluding China losses.