Rising interest rates are generally a good thing for investment service firms, such as money managers and brokerage firms.
Rising interest rates are generally a good thing for investment service companies, such as money managers and brokerage firms.
That’s because the interest rates they pay on the cash they borrow generally don’t rise as fast as the rates they receive on their fixed-income assets.
Moreover, clients at retail brokerages typically keep 5% to 20% of their account balances in cash, Susan Dziubinski, director of content for Morningstar.com, wrote in a commentary .
“The brokerage sweeps that cash into a bank subsidiary, and that bank uses those cash deposits to make loans or to invest in fixed-income securities. They [brokerages] may also earn asset management or distribution fees on client assets in money-market funds.”
There should be plenty of opportunity to take advantage of higher interest rates. The Fed has raised rates 225 basis points since March, and is expected to tighten another 75 basis points later this month, followed by additional moves in November and December.
Morningstar analysts chose two investment-service firms in particular that will benefit from rising rates. The analysts peg both stocks as about fairly valued.
“More than 50% of Charles Schwab’s net revenue is tied to interest rates, with about half of its interest-earning assets driven by short-term interest rates and the other half driven by longer-term interest rates,” Dziubinski said.
“The firm should receive an immediate revenue lift from rising interest rates, and then sustained earnings growth, as the yield of its securities portfolio tied to longer-term interest rates reprices over several years.”
Schwab earned a wide-moat designation from Morningstar analyst Michael Wong, who puts fair value for the stock at $84. It recently traded at $75.
“Given its massive size and industry-leading cost efficiency, Charles Schwab has significant competitive advantages,” Dziubinski said.
Wong said, “a combined Charles Schwab-TD Ameritrade is a financial sector powerhouse that will be able to compete in an environment where traditional industry lines have increasingly blurred.”
“LPL Financial should see significant operating margin expansion from a rise in short-term interest rates, as well as near-term revenue growth,” Dziubinski said.
“In fact, we forecast that gross profit will increase about 40% over the next two years, in large part because of rising interest rates.” Also, pre-tax income could double, she said.
Wong assigns LPL a narrow moat, based on the high retention of advisors on its platform and the stickiness of investor assets. He put fair value for the stock at $256. It recently traded at $231.15.
“Production retention, which measures the percentage of advisor-generated revenue maintained from the previous year, has recently been over 95%,” Wong said. “This indicates to us that LPL’s services have a high level of stickiness.”