The finance department at Charles Schwab (Nasdaq: SCHW) has a very large problem.
The firm has been so successful at attracting clients over the past half-decade that the cash Schwab holds for its clients has swelled nearly 190% from 2008, to a recent $86 billion. But in this era of low interest rates, the firm hasn't been able to fully capitalize on that success.
Schwab's net interest margin (which is the difference between the rate it pays to clients in their cash accounts and Schwab's own interest income on those assets held) has been squeezed to almost nothing.
Yet good new lies ahead. As interest rates start to rise, so will Schwab's net interest margins. It happens every cycle, and investors are only just beginning to warm up the profit boom yet to come. Shares of Schwab have already begun to move up in anticipation of this trend, moving back into the mid-$20s, right where they stood back in 2007.
But investors shouldn't think they've missed the boat. Schwab's base of clients has more than doubled since 2007 (leading to assets under management that now exceeds $2 trillion). So as interest rates move back to levels seen in 2007, Schwab is likely to post stunning amounts of interest income.
And Schwab's not alone. A host of other companies are anxiously awaiting the rebound in interest rates. Take Automatic Data Processing (NYSE: ADP) as an example. ADP takes in billions of dollars for its clients in order to cut payroll checks, and always aims to generate excess profits on that cash. ADP doesn't need to remit any interest profits back to clients, unlike Schwab, which must pay money market rates.
Back in fiscal 2008, ADP earned nearly $700 million in client interest income. These days, that figure has fallen by half. Analysts at Merrill Lynch predict that interest income will steadily rebound in fiscal 2014, and perhaps hit record levels in fiscal 2015, in part because the company's client base is now meaningfully larger than it was back in fiscal 2008. And they think that makes ADP a timely investment: "Over the last 20 years, ADP shares have had average annual gains of 16% when US short term interest rates were stable or rising (versus 6% gains in falling rate periods)," they noted in a recent research note.
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The Best Sector For Rising Rates
Yet it's the insurance companies that perhaps stand to garner the most benefits from rising interest rates. As I wrote in May, I've been recommending insurance stocks over the past year, largely because so many of them have been trading below book value and embarking on massive share buybacks. And although this entire group has been rallying higher, many insurers, amazingly, still trade below book value.
Yet there's a correlation between book value and interest rates to consider. As rates rise, these insurers are likely to profit sharply. And faster-rising profits leads to rising book values at an accelerating pace. So these insurers, despite posting solid recent gains, could be among the market leaders in 2014 and 2015 as well.
Risks to consider: Though we appear to be on the cusp of a rising interest rate environment as the global economy strengthens, a pullback in global economic growth would lead interest rates to stay depressed for a considerably longer time.
Action to Take --> You are likely to see the early benefits of rising rates start to impact these companies' income statements during this current earnings season. Look for management discussions about the projected impact of rising rates on these businesses. Though these stocks have started to benefit from this expected tailwind, considerable concern remains once interest rates begin to move materially higher.
P.S. In our latest research, "Top 10 Stocks For 2014," we've uncovered several more investments that are similar to ADP. They dominate their markets, pay increasing dividends, and repurchase billions in stock. To learn more about these ideas, including several names and ticker symbols, click here.
- David Sterman
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