Charles Schwab Corp.

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Charles Schwab Corp.

101 Montgomery St.
San Francisco, California 94104-4122
U.S.A.
(415) 627-7000
Fax: (415) 627-8538

Public Company
Incorporated: 1971
Employees: 4,600
Sales: $909 million
Stock Exchanges: New York Midwest Philadelphia Pacific
SICs: 6211 Security Brokers and Dealers; 6282 Investment Advice; 6719 Holding Companies, Nec

The Charles Schwab Corp., through its operating subsidiary Charles Schwab & Company, Inc., is the largest discount stock broker in the United States. It also deals in securities, investments, and other low-cost financial services.

Charles Schwab, the company’s founder, had received an M.B.A. degree from Stanford University and had been working for a small California investment advisor when, in 1971, he founded his own company. He and two partners created a stock mutual fund that soon had $20 million in assets. However, they ran into trouble with securities regulators, when it was learned that they had failed to register the fund. This error temporarily forced Schwab out of business, but he soon reopened a small money-management firm in San Francisco.

On May 1, 1975, the U.S. Congress deregulated the stock brokerage industry by taking away the power of the New York Stock Exchange to determine the commission rates charged by its members. This opened the door to discount brokers, who took orders to buy and sell securities, but did not offer advice or do research the way larger, established brokers like Merrill Lynch did. This presented an opportunity to win individual investors well enough versed in the stock market not to need the advice offered by established brokers. Schwab quickly took advantage of deregulation, opening a small San Francisco brokerage, financed primarily with borrowed money, and buying a seat on the New York Stock Exchange.

The new discount brokers, whose commissions might be only 30 percent of the rates before deregulation, were scorned by the old-line brokerages. During his first few years as a discount broker, Schwab had to contend with bad publicity generated by the older firms, some of whom threatened to break their leases if landlords allowed Schwab to rent offices in the same building.

Schwab fought back by buying newspaper ads featuring his photograph and asking customers to contact him personally, helping to build the firm’s credibility. Possibly the most important early decision made by Schwab was to open branch offices around the United States. He reasoned that even investors not needing advice would prefer doing business through a local office instead of a toll-free telephone number. The move won customers and helped differentiate Schwab from the large number of discount firms appearing after deregulation.

Over the next few years Schwab did several things to pull away from the pack. The company offered innovative new services including the ability to place orders 24-hours a day. It bought advanced computer systems to quickly deal with huge volumes of orders. And it continued its heavy advertising, seeking to project an upscale image. Top executives were given expensive foreign cars, and an interior design staff was commissioned to help showcase certain new branches. Some industry analysts maintain that with these measures Schwab helped bring discount brokering into the mainstream of financial institutions.

However, the firm’s rapid expansion was costly. Partly as a result of this, and partly because sales were dependent on the sentiments of small investors, profits were erratic. To raise money Schwab sometimes turned to employees and larger customers. By 1980 Schwab was by far the largest discounter. That year, in part to fund further expansion, Schwab decided to take the company public. The offering was called off, however, when some problems caused by the attempted conversion to a new computer system proved an embarrassment to the company. Raising sufficient capital in private became more difficult, partly because of the erratic earnings. Finally, in 1983, Schwab arranged for San Francisco’s Bank of America to acquire the company for $55 million in Bank of America stock. Bank of America also agreed to supply Schwab with capital. It loaned Schwab $50 million over the next three years, but Schwab remained one of the most highly leveraged brokerages.

The sale to Bank of America may have provided needed capital, but it fettered the company with banking regulations. Schwab wanted to offer new, proprietary lines of investments including Charles Schwab mutual funds. However, federal law at the time forbid banks and their subsidiaries from underwriting such securities. Although Schwab initially sought to challenge the law, as its wording contained some ambiguities, Bank of America did not want to irritate banking regulators. Tensions between Schwab and its parent were further exacerbated because Bank of America was experiencing difficulties, and the price of its stock was falling, making Schwab’s stake in it worth less.

Schwab introduced the Mutual Fund Marketplace in 1984 with an initial investment of $5 million. The Marketplace allowed customers to invest in 250 separate mutual funds and switch between them using Schwab as the bookkeeper. All of a customer’s mutual fund accounts were put on a single monthly statement. The company’s profile was further raised in 1984 when Schwab’s book How to be Your Own Stockbroker was published. In it Schwab presented himself as a populist fighting against Wall Street stockbrokers in the name of the average investor. He contended that there is an inherent conflict of interest when a firm owns stock in inventory, writes favorable research recommendations on those stocks, and has commissioned salespeople sell those stocks to the public. At the same time, the company was moving into an elegant new headquarters building in downtown San Francisco.

In 1985 Schwab had 90 branches and 1.2 million customers, generating $202 million in revenue. Though it was far larger than its leading discount competitors, it was small compared with the largest retail brokerages, which had over 300 branches. The firm was growing in other ways, however. It offered personal computer software called the Equalizer, which allowed investors to place orders via computer as well as call up stock information and obtain research reports.

In 1987, Charles Schwab and a group of investors bought the company back from Bank of America for $238 million. Seven weeks later, he announced plans to take the company public. The buyback had resulted in $200 million of debt, and the public offering was partly designed to eliminate some of this debt. It was also intended to raise money for further expansion. Schwab wanted to increase the number of branches to 120, including offices in Europe.

The discount brokerage business had grown intensely competitive. Discounters handled a significant amount of retail equity trades by 1987, but hundreds of firms had entered the field, including banks, savings and loans, and mutual fund companies. Since Schwab was clearly the player to beat in discounting, competitors’ advertisements specifically offered rates lower than Schwab’s. Nevertheless, at this time Schwab had 1.6 million customers, about five times as many as its nearest competitor, Quick & Reilly Group. In 1987 the firm had sales of $465 million and profits of $26 million, twice the industry’s average profit margin. To achieve this success, Schwab was spending about $15 million a year on advertising.

Schwab was already doing well in its expanded product line. Mutual Fund Marketplace had attracted $1.07 billion in client assets by year-end 1986. The company was also offering Individual Retirement Accounts, certificates of deposit, money-market accounts, and Schwab One cash-management accounts. Despite these successes, Schwab was badly hurt by the stock market crash of October 1987. By mid-1988, trading volume had fallen to about 10,400 trades a day, a 40 percent drop from the months before the crash. Schwab cut costs to maintain profitability, cutting managerial pay anywhere from five to 20 percent and laying off employees. Charles Schwab cut his own pay 20 percent for six months, and put branch expansion plans on hold. The firm also raised its trading commission ten percent, so that it needed only 8,000 trades a day to break even, down from 12,000 trades. Even with the cost-cutting, the firm’s 1988 earnings plummeted 70 percent to $7.4 million on sales of $392 million.

However, by 1989 Schwab was expanding again. It bought Chicago-based Rose & Co. for $34 million from Chase Manhattan, and as the fifth-largest discount broker in the United States, Rose & Co. brought Schwab 200,000 new customers at a cost of about $70 each. With the purchase, Schwab controlled about 40 percent of the discount market, though discounters made only eight percent of all retail commissions. Over the long run, Schwab realized its best strategy was to win customers from the full-service brokers. To help create more independent stock investors, it pioneered a service called Telebroker that let customers place stock orders and get price quotes from any touch-tone telephone 24 hours a day. It also released a new version of the Equalizer. The software had already sold 30,000 copies at $169 each since its introduction.

Individual investors returned to the stock market in 1989, and the firm’s income surged to $553 million, with profits of $18.9 million. Income was further helped by an increase in client assets, from $16.8 billion in 1987 to $25 billion in early 1990. Commissions accounted for 70 percent of revenue, down from 85 percent in 1987.

Throughout the 1980s, Schwab updated its Mutual Fund Marketplace to allow customers to switch among funds in different families by a telephone. Customers paid a commission ranging from .6 percent to .08 percent, with a minimum of $29. Analysts were generally positive, pointing out that the amount of interest lost from having a check in the mail would pay for most of the service’s commission fees. In 1991 Schwab also acquired Mayer & Schweitzer, an over-the-counter stock market maker, getting itself into a new and lucrative market.

Meanwhile Schwab was opening branch offices at a furious pace—17 in 1992 alone—and doubling the amount of money it spent on advertising. Schwab’s aggressive stance helped raise its share of the discount market to 46 percent as it attracted more than 40,000 new accounts a month. In 1992 Schwab acquired its first corporate jet, spending $12 million on a model with enough fuel capacity to reach London, where it was opening its first European branch. These additional costs helped drag down third-quarter earnings in 1992 when stock trading temporarily tapered off. The dip was a reminder that the company was still highly dependent on commissions, and caused its stock to drop 20 percent.

Schwab cut advertising by 20 percent and took other steps to slow the growth of its costs. It made a greater share of new branch offices into “bare bones” operations with only one broker. Schwab already paid its 2,500 brokers less than other discounters, an average of $31,000 a year, compared with $50,000 at Fidelity Brokerage Services and $36,000 at Quick & Reilly. The firm also continued searching for ways to become less dependent on commissions. The introduction in July of

1992 of a way to trade mutual funds by eight outside fund companies, resulting in no sales fee, attracted more than $500 million in assets within two months and over $4 billion by July of 1993; it was thus the most successful first-year pilot of any new service in Schwab’s history.

During 1992 Schwab customers opened 560,000 new accounts at its 175 branch offices, while assets in customer accounts grew 38 percent to $65.6 billion. Revenue soared to $909 million, with record profits of $81 million. As a result of these successes, Schwab announced plans to open 20 more branch offices in 1993 and several proprietary mutual funds. Schwab remained dependent on commissions, but was working steadily to ease its dependency even as it rapidly increased its customer base, largely at the expense of full-service brokerages.