Charles Schwab and the Secular Shift in Financial Services

The Scuttlebutt Investor recently discussed the mental models that have been very successful to him as an investor. The first mental model discussed is “The Power of Secular Shifts”.

I don’t know if this is a mental model that Munger would officially endorse, but secular shifts are an important phenomenon that are sometimes under-appreciated and other times over-appreciated by market participants. Secular shifts are a change in volume, demand or relevance driven by secular or permanent forces. This is as compared to a cyclical shift or change that is driven by temporary forces like supply and demand. Secular shifts have the power to put entire companies out of business if they are no longer relevant (think Kodak with the advent of digital photography).

We think the financial services industry is undergoing a secular shift. The shift will be to Charles Schwab’s benefit.

Financial Services Secular Shift

The business of financial advice has been shifting from transactional to fee-based. From brokers selling financial products to advisors charging for advice and long-term planning.

Since the 2008 financial crisis, the independent RIA channel is the only one in the financial services sector to grow market share according to Aite Group. Independent RIAs have taken 13.7% market share which equates to about $17 trillion in assets.

Cerulli Associates of Boston estimate independent RIAs and dually registered firms have a 23% market share and will reach 28% by 2018.

Wirehouses are still the dominant firms in the financial services industry. The market share for wirehouses is 36%. However, their market share used to be 41.6% in 2007.

LPL Financial (LPLA) is a combination of fee-based advisors, brokers, and hybrids. LPL Financial’s largest business is its brokerage business. The secular shift in financial services is squeezing and changing the focus of its business model.

LPL Financial saw its total assets under advisory decline from $485 billion in Q1 2015 to $479 billion in Q1 2016. LPL Financial’s brokerage assets declined from $301 billion in Q1 2015 to $289 billion in Q1 2016. Whereas LPL Financial’s Fee-Based advisory assets grew 3% year-over-year.

During Q1 2016 LPL Financial announced that it is transitioning all remaining commissioned based business to fee-based.

DOL Catalyst

The secular shift from transactional based business to fee-based received a boost with the Department of Labors new ruling on the fiduciary standard. Before the DOL’s new rules fee-base advisors operated under the fiduciary rule; everything done has to be in the best interest of the client. Brokers operated under the suitability rule; an investment had to be suitable to a client’s situation.

The DOL’s new rules will have the fiduciary standard applied to brokers too. Brokers can still do transactional business with their clients but the broker has to get in writing that the client understands the fees and agrees to continue to do business in this manner even if it’s not in the client’s best interest.

If the new rules stand, the increased regulation will spark more brokers to become fee-based advisors. If the brokers current wirehouse doesn’t embrace the shift then more brokers will break away from the wirehouses to set-up their own RIA or join other independent RIAs.

Charles Schwab is the largest custodian for independent RIAs. About $1.2 trillion of Charles Schwab custodial assets are under the management of an advisor. This includes about $193 billion managed by Charles Schwab advisors.

From Stockholder Meeting Presentation May 2016
From Stockholder Meeting Presentation May 2016

According to Charles Schwab, there are $23 trillion in affluent client assets that currently exist outside the RIA channel. Given Charles Schwab’s market position and committment to service, it is extremely well positioned to benefit in the secular shift from transactional based business to the fee-based advice business.

Sources:

Mental Models on My Mind (Scuttlebutt Investor)

No Slowing RIA Growth (Wealth Management)

America’s Fifth Largest Brokerage Goes Fiduciary (The Reformed Broker)

Schwab: RIAs Ascending, but $23 Trillion Is There for the Taking (Think Advisor)

What’s Wrong with Apple Becoming Like This?

Quartz recently suggested that Apple is the new IBM. If Apple was becoming like IBM in its aggressive accounting then I would be worried. The comparison of Apple to IBM is the following.

Of course, Berkshire Hathaway’s stake is actually just an acknowledgement of the direction Apple has been heading in for years under CEO Tim Cook. Since taking the helm in 2011, Cook has essentially been tasked with managing the transformation of Apple from a fast-growing company seemingly immune to the law of large numbers, to a more stately—but still incredibly profitable—corporate powerhouse that consistently showers shareholders with dividends and buybacks.

So what’s wrong with being incredibly profitable that showers shareholders with dividends and buybacks?

It’s not sexy for one thing. People can’t brag anymore about how much and how fast their Apple investment is growing. If you’re investing for sex appeal then you’re doing it wrong to begin with. If this is your style of investing then just buy a t-shirt that says you own shares in the latest hottest company.

What I Wish I Wrote ~ May 13, 2016

The timing for when the bulk of your investing returns occur plays big role in your ending portfolio value. (Gerstein Fisher)

Banking on the blockchain. (a16z Podcast)

Finance is a big focus for implementing blockchain’s ledger technology but the power of the blockchain goes far beyond finance. (HBR)

The Business Blockchain: Promise, Practice, and Application of the Next Internet Technology (Amazon)

Blockchain Revolution: How the Technology Behind Bitcoin Is Changing Money, Business, and the World (Amazon)

Stanley Drunkenmiller’s “The Endgame” presentation from the 2016 Ira Sohn Conference. (ZeroHedge)

Warren Buffett’s 1998 talk at the University of Florida. (YouTube)

A breakdown of the key points and additional thoughts from Warren Buffett’s University of Florida talk. (Base Hit Investing)

Is ExxonMobil still a better bet than Apple? (The Confessions of a Contrarian Investor)

Learning from and copying from our investing heros is good and necessary for our personal development. Just don’t take the hero worship too far. (Clear Eyes Investing)

Some insight on Lou Simpson and how he works. (Value Investing World)

Kerrisdale Capital’s short thesis on Dish Networks (DISH). (Marketfolly)

Talk at Google: Howard Marks on the Origin and Inspiration for The Most Important Thing

From Talks at Google, Howard Marks discusses his book “The Most Important Thing“. Here is the memo that inspired the book.

h/t Marketfolly

And the book Howard thinks everyone should read is Fooled by Randomness

What is Holding Apple Back in Software and Services?

As the smartphone market matures, Apple will need to shift from selling hardware to selling more software and services to its extremely loyal customer base. Tim Cook and Luca Maestri know this and pointed it out during the Q1 2016 earnings call.

Especially during a period of economic uncertainty, we believe it is important to appreciate that a significant portion of Apple’s revenue recurs over time…a growing portion of our revenue is directly driven by our existing install base. Because our customers are very satisfied and engaged, they spend a lot of time on their devices and purchase apps, content, and other services. – Tim Cook

And Luca.

Each quarter, we report results for our Services category, which includes revenue from iTunes, the App Store, AppleCare, iCloud, Apple Pay, licensing, and some other items. Today, we would like to highlight the major drivers of growth in this category, which we have summarized on page three of our supplemental material. – Luca Maestri

It’s great that management knows it needs to monetize its customer base better. Especially when iPhone Users spend on average more than any other smartphone user. The problem is Apple isn’t very good at services, software, and subscriptions. With customers that spend the most money than other smartphone users, Apple isn’t number one in any cloud based services.

Also, Apple is lagging behind its rivals when it comes to analytics. With such a valuable customer base imagine if Apple’s analytics and were like Amazon’s? Apple would be monetizing their customer base at such a higher rate.

Why is Apple Bad at Services?

Apple is really good at making very desireable high-end hardware. So what is holding them back at software?

It may be their organizational structure. Apple operates under the “Unitary Organizational Form”.

Image courtesy of Stratechery. Click Image to enlarge.
Image courtesy of Stratechery. Click Image to enlarge.

The “Unitary Organizational Form” has served Apple well in building and selling great hardware but it has some disadvantages to selling software. Ben Thompson Elaborates.

The problem is that everything that goes into creating these jewel-like devices works against being good at services:

    • You only get one shot to get a device right, so all of Apple’s internal rhythms and processes are organized around delivering as perfect a product as possible at a specific moment in time.

      Services, on the other hand, which are subject to an effectively infinite number of variables ranging from bandwidth to device capability to hacking attempts to data integrity to power outages — the list goes on and on — can never be perfect; the ideal go-to-market is releasing a minimum viable product that is engineered for resiliency and then updated multiple times a week if not multiple times a day. The rhythms and processes are the exact opposite of what is required to build a great device.

 

    • As Apple is happy to tell you, a superior experience on a device comes from integration: the software can be tailored to the hardware, all the way down to the component level; this is why Apple designs their own system-on-a-chip hand-in-hand with iOS. Integration to this degree, though, is only possible when there is a static endpoint: the device that goes on sale to the public.

      In the case of services, though, which develop organically and iteratively, an integrated approach is unworkable: you can’t build everything from scratch multiple times a day. Rather, an effective set of services are modular in the extreme: different capabilities snap together like lego blocks to deliver different types of experiences, and each of those capabilities can be iterated on without disrupting the end product.

 

  • The fact that smartphones are such an important part of people’s lives, combined with the fact that physical objects can have additional consumer benefits like status, enables Apple to sell each iPhone with a huge amount of margin. However, not everyone values smartphones that much, or has the willingness to pay, which means Apple has to be ok with not serving the entire market; after all, to make a single iPhone costs money that has to be made up for in the purchase price.

    Services, though, have a very different business model. First, there is precious little evidencethat consumers are willing to pay more than a nominal amount for services (if that!), which means the most profitable services make money through volume. Secondly, services are effectively free on a marginal basis; the real costs are fixed, which means that services business have a strong economic imperative to reach as many people as possible.

These differences get at the very fundamental reasons why Apple struggles with services: it’s not that the company is incompetent, but rather that the company is brilliant — brilliant at making devices, which require completely different business structures and incentives.

Apple has other opportunities to grow. Software and services is one of them. The question is can Apple rise above its mediocre past in sfotware and services to capitalize on this opportunity?

Sources:

Apple’s Organizational Crossroads (Stratechery)

Why Apple Must Move Beyond the ‘Wow’ Moment (Knowledge @ Wharton)