Going Long On Noah, Short On Chuck

Here is a pair of stocks, one that I recommend investors go long on, and the other that they should short. Long: Noah Holdings Ltd. (NOAH) Current price: $34.09 12-month target: $42 Noah Holdings Ltd. (NOAH) is a leading wealth management firm, located in the People’s Republic of China, that focuses on high net worth investors, providing access to fund managers, private equity, venture capital real estate and asset allocation services. Similar to an emerging markets version of Merrill Lynch or Morgan Stanley, Noah is well positioned to benefit from several factors: 1) Growth of wealth creation in China, driven by rapid GDP growth of the world’s fastest growing major economy, and largest population base. 2) An undervalued market, at 50% discount to GDP vs. U.S. at a 30% premium, with 2-3 times more growth. 3) The rapid growth of high net worth, high income upper class in China . 4) A gradual opening up of Chinese markets to outside investment opportunities and investors. China’s GDP has grown from $2.2 billion to $ 9.2 billion over the last eight years.  In 2013, there were 2.4 million millionaires in China, up 83% from 2012.  Over $37 trillion, or 24% of the world’s private wealth is domiciled in Asia outside of Japan. Noah is one of the few pure plays on the growth of wealth management industry in China available to U.S. investors. Noah sold $3.9 billion of wealth management products during the first quarter this year, representing a 64% increase year-over-year and a 108% increase quarter-over-quarter while total active clients experienced a 62% increase from the corresponding period last year. Noah has increased market penetration as its network grew to 104 offices covering 64 cities. In November last year, the Chinese government finally elected to more broadly open up domestic equity markets to outside investors. The Shanghai-Hong Kong Stock Connect program allows all investors to buy shares on the Shanghai Stock Exchange, while also permitting wealthy investors in mainland China to buy stocks listed in Hong Kong. The move allows investors to access companies with an overall market value of roughly $2 trillion. All of these are positive for Noah. Earnings have grown over 60% annually over last five years and are likely to grow over 30% per year over next five year.  We see fair value at $42, or 20 times our 2016 EPS estimate of $2.10. The Short:  The Charles Schwab Corporation (SCHW) Current price: $32.29 12-month target: $23 The Charles Schwab Corporation, (SCHW), the venerable Wal-Mart of the financial services industry, may finally have to bite the hand that feeds it, and transform into the cursed, evil creation it has built its franchise on condemning, a full-service investment firm, in order to meet Wall Street expectations of continued growth. Additionally, Schwab is trading at lofty price to earnings and price to book value ratios. I doubt that Schwab can continue to grow enough to support high valuations of 34 times earnings and nearly four times book value, almost double the valuation of the S&P 500 and the financial services sector.

Finally, if the fed finds the U.S. economy too weak to hike short rates this year or next, Schwab is likely to fall short of consensus 2016 EPS estimates. Asset growth, adjusted for market appreciation, has been lackluster at 5% and operating margins have started to decline. Schwab, to launch its ‘robo-advisor’ program, is spending aggressively on marketing, while cannibalizing and alienating existing accounts and advisors with a much lower margin product. It is estimated that 80% of assets into this program thus far have come from existing accounts.

Meanwhile, Schwab’s cutthroat tactics to aggressively grab assets and manage them for no fee may alienate its advisor base. Also, Schwab will inevitably have to squeeze vendors, Walmart style, for a increasingly larger cut of the spread on ETF fees and trading.  Schwab’s bank is already waiving money market management fees to entice investors.  It may also be wrong in betting on ‘Drone investing’ as the wave of the future for tech savvy Millennials. They may want to beat the market rather than be the market, as has been the plight of every preceding generation.

Schwab’s current high valuation leaves it extremely vulnerable to an earnings shortfall and a market correction. Other comparable financials sector firms trade at much lower PE ratios, like Goldman Sacks (GS) at 12, LPL Financial (LPLA) at 18, JP Morgan (JPM) at 11. With market share gains becoming much harder to attain, and while competition is becoming much tougher in the high growth ETF arena from other discount heavy weights such as Fidelity and Vanguard, Schwab has a rough road to hoe. Of course, Schwab has a good brand and a mountain of assets, but Schwab has no other real choice than look within to improve ROA. At 24 bps Schwab is clearly at levels far below full-service wealth managers such as JP Morgan (JPM) at 50 bps. With EPS expected at $1.25 next year, we could see Schwab trading at the lower end of its historical P/E range of 15-18x as the market diminishes its growth expectations. Look for Schwab to trade down to $23 in 2016. Source: Forbes, June 3, 2015 Disclosure: Maltbie’s firm is long Noah Holdings and short Charles Schwab.

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