Discount Broker Goes First Class : Schwab Prospers as More Investors Favor Cut-Rate Fees

Charles Schwab & Co.’s new 28-story headquarters tower sits just across Montgomery Street from the small two-room suite in which Schwab and a handful of employees founded the discount stock broker about a decade ago.

But the short distance between the two sites belies the great strides made by Schwab and other discount brokers since the New York Stock Exchange abolished its 183-year-old system of fixed commission rates on May 1, 1975.

Ten years after “May Day,” Charles Schwab & Co. has 1,550 on its payroll, 92 offices from New York to Hong Kong and a state-of-the-art computer system that features IBM’s biggest mainframe and 10% more terminals than employees. Revenues last year of $148.5 million made Schwab, since 1983 a unit of BankAmerica Corp., the nation’s largest discount broker.

That’s a drop in the bucket compared to the world’s biggest brokerage firm, Merrill Lynch & Co., which posted total revenues of $6.04 billion last year. Commissions alone accounted for $1.2 billion of the total.

Still, discounters have grabbed an ever larger share of the retail brokerage market. Discounters currently account for up to 23% of all retail brokerage transactions, the Securities Industry Assn. estimates, compared to just 15% in 1982. Discounters predict that their share of the retail market will climb to 40% in the next 10 years.

“More and more people want to take control of their own financial affairs,” says Schwab, a 47-year-old Stanford MBA who is his firm’s chairman and chief executive officer and a member of BankAmerica’s board.

Discounters, whose commissions are as much as 70% lower than full-service brokers such as Merrill Lynch, are well positioned to take advantage of this trend because they cater to investors who like to call their own shots. “This business is still in its embryonic stage,” says James R. Quandt, president and chief executive officer of Security Pacific Brokers Inc.

Discount brokers are able to undercut the majors’ commission rates and still make a profit because they lack the platoons of highly paid research analysts and commissioned salesmen of the established firms.

The lack of commissioned salesmen has allowed discounters to pioneer in the use of systems allowing customers to trade securities via personal computers. C. D. Anderson & Co., a one-office San Francisco discounter, executed the first such trade on June 14, 1983, when a doctor in Michigan bought 100 shares of Merrill Lynch.

Use Personal Computers

Today, most of the big discounters offer PC-based services that allow customers to trade, track investments and tap financial data bases such as those operated by Dow Jones & Co. and Standard & Poor’s Corp. on their personal computers.

“We’re leading the way to home access because we don’t have squads of commissioned brokers getting in the way,” says Roger Servison, senior vice president of the Boston-based Fidelity group of companies’ marketing unit.

As the nation’s largest independent mutual-fund company, Fidelity lent respectability to the nascent discount brokerage industry by setting up its brokerage unit in 1979, industry observers say.

“Fidelity legitimized the industry, and BankAmerica brought it into the mainstream,” says industry consultant Mark Coler, head of New York-based Discount Brokerage Advisory. The two big nationally known firms “eliminated connotations of discounters as cheap or sleazy,” he adds.

BankAmerica’s 1981 agreement to buy Schwab for $53 million in stock led to a stampede of banks into the discount brokerage business. Los Angeles-based Security Pacific Corp. set up a brokerage unit in 1982; the operation currently services customers of Security Pacific and 267 other banks and savings and loan associations nationwide through toll-free “800” phone lines.

Chase Joins Field

Another major bank player is New York-based Chase Manhattan Corp., which purchased Rose & Co. of Chicago in 1983.

Other banks and S&Ls; offer discount brokerage services to their customers but funnel the business to established discounters, which actually execute the transactions. Citibank, for example, executes transactions through New York-based Quick & Reilly, while Great Western Savings and First Interstate Bank do business through Fidelity.

Typically, the banks that funnel their customers elsewhere keep between 20% and 35% of the commissions their customers generate. But low commission rates and high marketing and administrative expenses have taken their toll; four out of five banks are either losing money or only breaking even on discount brokerage operations of any type, according to industry officials.

With the exception of banking giants that have the financial clout to carve out large and profitable shares of the market, “most banks view the introduction of discount brokerage as a defensive measure,” notes Security Pacific’s Quandt. These banks only grudgingly introduced the service to hold onto depositors in the wake of deregulation and the flare-up of competition in the financial services industry.

Earnings Depressed

Even the big banks had a tough time making big profits last year as the sluggish stock market kept many retail traders on the sidelines. BankAmerica’s Schwab unit earned just $2 million, about a tenth of what the firm made a year earlier. (Schwab’s expenses soared as a result of investments in new technology and the move to a new skyscraper.)

Security Pacific’s profits were also small. “Profits take time to germinate when you introduce new products,” the firm’s Quandt says.

Quick & Reilly was probably the most profitable discounter last year. In the fiscal year ended Feb. 28, the firm posted net income of $8 million on revenues of $65 million. The firm, whose shares are publicly traded, entertains major customers on a 65-foot yacht.

Quick & Reilly Chairman Leslie C. Quick Jr. has a ready answer to the old quip, “but where are the customers’ yachts?” “If customers had bought and sold through us regularly, they could have shunted aside their commission savings and at least bought a rowboat,” he jests.

Actually, the money investors can save using discount brokers is no laughing matter. In some cases, it can mean the difference between a profit and a loss. The commission on 100 shares of a $40 stock would be $41 at Quick & Reilly and $49 at Schwab but $86 at Merrill Lynch.

Thus, a 1.5-point gain in the stock’s price wouldn’t even cover the “round-trip” or buy-and-sell commission at Merrill Lynch or the other “full-service” brokers. At a discounter, such a gain would yield a profit even after deducting commissions.

Customers Gather

That arithmetic--and many investors’ aversion to pushy salespeople--keeps customers flocking to Schwab and the other discounters. Typical of them are the several dozen Schwab customers who gather in the firm’s San Francisco “board room” every weekday. There, they furiously punch stock symbols into five Quotron machines and watch intently as orange luminescent characters reporting the latest prices of New York and American exchange stocks stream across two electronic blackboards.

Schwab is one of the few remaining firms to provide this service for its customers. “We like customers who trade,” says Hugo Quackenbush, Schwab’s senior vice president for marketing, who likens the atmosphere of the board room to a race track’s.

“If you go to watch the fillies run, you’re going to place a bet,” he says. Likewise, “If you’re watching the tape in the board room and it starts to move, you’re going to place a trade.”

Habitues of Schwab’s board room run the gamut from a diamond-studded widow wearing bright red lipstick and an impeccably tailored cream-colored chiffon outfit to a pony-tailed astrologer in faded blue jeans. They gather in small groups, swapping tidbits of information and comparing trading strategies.

Likes Low Pressure

Many retirees seem to come by just to pass the time; several snooze on the room’s 22 well-upholstered seats. “Everyone here is doing their own investing,” says a retired banker who stopped by to watch the tape. “I like Schwab because they’re not always trying to sell me something, like my old broker did.”

Such testimonials are music to the ears of Chuck Schwab, who delights in castigating “unfair, bloated commissions” and “self-serving brokers whose ‘advice’ is tainted.” He began his brokerage firm after a couple of failed ventures in the securities business, including a financial newsletter and a mutual fund.

He started discounting in April, 1974, taking advantage of a 13-month trial period the New York Stock Exchange instituted before officially letting commissions free. “But May Day, 1975, was really what triggered this industry,” Schwab recalls.

“Initially, we set our rate at 50% of the old fixed rate,” he says. “To our amazement, most established brokers raised their rates 7%.” Schwab grew rapidly--perhaps too rapidly.

In 1980, for example, Schwab scrubbed a planned offering of its own shares to the public after the firm received bad publicity over a 212% jump in execution errors and bad debts; the firm attributed the problems to a surge in volume and glitches in a new computer system.

“Wall Street wasn’t willing to finance our growth,” Schwab recalls bitterly. So instead of a public offering, Schwab sold a 20% stake to the corporate predecessor of First Nationwide Financial Corp.

Touched by Scandal

That same year, the firm suffered another blow when the assistant manager of its Newport Beach office was charged with operating a Ponzi scheme. In such illegal schemes, named after legendary Boston con man Charles Ponzi, promoters use proceeds from later investors to pay early investors their promised returns.

Last year, a Securities and Exchange Commission administrative law judge ruled that the training procedures for the cashiers in the Newport Beach office were “woefully” inadequate at the time of the problem and allowed the “extended ongoing fraud” to flourish. Finding that Schwab had failed to properly supervise the Newport Beach office, the judge ordered the firm to hire an accounting firm to audit Schwab’s internal controls.

The case was closed earlier this month after the auditor vouched for Schwab’s internal controls. Schwab considers the matter “dead and buried.”

Still a problem are the firm’s sometimes rocky relations with its new parent, BankAmerica. Some Schwab officials refer to the banking giant as “the monolith.” Others are bitter that the $53 million in BankAmerica stock that Schwab’s holders received has declined in value as a result of BankAmerica’s loan losses and other woes.

“As an investor, I, like a lot of people, thought the bank’s turnaround would come sooner than it has,” Schwab says. Still, he insists that he’s “a long-term player” (though he has sold 15% of his BankAmerica holdings) and that he hasn’t “any regrets whatsoever” over the merger.

“The bank has provided the capital we need to expand,” he says.

Cultures Clash

Perhaps inevitably, corporate cultures clashed as Schwab’s entrepreneurial style collided with BankAmerica’s legendary bureaucracy. BankAmerica’s automobile fleet manager tried--and failed--to get Schwab’s executives to trade in their BMWs, Porsches and Mercedes for company-issued Pontiacs and Buicks.

Later, the bank’s real-estate people opposed Schwab’s move into its new building in the high-rent financial district. When Schwab insisted on larger quarters, bank officials proposed a windowless former men’s clothing store on a somewhat seedy stretch of Market Street.

Schwab won that battle too, later complaining that the move to the windowless structure would have given the firm the reputation of “the moles of Wall Street.”

MAJOR DISCOUNT BROKERS

Number of Firm 1984 Revenues Offices Accounts Charles Schwab & Co. $148.5 million 92 1,051,000 Fidelity Investments 80 million 28 700,000 Quick & Reilly 65 million* 44 255,000 Security Pacific Brokers 16 million 20 230,000 Rose & Co. won’t disclose 8 125,000 Olde Discount Brokerage won’t disclose 50 won’t disclose

(Schwab is a unit of BankAmerica Corp., and Rose is a unit of Chase Manhattan Corp.) *fiscal year ended Feb. 28, 1985.