As commissions fall and investors crave advice, the discount broker bets big on the Web

Quick. Which stock performed best in the bull market of the 1990s: Microsoft, Intel, or Charles Schwab? If you picked either of the dynamic duo of high tech, you guessed wrong. Schwab left both in the dust. A dollar invested in Microsoft at the start of 1991 grew to a little more than $15 by the end of 1997; Intel, a little less. But during the same period, a dollar put into the discount brokerage firm blossomed into $39.

The rising tide of a bull market lifts all securities firms, but no firm rode the bull like Schwab. Customer accounts more than tripled, customer assets swelled tenfold, revenues jumped by a factor of six, and best of all, net income rose nearly fourteenfold (charts).

But 1998 is unfolding as a different story. Competition from both deep-discount Internet brokers and full-service investment firms is keener than ever. Commission rates are collapsing while expenses are surging.

True, judged by what’s coming through the doors, the Schwab juggernaut has lost none of its momentum. In the first quarter, 358,000 new accounts were opened, bringing the total to 5 million, and customer assets climbed $55 billion—$21 billion of which is new money—and now is over $400 billion. But here’s the bottom line: Revenue growth slowed to 13% and profit gains to just 2%. The stock, now at 35, is down more than 20% from its all-time high of 44, and it’s the only major brokerage stock with negative returns this year.

Over the past two years, daily trades have jumped 60% to 85,400, but commissions income is up only 23%. Now, commissions make up 49% of revenues, vs. 53% in 1995. »We can’t build a business on trading anymore because that service is a commodity,» says Susanne D. Lyons, president of Schwab’s Specialized Investor Services unit.

NO PROTOTYPE. Is the Schwab era about to end? In one sense, yes. The old Schwab that catered to the investors who knew exactly what they wanted is disappearing. What is emerging is Schwab II, shaped by the explosive growth of Internet trading and the mounting demand from investors for help and advice on where to put their money.

The Schwab team is striving to build a brokerage firm for which there is no prototype. »Schwab has got to become more of a full-service brokerage firm,» says David S. Pottruck, 49, president, co-CEO, and heir apparent to Chairman and co-CEO Charles R. Schwab, now 60. »But we’re not going to become another Merrill Lynch or Dean Witter.» Schwab doesn’t plan to spoon-feed investments to its customers. But with a strategy built around the Internet, the company aims to teach investors to feed themselves. »Our mission,» says Schwab, »is to coach people on investing.»

Schwab’s full-service competitors point out that investors already suffer from too much information and too little time—and that’s what will keep people coming to the full-service firms. »You need help in sorting out the information and figuring out what it means for you,» says Jay Mandelbaum, senior vice-president at Salomon Smith Barney. And John L. Steffens, vice-chairman of Merrill Lynch & Co. argues that while the bull market has made it easy for investors to fend for themselves, many will seek Merrill’s advice when times get tougher. Not that business is bad now. Both firms have been signing up customers at the rate of more than 30,000 a week.

Schwab is banking that more attention and service will keep customers from bolting. That’s what often happens as investors age, grow wealthier, and have larger and more complex portfolios. The average age of a Schwab customer is 47, vs. 57 for the full-service firms, and the challenge will be to keep older ones in the fold. Last year, 35,000 accounts left Schwab for full-service, or what Pottruck calls »full-cost» firms. True, 60,000 came in from those firms, but it burns the competitive Pottruck to lose even one. That’s why Schwab developed AdvisorSource, a network of 425 independent money managers. This way, clients who want advisers can get them, but the assets remain at Schwab.

For the take-charge types, Schwab offers enhanced services. Those who make at least four trades a month and maintain $50,000 in their account qualify for the Schwab 500 Active Trader service. Two monthly trades and $25,000 get customers into Schwab Select service. There’s no trading requirement for Priority service, just $500,000 in assets. Those with $1 million get the Priority Gold treatment.

With these services, clients don’t get personal brokers, but each is assigned to a small team in one of several national call centers with which he or she can plot a strategy for a large trade, discuss the merits of an investment idea, exercise stock options, or get a referral to an estate-planning attorney. »Your team is your concierge,» says Lyons.

Increased help and advice is the strategy that Schwab is using to build customer assets. And at Schwab, the key to profitability is gathering those assets, not trading them frequently. Schwab’s customer representatives are salaried, not commissioned, and incentive bonuses to branch staff are paid based on asset growth and the quality of the customer service provided.

The bigger the asset base, the less dependence the firm will have on commissions where competition is cutthroat. From the asset base, the firm can make money from margin lending, customer cash balances, and mutual-fund servicing fees.

Schwab insists his firm can remake itself without getting swept up in the merger mania engulfing the brokerage business. »I have no interest in participating in these megamergers,» says Schwab. »What for? We don’t need anybody else’s capital, and we don’t need anybody else’s technology, and we already have a national brand name.» He sold Schwab to BankAmerica Corp. in the early 1980s, only to buy it back and take it public in 1987. He does not rule out making an acquisition »if it would enhance customer service.»

Schwab says the firm can benefit from the merger wave without becoming part of it. »Those mergers are about cost-cutting and balance sheets and capital,» he says. »They’re not about serving the customers.» The founder’s opinion counts plenty. He owns 20.2% of the stock, worth $1.9 billion. An employee stock option plan has an additional 8.6%. Other employee holdings bring total inside ownership to around 40%.

Schwab II is a far cry from the novel idea Chuck Schwab had when he started the firm in the depths of the 1970s bear market. Investors were angry with their brokers, who were not only handing out bad advice but also were charging like bandits. Schwab positioned the firm as the un-broker. His goal was to give top-notch service but not push products or make recommendations on which stocks to buy. That worked well during the 1980s as the bull market took off. Even 10 years ago, says Pottruck, nearly all of Schwab’s new customers had had at least two years of investing experience.

»WARM CALLS.» But in the 1990s, customers arrived at Schwab’s doors who didn’t know a stock from a bond, let alone a mutual fund. Rather than turn them away, Schwab slowly moved into the advice business, plying newcomers with asset-allocation planners and investment tool kits, and offering them a select list of outside mutual funds that could be purchased through the no-fee OneSource program.

Schwab has even crossed some lines into what was once taboo. It now has proprietary products that carry the Schwab name, like a series of asset-allocation and index mutual funds. But here, too, Schwab differentiates its product from the house-brand funds at full-service firms: Schwab funds have lower management fees and levy no loads or sales charges. And, unlike most other brokerage funds, the Schwab equity funds are either index portfolios or funds that invest in other managers’ funds.

Another change in the Schwab culture: Customers never had to tell a Schwab broker »don’t call me, I’ll call you.» Now the firm makes »warm calls.» If you ask for an account application, but don’t fill it out, you’ll get a phone call to ask if you have questions or need assistance. Schwab is also testing software that will identify accounts where activity seems to have stopped, or cash has built up. »That could be a sign the investor is confused,» says Pottruck. In the future, such customers might get a call to ask if he or she wants help.

Then there’s the red-hot call. Frequent trader Joe Parascandolo of Holmdel, N.J. recalls that on a day the stock market was taking a dive, one of his Schwab 500 team reps insisted his wife rouse him from his sickbed. »I had several hundred index options and they collapsed from $15 to $2 that day,» says Parascandolo, who owns a printing business. »Because of that call, I got out at $12, and I saved $75,000 to $100,000.» He thinks Schwab’s team service beats the one-on-one approach at Merrill Lynch, where he has a small account. »It’s like having eight pair of eyes working for me,» he says.

The mass of Schwab clients, though, will have to use their own eyes. For stockpickers, the Analyst Center on the Schwab Web site rivals what many stockbrokers have on their desks: company and industry research reports from Standard & Poor’s Corp.; earnings forecasts by First Call Corp.; data on corporate insiders’ trading from Vickers Inc.; price and volume charts by BigCharts; interviews with executives and industry experts from Briefing.com; and news stories from Dow Jones & Co. Schwab now delivers Web users some reports for free that might cost a few dollars if ordered by mail or phone.

IPO ACCESS. Customers in the Schwab 500 and Priority services have access to their own Web pages, including a powerful sorting tool called Stock Screener, which allows users to hunt down stocks according to a myriad of different criteria such as stock-price performance, earnings expectations, market capitalization, or sectors and industries. Other perks include access to initial public offerings and online interviews with top executives like Intel Corp.’s Andrew S. Grove and Dell Computer Corp.’s Michael S. Dell.

All this data is generated elsewhere, and Schwab collects and delivers it. One thing you don’t get from Schwab is an official opinion on a particular company. That’s the stock-in-trade of full-service brokerage firms, and verboten at Schwab.

Schwab is beefing up its advisory services for mutual-fund investors, who hold about $131 billion in funds at the firm. Late last year, Schwab hired Mark W. Riepe from investment consultant Ibbotson Associates to head up the Charles Schwab Center for Investment Research. The in-house think tank tackles such questions as what are the rules to follow in deciding whether to sell a fund and what happens to performance after funds close to new investors.

Riepe is also studying such questions as what’s the impact on a fund of getting tapped for the Schwab Mutual Fund Select List. Making the quarterly list can lead to huge inflows that swamp a fund and undercut the reason for which it was selected. »Is it the dollar value of the assets that go in, or the amount of assets relative to size of the fund?» asks Riepe. »We’re still trying to nail that one.»

The Select List runs about 90 funds, a mix of domestic and international equity, asset allocation, and bond funds. Most, but not all, are in the no-fee OneSource program. The current list includes offerings from rival Fidelity Investments and even has several Vanguard index funds that compete head-on with Schwab products. Other information available to investors includes a one-page Mutual Fund Report Card on about 7,000 funds, highlighting performance, risk, ratings, and expenses. And this month, Schwab will introduce a customized one-page Mutual Fund Performance Snapshot that compares all the funds held by an investor with market indexes and other funds in the same peer group.

In reshaping the company, the branches—now 274—have been revamped in look and in mission. Gone are the teller-like counters for transactions, replaced with desks and private conference areas for meeting customers. Call the local branch, and you are switched through to one of five national call centers where much branch-like business can be handled by an automated line or rep—a trade, a request for a prospectus, or a question about an account. Customers can also ask to talk to an individual at the branch, but most queries never go that far.

That frees up time for branch reps to discuss with investors such topics as financial planning, mutual-fund selection, or the pros and cons of variable annuities. Over the last several years, reps have been replaced or retrained as the job has been upgraded from order-taking to help and advice. Reps are also encouraged to develop a specific field of expertise, like retirement planning, fixed-income investing, or insurance, which Schwab also sells.

Stocks, bonds, or funds, Schwab’s strategy relies on moving as many of its customers as it can onto the Internet. The more they go online for routine business—checking balances, requesting quotes, or making trades—the less the staffing needs at service centers and branches. On that score, Schwab starts with a solid base: 70% of customers own PCs, and 50% have Net access. About 29% of total accounts are online, and 300,000 of the 500,000 new customers who joined since January are also online.

PRIVATE CLASS. To speed the move to the Web, Schwab is putting Net-linked PCs in branches and offering training sessions. One branch manager even gave an in-home session to a customer who wasn’t able to make the classes. The company has also increased Web-trading capacity. Arthur V. Shaw, senior vice-president of electronic brokerage, says the Web system has already experienced several days when online trading exceeded that on Oct. 27, 1997, the day of the stock market’s minicrash. It’s a relevant comparison: Online customers of Schwab and others complained about inability to gain access to Web sites or execute trades that day.

Clients remain free to contact Schwab by other means. One criticism of its earlier Web service, e.Schwab, was that all contact had to be online, and phone calls or branch visits cost extra. That service has since been folded into Web trading.

The more customers migrate to the Web, the less pressure the company will face on brokerage rates. Schwab’s new charge for Internet trading—$29.95 for trades up to 1,000 shares and an additional 3 cents a share after that—is expensive by Net standards. In fact, it’s six times higher than the cheapest online discounters. »Others charge less, but I don’t trade daily or even weekly,» says Schwab customer James Willis, an automotive engineer from Frankenmuth, Mich. »The breadth of the information and the ability to talk to someone is worth a few dollars more.»

Indeed, for millions of Schwab clients, $29.95 is still far less than the standard commission rates. Right now, purchasing 200 shares of $40 stock would cost $103 in commissions in a branch or through telephone reps, and $93 if ordered through TeleBroker or using StreetSmart, a pre-Web online system.

Pottruck says that the company has bitten the bullet on commission rates—and shouldn’t need to go any lower. If anything, the rate cut spurred usage. Web trades now account for about half of all Schwab trades, vs. 37% last year. Schwab is by far the largest online broker, with 1.5 million accounts and 30% of the daily trading and 67% of all online assets.

FALLING BEHIND. But even if rates hold steady, the Web is a place where standing pat means falling behind. In the first quarter, Schwab ranked 7th out of 52 sites by Gomez Advisors Inc. which rates Internet brokerage sites. But in second-quarter rankings, Schwab dropped to 20th out of 69. »New entries and site redesigns have raised the bar,» says Alexander Stein of Gomez Advisors. What’s more, the fuller-service discounters like Quick & Reilly and Fidelity Brokerage Services now earn higher ratings than Schwab for their Internet brokerage sites.

Schwab’s Web service earns its highest ratings on »customer confidence.» But it does not fare as well in »ease-of-use,» and that’s critical if the company is going to get more people to use it. Webmeister Shaw takes issue with the criticism, since schwab.com is by far the Net’s most active brokerage site. »Part of our Web experience is, if you have a problem, you can get service and support right away,» says Shaw. »But we’re always trying to improve the ease of use.» Shaw is planning to redesign the opening pages with »clearer customer pathing» to the services they want.

Can Schwab succeed in planting a new sort of firm in a business that’s polarizing between deep-discount and full-service? Daniel O. Leemon, Schwab’s chief strategy officer, argues that demographics and technology will help make it happen. Of some 30 million U.S. households which have brokerage accounts, says Leemon, about 12 million are »delegators»—those who want to offload the investment chores to others—and 3 million are largely self-directed. But in the middle are 15 million households, what Leemon calls the »validators,» these are people who know what they want, but at times need some information or advice to confirm it.

Validators usually turn to full-service firms to get that support. But Leemon thinks Schwab can win over some of the validators’ business with the right mix of information, advice, and technology, and says extensive customer research bears this out. »Where we’re going,» he says, »is the direction in which our customers are leading us.»

Certainly, Schwab has ample resources with which to pursue its new strategy: a strong foothold on the Net, a young customer base, a branch network, and high brand-name recognition. It also plans to boost its ad budget by more than 20%, to over $100 million this year, and recently hired a new agency to promote retail brokerage. And it spends about 13% of revenues on technology. But the competition’s getting keener, too, and not just from the big Wall Street firms. Privately held Fidelity Brokerage Services competes for the same customers as Schwab. And a few rivals recently hooked up with deeper-pocketed parents: Quick & Reilly with Fleet Financial, and Jack White & Co. with the Waterhouse Investors Services division of the Toronto Dominion Bank.

Chuck Schwab believes he can harness the power of the Net to create a firm that delivers the kind of advice and services investors want. Considering his record as an innovator and judge of what investors really need, it would be foolish to bet against him.

By Jeffrey M. Laderman in San Francisco