David Sterman

The finance department at Charles Schwab (Nasdaq: SCHW) has a very large problem.

The firm has been so successful at attracting clients over the past half-decade that the cash Schwab holds for its clients has swelled nearly 190% from 2008, to a recent $86 billion. But in this era of low interest rates, the firm hasn't been able to fully capitalize on that success.

Schwab's net interest margin (which is the difference between the rate it pays to clients in their cash accounts and Schwab's own interest income on those assets held) has been squeezed to almost nothing.

Yet good new lies ahead. As interest rates start to rise, so will Schwab's net interest margins. It happens every cycle, and investors are only just beginning to warm up the profit boom yet to come. Shares of Schwab have already begun to move up in anticipation of this trend, moving back into the mid-$20s, right where they stood back in 2007.

But investors shouldn't think they've missed the boat. Schwab's base of clients has more than doubled since 2007 (leading to assets under management that now exceeds $2 trillion). So as interest rates move back to levels seen in 2007, Schwab is likely to post stunning amounts of interest income.

And Schwab's not alone. A host of other companies are anxiously awaiting the rebound in interest rates. Take Automatic Data Processing (NYSE: ADP) as an example. ADP takes in billions of dollars for its clients in order to cut payroll checks, and always aims to generate excess profits on that cash. ADP doesn't need to remit any interest profits back to clients, unlike Schwab, which must pay money market rates.

Back in fiscal 2008, ADP earned nearly $700 million in client interest income. These days, that figure has fallen by half. Analysts at Merrill Lynch predict that interest income will steadily rebound in fiscal 2014, and perhaps hit record levels in fiscal 2015, in part because the company's client base is now meaningfully larger than it was back in fiscal 2008. And they think that makes ADP a timely investment: "Over the last 20 years, ADP shares have had average annual gains of 16% when US short term interest rates were stable or rising (versus 6% gains in falling rate periods)," they noted in a recent research note.


David Sterman

David Sterman has worked as an investment analyst for nearly two decades. He is currently an analyst for StreetAuthority.com
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