Schwab Is `Fighting On Three Fronts'

As rivals invade its turf, the broker is inventing new ways to retain clients

On Feb. 5, David S. Pottruck, president of Charles Schwab & Co., nearly fell off his Stairmaster when he read that rivals Morgan Stanley & Co. and Dean Witter, Discover & Co. planned to merge. But after regaining his stride, Pottruck dismissed any threat from the unexpected union. "A grizzly bear and a koala bear just made it in the zoo," he quips. "Why should I be losing sleep over that?"

Perhaps he's not worried about that particular combo. But it's only the latest in a string of moves by big Wall Street firms and others to reshape themselves to court the small investors whom Schwab has so successfully romanced. Merrill Lynch, Smith Barney, Prudential Securities, and even NationsBank have all launched their own mutual-fund "supermarkets" to go head-to-head with Schwab's winning OneSource program. Merrill Lynch has also created an aggressive pricing structure to lower its fees and commissions. Fidelity Investments and Salomon Brothers Inc. have teamed up to offer Fidelity's customers Salomon's initial public offerings and research. And Internet brokers such as E*TRADE Group Inc. offer trading to the cost-conscious investors at half Schwab's commission. "Schwab is like an army fighting on three fronts," says Christos M. Cotsakos, E*TRADE's president and CEO, noting that the largest influx of new accounts at E*TRADE comes at Schwab's expense.

These maneuvers, coupled with an avalanche of aggressive ad campaigns and the sizzling market, make rivals appear to be closing in on Schwab. Michael A. Flanagan, a securities analyst at Financial Service Analytics Inc. in Philadelphia, says that from 1991 to 1994, Schwab's compounded annual revenues grew more than twice as fast as the industry average. But in 1995-96, Schwab barely edged out rivals--with 30% growth, compared with an industry average of 28%. "For the past 10 years, Schwab has had most of the arrows in its quiver," says Flanagan. "It now finds its competitors very well-armed."

Stiff competition is nothing new to the San Francisco discounter. "Competition is the source of all innovation," says Chairman and CEO Charles R. Schwab. So are industry shake-ups. In 1974, Schwab sent ripples through the brokerage Establishment by being the first to discount commissions. Then, Schwab transformed the way mutual funds are sold--with its 1984 launch of a supermarket that lets investors choose among a wide range of funds and consolidate them in one account.

Now, as the company sets its sights on the Internet and on offering customers financial advice, Schwab believes it's on the cusp of revolution No.3. "If Schwab remains sleek, [the industry changes] will give us more room for our own development and expansion," says Schwab.

LABYRINTHINE. So far, Schwab has done pretty well. The brokerage has expanded its earnings by 36% in each of the past five years. Customer assets, aided by a booming stock market and the increased control that individuals exert over their retirement funds, have more than doubled since 1994, to $253 billion. Even Schwab's 10-month-old Internet trading program has already captured $9 billion in client funds. And Schwab's stock has outperformed brokerage stocks in the Standard & Poor's 500-stock index, jumping 275%, vs. 160% for the industry group since the stock market bottomed in late 1994. "We really shouldn't be asking what full-service brokers are going to do to Schwab," says Richard K. Strauss, a securities analyst at Goldman, Sachs & Co. "We should be asking what Schwab will do to full-service brokers."

The discounter is spending heavily on computer programs to guide customers through the labyrinth of investment options. In February, Schwab launched Market Buzz, an information service on its Website that offers market news, data, and research. Perhaps most important, Schwab is beefing up the back-office support and investment services it offers to its network of 5,000 independent investment advisers. Those advisers' clients account for $72.9 billion, or nearly one-third, of Schwab assets. The company wants to increase its army of advisers, who are guaranteed at least one referral a month.

These days, Schwab's clients could use the help. A striking 50% of the brokerage's new customers today have never invested before--compared with less than 5% in 1987. "Our current push is to make sure that our customers who need help get it and that our customers who don't, don't get it--and don't have to pay for it," explains Pottruck.

To get that message out, Schwab has boosted its ad budget. In 1996, the company spent $84 million on ads, up from $53 million in 1995. This year promises to be even costlier, with the introduction of splashy campaigns on broadcast networks in addition to the cable channels.

Schwab is also retooling customer service, importing fresh ideas from outside the financial-services industry. For instance, Schwab has studied fast-food companies such as McDonald's Corp. to see how their management of franchises might help Schwab's interaction with branch offices. Pottruck has also met with the CEOs of Hewlett-Packard Co. and Home Depot Inc. to learn how they deal with customers. As a result, in part, the discounter recently consolidated its phone centers so that inquiries or complaints from customers at certain branches are answered by the same people each time. In addition, these phone banks free up branch employees to devote more time to assisting customers who need investment help.

IPO OPTION. Schwab is particularly interested in identifying customers who might defect to a full-service broker because they aren't getting the attention they need. By the end of 1997, the company hopes to have a system in place that will flag accounts in which there has been a fall-off in transactions or an accumulation of cash in money-market accounts. Schwab would then contact these investors to see if they need more assistance.

Improved service is only part of the strategy. Schwab is also trying to create a broader menu of products. To simplify mutual-fund selection, Schwab has rolled out "funds of funds"--giving investors an array of funds in one package. It's also testing a number of new products, including a futures trading program. Of course, not all the initiatives meet with customer approval. Trials for mortgages and credit cards, for instance, have been disappointing so Schwab won't be pushing on those fronts.

In addition, Schwab is talking to investment banks, notably Goldman Sachs, about forming an alliance that would give its retail clients the chance to invest in underwritings such as IPOs. Right now, Schwab's customers have to wait until a hot stock starts trading rather than buy it on the offering--usually at a lower price. Pottruck calls it "quite possible that we would have alliance with a firm like Goldman." Goldman Sachs declined to comment.

Of course, none of this means Schwab is on its way to replacing giants such as Merrill Lynch. Discounters and mutual-fund companies combined still only account for a quarter of the retail brokerage market. Moreover, some consultants predict that investors could flee discount brokerages when the current market turns bearish. "You'll see more people shifting back to full-service houses because they want hand-holding in a crisis," says Navtej S. Nandra, a partner in the financial-services group at Booz Allen & Hamilton Inc. Not if Schwab gets its way. Its game plan is to make its products, services, and investment advice so appealing that customers will have no reason to run.

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