Discount Brokers: Disruption, Bundling, and the Battle for the Mass Affluent; Part 1

I define culture as the set of unspoken assumptions that guides behavior.  Whether it intends to or not, every company has a culture.  However, not every culture, even ones underpinned by values that make the world a better place, confers competitive advantage.  From the perspective of value creation, the question is not so much is such-and-such company mission oriented, innovation centric, committed to diversity, and customer obsessed – assuming those values truly are inculcated in the company’s implicit norms and behaviors – but rather, is it more so than its competitors who often profess the same exact thing and is this a governing explanation for the company’s success?  In light of how difficult it can be to confidently gauge a company’s culture, differentiate it from peers, and validly attribute success to it, I feel that culture is too gratuitously and casually referenced as a moat, by both investors and management teams. 

Someone once said “culture eats strategy for lunch” and who would disagree?  Culture is what guides the innumerable day-to-day decisions that can’t be dictated by explicit mandate; culture arguably gives rise to strategy and incontestably sustains it.  But arguing that culture is critical to success is sort of like saying gravity causes planes to crash: it’s not necessarily wrong, just too obviously and broadly true in most cases to be helpful as an explanation.  Google, I’m sure, has an innovative culture.  So do countless tech start-ups that failed.  An innovative culture may be a reason why Google didn’t fail, but I would not count it among the unique governing explanations for its success. 

But then there are select cases where culture talk doesn’t feel cheap, where there exists a clear and obvious foil in the form of an industry whose antiquated behaviors and norms stand in stark relief to those of the company.  CarMax in relation to most used car dealers comes to mind.  So does Charles Schwab in the 1970s and 1980s¹. Throughout most of this country’s history, the member firms of all American stock exchanges comprised a swarthy cabal that colluded in charging their customers the same fixed rate to buy and sell shares, no matter how small or large the order.  Absent the forces of competition to align price with value, a retail investor trading 100 shares was charged the same commission as a financial institution trading 10,000 shares.  Those commissions sustained a hopelessly conflicted system that fed throngs of salesmen who pushed inappropriate securities to customers and pressured research analysts to more of less automatically assign “buy” ratings on the companies these full service brokerages were advising. 

Then, in May 1975, regulators abolished fixed rate commissions, introducing competition to the brokerage industry for the first time in 183 years,  giving rise to a crop of discount brokers who delivered on a set of different value propositions.  Extricated from conflict ridden investment banking relationships, discount brokers were under no pressure to “sell” securities and could dedicate themselves to doing right by investors and traders, executing trade orders at commission rates that full service wirehouses, encumbered as they were with bloated research and sales staffs, could not match.  While the full service brokers cut their commissions between 25%-60% following “May Day”, they reserved those price cuts for mutual funds and other financial institutions with large orders, leaving an opening for discount brokers to pursue the retail investors who were left holding the bag². The first of these discount brokers was Charles Schwab. 

Named after its eponymous founder, Charles Schwab’s setup cut against the prevailing norms of financial institutions at the time: it was headquartered in San Francisco, not New York City; its charismatic and kind-faced founder placed his own image in advertisements, a human touch that was considered gauche by the anal retentives at Merrill Lynch and EF Hutton; it hired women and minorities and felt no misgivings placing them in positions of authority; it invested aggressively in technology.  Schwab was the first discount broker to adopt an automated order entry system and had an independently operated skunk works division that developed some pioneering technology, including a service that allowed customers to retrieve real time stock quotes and news from a touch tone phone and later, make trades.

[the contrast between Schwab’s renegade, laid back attitude and the staid, humorless tones of the financial institutions at the time was starkly on display when Bank of America acquired it in 1981.  So culturally at odds were the two entities, so dyspeptic was Chuck’s presence in the boardroom, and so fed up were Schwab’s managers of B of A’s suffocating bureaucracy, that Chuck and his lieutenants effected a management buyout of Schwab 6 years after being bought (and IPO’ed 8 months after that, barely missing the 1987 crash)].

But perhaps the thing most behaviorally at odds with full service incumbents was Schwab’s fierce and single minded dedication to serving investors.  For Schwab, at the beginning, serving investors meant removing any incentive scheme that even whiffed of misaligned interests: brokers were paid salaries, not commissions, and were forbidden from recommending stocks and mutual funds.  The rule proscribing investment advice was so precious that brokers could be (and were) fired for violating it.  To forestall the possibility of a personal relationship developing between its brokers and its customers (brokers were discouraged from referring to investors as “clients”) – the sort of one-on-one fraternizing that traditional wirehouses exploited to rip off investors – trade orders were randomly routed to whoever was available to take the call. 

The company had no physical branches; rather than interacting with dedicated points of contact, customers were instead encouraged to “talk to Chuck”. For the first ~decade this no-touch arrangement worked fine, as early adopters of discount brokerage services were mostly self-directed traders who didn’t really need or want assistance.  But as Schwab’s customer base expanded to include relatively inexperienced investors who, in fact, were requesting but being denied a helping hand, the expression of Schwab’s cherished customer centric values – as an army of brokers ready and able to provide excellent trade execution but nothing else – clearly needed re-thinking. 

Now, despite Schwab’s drive towards automation and its dismissal of client relationships, the importance of human connection was recognized from the very start.  Schwab opened its first branch office in 1975, just a few years after its inception and certainly well before it even tacitly acknowledged the wisdom of a high touch approach.  Something about seeing a physical structure apparently provided psychological relief for investors who wanted to be “close” to their money, even if they no intention of frequenting the office after opening their accounts there.  Even as late as 2000 – by which time the company was a trusted, well-known brand and most customers conducted their trades online – half of Schwab’s retail flows still came from its branches. That’s not to say that in representing itself as an honest broker, Schwab was purely motivated by consumer welfare.  Without even applying a cynical lens, you could argue that Chuck’s prohibition of personalized financial advice had little to do with eschewing perverse incentives and was more about commodifying brokers into simple order takers who were handicapped from developing client relationships that could be poached; that by hiring order takers rather than advisors, the company could legally avoid the regulatory constraints that, at least in theory, required brokers to tailor financial advice to customer risk tolerances because Schwab, in a real sense, didn’t know the financial circumstances of its customers; that Schwab’s low commission rates couldn’t support a knowledgeable advisory staff anyhow.