Since the start of this year, Charles Schwab (SCHW 0.13%) has been the subject of investor scrutiny. The company saw some deposit outflows related to interest rates reaching their highest level in decades. After a couple of regional banks failed in March, Charles Schwab's deposit struggles came into focus.
Schwab stock is down 34% this year and trades around its cheapest valuation in years. On the surface, the stock looks like an intriguing option for value investors. However, before buying Charles Schwab, you might want to take a closer look at Morgan Stanley (MS 0.29%). The banking giant navigated a challenging market for financial companies and has levers it can pull to bounce back big when market conditions improve.
Charles Schwab's "cash sorting" problem
Charles Schwab offers a variety of financial services to customers, including wealth management, banking, brokerage, and other financial advisory services. The company has dealt with challenges stemming from interest rates at a level not seen in two decades. These high rates are due to the Federal Reserve's strategy to aggressively raise its benchmark interest rate as it attempts to put a lid on inflationary pressures in the economy.
As a result, Schwab has dealt with something it calls "client cash sorting," where clients move funds from low-yielding assets to higher-yielding ones, such as high-yield savings accounts, money market funds, or certificates of deposits (CDs). At the end of 2021, before the Federal Reserve raised interest rates, Schwab had $444 billion in bank deposits. As of June 30, Schwab's bank deposits have fallen nearly 32% to $304 billion.
Morgan Stanley's robust business model
Morgan Stanley provides various financial services, including investment banking, wealth management, and brokerage services. Something Morgan Stanley has going for it is its wealth and investment management businesses. A couple of years ago, it made a smart move by expanding its presence in these areas by acquiring Eaton Vance and E*Trade for $20 billion in total.
Morgan Stanley previously relied heavily on investment banking services for revenue, which subjected it to fluctuating income based on how active the capital markets were. By expanding into wealth and investment management, the bank diversified its deposit base and revenue stream, which gave it more resilient cash flows during different times of the economic cycle.
In the first half of this year, revenue from wealth management grew 13% and helped balance out a decline in investment banking activity. Morgan Stanley also doesn't share Charles Schwab's cash sorting issue. At the end of the second quarter, Morgan Stanley's deposits of $348 billion were right around where they were at the end of 2021.
Comparing the valuations of Charles Schwab and Morgan Stanley
Charles Schwab stock historically trades at a premium to Morgan Stanley, in part because of Morgan Stanley's less predictable business that relied heavily on the active markets of initial public offerings (IPOs) and mergers and acquisitions (M&A). However, Morgan Stanley's acquisitions made its business more robust, and the valuation gap between the two stocks has closed.
Today, Morgan Stanley trades at 14.7 times earnings compared to Schwab's valuation of 16.1 times earnings. A more pronounced difference is seen between the companies' book values. Schwab is valued at 3.6 times its book value, while Morgan Stanley trades at around 1.5 times its book value.
SCHW PE Ratio data by YCharts
Morgan Stanley has a potential catalyst that can drive revenue growth
On a valuation basis, Morgan Stanley has an edge. I also like the company because it hasn't faced significant deposit outflows and held up much better than Schwab during the Fed's rate-hiking campaign. Not only that, but Morgan Stanley's investment banking business gives it added potential upside.
Investment banking activity slowed to a crawl in recent years, but the slowdown hasn't hurt Morgan Stanley as much as it would have in the past. Action will eventually return to these capital markets once interest rate volatility slows down and companies see more certainty on the future path of interest rates. When that happens, pent-up IPO and M&A activity could propel solid growth for Morgan Stanley, which is why I think buying this stock over Charles Schwab today is a smart move.
