- The earnings season is upon us, and Goldman Sachs is due to report on April 17th before the open.
- Goldman is priced to deliver negative alpha at a lower level than negative alpha available in the presently expensive markets. It is priced to hold, and even perhaps nibble.
- Market weakness could create a very decent buy opportunity for investors interested in allocating capital to the financial services sector.
I recently read this post on MarketWatch, and remembered the "vampire squid wrapped around the face of humanity" quote from Matt Taibbi. What a change: today we have Goldman Sachs leading the way towards a fairer marketplace for stocks!
Vampire Squid or not, long-term buy and hold style investors at Goldman Sachs have done quite well for themselves, relative to investors at other banks. After all, from amongst JPMorgan, Wells Fargo and Goldman Sachs, Goldman Sachs alone has been able to deliver a positive dividend and buyback yield over the past ten years. The Vampire Squid has outperformed the mere mortals by miles.
And it's not been unkind to traders either. Over the past three years, the standard deviation in weekly prices has been 4.08% for Goldman Sachs, and 2.11% for the S&P 500. Over the past five years, the standard deviation in weekly prices has been 3.92% for Goldman Sachs, and 2.21% for the S&P 500. And this will have provided traders with ample opportunity.
Anyway, the earnings season is upon us. And with reports due from Goldman Sachs (NYSE:GS) and Bank of America on April 17th and April 16th, respectively, this is an interesting time because we always see a price response to earnings expectations in the lead up to earnings, with potential for further volatility when expectations adjust based on new information available. When there is a price response, there is an opportunity to benefit from a price/value arbitrage.
In this post I express my perception of Goldman Sachs's value, and hopefully leave enough information to allow readers to form their own view on the value if they are so inclined.
In my view, a price to nibble at is $156: this price represents a very small premium to the book value per share of $152.48 at end of 2013. When I say "nibble", I mean a small position set at a level which will hurt the ego, but not the portfolio if the stock declines.
In my view, a price to buy to allocation lies near the tangible book value per share of $144. At this price the shares trade close to the $143.11 tangible book value at the end of 2013. When I say buy to allocation, I mean buy as much as you think is sensible to own for the long term: for example, if you'd like to own 20 stocks and allocate 5% to each, 5% is what should be allocated to Goldman Sachs.
And a price to bite can be found at $137 - this lies below the tangible book value per share of $143.11. At this level, the downside is likely limited, and it would make sense to return to allocation, and even consider an over-allocation to Goldman Sachs. At this price the low end of analyst expectations for 2014 are priced.
And I have a price to steal too. If the price ever gets to $122, the stock would trade at a 20% discount to book value: a very attractive level. At this price, the lowest analyst expectations for 2014 are priced using a higher investor return expectation (and therefore a lower multiple), on account of a rise in the three-year beta versus the five-year beta.
Ultimately, the markets are presently expensive. And within the market, most banks are yet more expensive. The pockets of value priced to outperform the markets and deliver alpha over the long term are to be found elsewhere. However, amongst the banks I have reviewed to date, Goldman Sachs has a negative alpha of 0.24%, which is lower than the negative alpha offered by the market at large.
How do different market participants view Goldman Sachs?
A couple of years ago, I had written some code to facilitate stock selection. You can view the model output here. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better.
AOM Statistical Scores
The AOM statistical scores are a statistical evaluation of thirty-eight key indicators for the company, grouped into value, growth, quality, and momentum categories. It illustrates how the key indicators for the stock, perform in comparison to the market capitalization weighted scores for the market, the stocks sector and the stocks industry of operation.
Goldman Sachs scores high on value, regardless of whether viewed relative to the broad market, or Goldman Sachs's sector or industry of operations. Growth scores are weak in comparison to the broad market, or Goldman Sachs's sector or industry of operations. Quality scores are mediocre across the board, though slightly higher when quality is compared versus industry participants. Momentum is ugly.
Source: Alpha Omega Mathematica
AOM Model Recommendation
This stock is attractive to persons who use a stock selection style with a value bias and allocate capital with no sector or industry bias. All else remain neutral to this stock.
Source: Alpha Omega Mathematica
Overall, after analyzing the fifteen stock selection and capital allocation strategy combinations, the system assigns an AOM Score of 52% and an AOM Hold Recommendation for Goldman Sachs.
The AOM statistical scores for each of the fifteen strategy combinations are unique and not comparable with each other. The AOM Score is very different from AOM Statistical scores: it evaluates and rates the AOM Statistical scores for each of the fifteen strategy combinations, and uses a unique technique to make the statistical scores across the strategy combinations comparable. The output is the AOM Score: a quantitative assessment of the output from the fifteen strategy combinations. The AOM Recommendation is a plain English recommendation based on the quintile the AOM Score falls in.
I'll hasten to add that this is a package aimed at generating ideas, it does not intend to, and nor does it replace the due diligence we must do as investors. It is a tool which uses quantitative techniques to understand the behavior of different market participants, and then brings that data together so that users can hear the voice of the market through the noise. The AOM system can guide you where to look, but make no mistake about it - it cannot look for you.
How safe is Goldman Sachs
Goldman Sachs in their annual report say:
And they add
And finally, in their annual report, they estimate that their supplementary leverage ratios [SLR] are at 5%.
Based on this, it does appear that Goldman Sachs will not have problems meeting the new Basel III regulatory requirements. The SLR at Goldman Sachs is likely strong enough to satisfy proposed U.S. regulations, which might lead to the SLR for the top eight U.S. Banks being raised to 5% for the Holding Company and 6% for Insured Subsidiaries. Though I suspect there will be a small impact on the capital plan to strengthen the SLR. And this suggests they are safe.
The Case for Goldman Sachs:
Why look at Goldman Sachs now?
Firstly, Goldman Sachs is a mega cap stock. This gives it a defensive character, which appeals to me when I perceive the markets are expensive.
Goldman Sachs pays a dividend of $2.20 per share which provides a dividend yield of 1.4%, which is a considerable discount to the dividend yield offered by the broad market. The Federal Reserve Board [FRB] did not object to the Company's 2014 Capital Plan after Goldman Sachs made revisions. However, unlike other banks, Goldman Sachs is not forthcoming with the details of its return of capital plan. I'll be looking for a hike in dividend to $2.30, which provides a dividend yield of 1.47%. This is lower than other banks, but yet much better than other banks, because Goldman Sachs is amongst the few majors that has actually successfully returned value to shareholders through buybacks net of dilution on account of employee share issuances.
JPMorgan conducted buyback programs, but despite these buybacks, annual average shares outstanding rose at an annualized rate of 2.96% over the past ten years. Wells Fargo was worse, with annual average shares outstanding rising at an annualized rate of 4.60% over the past ten years. And in the case of both, the dilution rates shareholders suffered is greater than the present dividend yield.
Like others in the financial services sector, executive compensation is overly generous at Goldman Sachs. Banking at its heart is a simple business: it connects depositors and lenders to borrowers, and buyers to sellers. Unfortunately, the mid ground where risks get managed gets overly complicated, at least in part due to a poor incentive structure. But we can't hold this against Goldman Sachs, since it is an industry wide problem, and perhaps even a nation-wide problem!
Yet, at Goldman Sachs, over the past five-years, the annual diluted average share count has declined by 2.14%, which represents an annualized rate of 0.43%. This is pretty creditable considering the impact of the Warren Buffett transaction in 2013, which is likely a one off event.
Looking at things over a ten year period, we see a decline in annual average diluted shares of 9.31%. This works out to an annualized rate of 0.97%. In my view this is creditable when we viewed in light of the crisis years, and the dilution suffered at other major banks.
So despite a stingy dividend pay-out ratio of 13.3%, which is expected to provide a dividend yield of 1.47% assuming a dividend hike to $2.30, the pay-out ratio including value returned through buybacks is likely to be close to 50%.
During 2013, Goldman Sachs has net earnings of $8 billion, and paid a dividend of $988 million, and spent $6.2 billion in share buybacks. As a consequence of the buyback program, share count declined by 4.12%. Add this to your dividend yield of 1.4%, and compare the 5.52% with the dividend plus the buyback, net of dilution yield provided by other banks and you will find Goldman Sachs came out on top.
Beta, co-efficient of determination and alpha intercept considerations
Value Line reports a beta of 1.15 for Goldman Sachs: you can download their report here. The Value Line beta is calculated as a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge towards one.
I calculate the raw beta based on the five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the S&P 500 at 1.22, and I adjust it to 1.10 on account of the beta's tendency to converge towards one. This beta of over one can be constructive in a rising market, and destructive in declines, thus it cannot be said to possess defensive characteristics.
The coefficient of determination for Goldman Sachs is 47.25%. This suggests that 47.25% of the price movement in Goldman Sachs is explained by movements in the market: the residual price movement is based on company specific factors. This coefficient of determination suggests that the market related risks are average. And because 52.75% of the price movement represents company specific risks, these risks should be diversified.
A note of caution: the raw beta based on a three year regression has risen to 1.40, and adjusting this beta for the convergence towards one tendency provides an adjusted beta of 1.21. In addition, the three year coefficient of determination has risen to 52.56%. This suggests that the risk at Goldman Sachs as far as it relates to the broad market is rising.
Cyclicality and Goldman Sachs
In my view, the U.S. economy is getting ready to shift from mid-cycle to late-cycle conditions. And during late-cycle, no discernible pattern is evident for stocks in the financial services sector. In my view, the late-cycle conditions are associated with a flattening of the yield curve, and even an inversion towards the end of the late-cycle. If I am right, this is negative for Goldman Sachs investors, but it is a positive for potential investors in Goldman Sachs, because late in the late-cycle and early in the recession is a time when a buy opportunity often, but not always arises. And coming on the heels of a recession is the early-cycle: a period when the financial services sector tends to outperform very substantially.
You can have a look at this information from Fidelity here to understand their take on sectors and the business cycle. One note of caution: I find reading the business cycle is getting increasingly difficult with globalization - for instance today I think U.S. is exhibiting classic signals of a move towards late-cycle conditions. However, the global business cycle is quite out of sync, with the U.S. business cycle. And since many U.S. companies are very influenced by the global business cycle, it is more difficult to figure out how U.S. sectors will behave. For example, if Europe, other developed markets, or emerging markets, shift into early-cycle conditions, this is a time when the financial services sector typically outperforms, and U.S. companies in the financial services sector could well outperform too.
Analyst price expectations
Recently Goldman Sachs traded at $155.98. From Yahoo Finance we know that twenty-three analysts expect an average price target of $176.87 (median $180.00), with a high target of $205 and a low target of $136. This is a wide dispersion in expectations, which suggests risks are high. It is early in the year. So far, with the share price at $155.98, the bulls looking for $205 trail the bears looking for $136.
We might believe that Goldman Sachs is attractively valued. But thus far, its attractiveness has been viewed relative to other stocks in its sector, industry or the coverage universe in the analysis of the perception of different market participants. We also know that Goldman Sachs is cheap relative to the broad markets. What we do not know is whether the stock is priced to deliver a long-term return in-line with our long-term expectations on a stand-alone basis and regardless of broad market valuations.
Mathematically, the worth of Goldman Sachs is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Pay-out Ratio / [Long-term Return Expectation-Long-term Growth Rate].
What is our long-term return expectation for a stock with a beta of 1.10, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for Goldman Sachs, we should be targeting a long-term return of 10.825%. Is the stock priced to deliver that return?
Earnings tend to be volatile from year-to-year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time.
Twenty-seven analysts included on Reuters data estimate average earnings of $15.30 (High: $16.62, Low: $13.84) for the year ended December 14, while twenty-eight analysts estimate that it will rise to an average of $16.65 (High: $18.00, Low: $12.91) for the year ending December 15. Three analysts assess long-term growth rates at 5.39% on average, with a high estimate of 6.60% and a low estimate of 4.58%.
This chart displays normalized diluted EPS on a trailing twelve month basis for the past five years and estimates for the current and coming three fiscal years.
I am comfortable with $15.00 as a fair representation of sustainable earnings.
I expect Goldman Sachs will pay out approximately 13.50% of earnings via a dividend, and 36.50% via buybacks. That will leave 50.00% available for reinvestment in growth. This 50% of retained profit re-invested at an 11% return on equity, indicates a long-term potential growth rate of 5.50% (50% * 11% = 5.50%). This return on incremental equity is not unreasonable to expect, and it is consistent with the return on equity during 2013.
The buyback program is likely to be in excess of 36.50%. However, the excess will not constitute a return of shareholder value. The company retains 50% to reinvest in growth, and one of the key areas of investment is employee incentive and retention. If 15% of earnings are earmarked for investment in employees, and is provided via share grants and options, then when shares are issued to employees, we will have a dilutive event. And the buyback program could be raised to offset the dilution. But this element of the buyback program is not considered a return of shareholder value. It represents payment of consideration on account of an investment in growth.
If we use a very long-term growth expectation of 5.74%, Goldman Sachs is worth $155.98. Goldman Sachs Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Pay-out Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 105.74% * $15.00 * 50% / (10.825%-5.74%) = $155.98. At this price, it is likely that an investor with a return expectation of 10.825% will be satisfied.
The growth estimate implied by the current market price of 5.74% is reasonable. Alpha is the difference between actual returns and the risk adjusted return expectation. If Goldman Sachs grows at a long-term rate of 5.50%, in line with my estimate, we have negative growth alpha of 0.24%. And an investor buying at present levels can expect a long-term return of 10.585%. And since this negative alpha is lower than the negative alpha offered by the markets as priced, $155.98 is an acceptable price to nibble. This price level is near Goldman Sachs' book value per share of $152.48 at end 2013.
A better buy price is $144, which lies nearer the tangible book value at end 2013 of $143.11. This represents good value, assuming a long-term growth rate of 5.75%, sustainable earnings of $13.84 (the low analyst estimates for 2014), an adjusted pay-out ratio of 50%, beta of 1.10, and an investor target return of 10.825% (105.75% * $13.84 * 50% / (10.825%-5.75%)=$144). This is a time to buy.
A yet better buy price is $137: a price level close to the analyst low expectation for Goldman Sachs. This represents good value, assuming a long-term growth rate of 5.50%, sustainable earnings of $13.84 (the low analyst estimates for 2014), an adjusted pay-out ratio of 50%, beta of 1.10, and an investor target return of 10.825% (105.50% * $13.84 * 50% / (10.825%-5.50%)=$137). This is a time to bite.
However, given that the three-year beta versus the five-year suggests that beta risk is rising, it might be worth waiting for $122 (if it gets there) to bite. Raising the beta estimate to 1.21 would change the target return expectation to 11.4575%. And a higher return on expectation means a lower multiple. At this price we assume a long-term growth rate of 5.50%, sustainable earnings of $13.84 (the low analyst estimates for 2014), an adjusted pay-out ratio of 50%, beta of 1.21, and an investor target return of 11.4575% (105.50% * $13.84 * 50% / (11.4575%-5.50%)=$122). At this price you would be getting the shares at a 20% discount to book value: in my view this is a level which is very attractive, even irresistible, indeed a price to steal.
If you use the above formula, do read this explanatory note.