Goldman Sachs: The Strongest And The Cheapest

| About: Goldman Sachs (GS)

A few days of relative underperformance don't take away the iconic status of Goldman Sachs (NYSE:GS). Rather, it presents an interesting opportunity to buy the investment bank having a strategic competitive advantage. Goldman's management intends to keep its reliance on technology to maintain its competitive edge and profitability. On the technology front, Goldman has recently taken few initiatives to expand its direct market access, and solutions related to the algorithmic trading and smart order routing.

Investment Rationale

GS remains the best brokerage franchise, and despite a challenging operating environment for the brokerage industry, I have an overweight stance on the stock. The stock deserves premium valuation due to its solid positioning in the market, balance sheet strength, superior technology and a good track record of gaining and sustaining market share. In 1Q12, quarterly dividend was raised to $0.46/per share, a 31% increase. In addition, so far Goldman has been successful in its cost cutting initiatives. I expect Goldman to continue deliver results above that of its peers.

Recent Earnings Report

Goldman reported 1Q12 earnings on April 17th. Net revenue of $9.95bn was down 16% year over year. However, it was higher than the street expectations of $9.4bn. Its earnings per share of $3.92, too, were higher than the estimated $3.55. Market participants were not happy with these results and the stock traded down nearly 75bps.

If one reads between the lines, the earnings report is not a disappointment. During 1Q12, they were able to reduce risk significantly: the daily VAR was reduced by $40m to $95m. The fall in revenue was a result of 20% decline in fixed income trading revenue. Its counterparts JP Morgan (NYSE:JPM) and Citi Group (NYSE:C) reported lower drops in the fixed income trading revenue. The reason could be Goldman's recent focus on the equities and investment banking divisions. Investment banking revenues of $1.2bn were higher than the forecast; the same is true for the equities division where net revenue of $2.25bn makes it one of the best in class.

On the front of cost reduction, they were able to reduce the non-comp expense by 8.8% or $231m.

Industry Overview

The banking sector is expected to post sluggish growth over 1H of this year. Slow economic recovery in the US and Europe-specific risks will continue to haunt the industry. As a result, valuations across the board for banks and diversified financials are at a heavy discount. However, I believe that the share repurchase programs and rising dividends along with the continuation of improvement in macro-economic fundamentals in 2H2012 will help the bank stocks to trade higher.

The catalysts for growth in the core bank earnings will be as follows:

  • Loan growth recovery
  • Improvement in the credit cost
  • Continuation of expense reduction efforts
  • Share buyback programs

However, the interest rate environment will remain challenging, putting pressure on the net interest margin and hampering the earnings growth.

As for the brokerage industry, the year 2012 started with improved activity levels, investors' increasing risk appetite, and rising asset prices. Improvement in US economic data, post LTRO alleviation of Europe related risk and actions taken by global central bank to open swap lines all made their contribution. In any case, the activity in the equity market remains on the much lower side, and the new issuance plus M&A activity have not increased significantly. Uncertain macroeconomic events will remain a major headwind and will keep the environment challenging for the industry as a whole, translating into higher capital and liquidity requirements. Recently there also has been stress on greater automation, transparency and globalization.

Company Profile

The Goldman Sachs Group Inc. is engaged in global investment banking, securities and investment management and other financial services primarily dealing with institutional clients. Its subsidiary, Goldman Sachs Bank USA (GS Bank USA) offers banking services chartered in the New York State. The group operates in three segments: Investment Banking, Institutional Client Services, Investing & Lending and Investment Management. The firm provides consulting and advisory services related to mergers and acquisitions, underwriting, asset management and prime brokerage services.

Key Focus and Current strategy

According to the IMF, European banks might have to reduce their scale of business due to forced asset sales. The resulting deleveraging will likely open new avenues for the company over time and is also likely to increase sales and market share. This deleveraging may also increase investment banking mandates and acquisition of distressed assets.

From the risk perspective, the company maintains high levels of liquidity and capital. The firm was able to reduce its relatively illiquid assets by 50% compared to its highest levels, at the same time Level 3 assets were brought at 5% of total assets. Moreover, the firm increased its weighted average maturity by over 50% since 2008.


JPMorgan Chase, being one of the major competitors of Goldman, also stands out due to the strength and stability of a senior leadership team and its balance sheet. JPM repurchased $950mn shares in 2011 and plans to repurchase more during this year. Its dividends are rising too which is likely to give upside to stock prices in the near future.

Credit Suisse Group AG (NYSE:CS), on the other hand, still holds high-risk assets. However, EPS for the company is expected to grow by 75% over 2012, which is likely to increase ROE for the company from 8% in 2011 to 12.7% in 2012.

Morgan Stanley's (NYSE:MS) adjusted earnings are expected to decline by 31% in 2012, while dividends are expected to remain flat. However, the firm has extremely healthy capital ratios, which adds room to enhance its earnings going forward and can take more risk to achieve growth.

Capital Ratios

Goldman Sachs maintains healthy capital ratios in line with most of its big peers. Firm's Basel III Tier 1 Common ratio stood at 8%, which is expected to reach at 11% by 2013. At the same time, Basel III Tier 1 common ratio for JPM and CS was 7.9% and 6.9% respectively. Only MS had a Basel III Tier 1 common ratio higher than that of GS at 9.9%. The Core and Total Tier I ratio for the firm, at CY11 end, stood at 12.1% and 13.9%, compared to 10% and 12.3% for JPM, 9.3% and 15.2% for CS, and 13.1% and 16.7% for MS respectively.


The stock is trading at forward P/E of 8.7 times and P/TBV of 0.95 times compared to the peer average of 11.0 times and 1.4 times, respectively. JPM is currently trading at forward P/E and P/TBV of 7.2 times and 1.1 times; CS is trading at forward P/E and P/TBV 6.9 times and 1.2 times, while MS is trading at a forward P/E and P/TBV of 8.2 times and 0.8 times respectively.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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