Goldman Sachs, without doubt can be deemed as a global leader in investment banking and securities services – with an extensive history and a prestigious list of alumni to boast of, Goldman Sachs has been at the front of the current financial crisis – inviting the wrath of main-street. A strong network of alumni, dotted in government and academia across the world – coupled with a generous compensation structure, has kept Goldman Sachs amongst top-tier investment banks and security service providers.

Over the course of last 100 or so years, the bank has been at the forefront of financial innovation, and has been spearheading the movement for Wallstreet – and hence has been able to withstand financial storms, time and again. In the recent financial crisis, in order to shore up its capital position – Goldman Sachs restructured itself into a commercial bank, enabling it to receive bailout money, which amounted to USD10bn. The low-cost, albeit almost free funding has been used to yield billions in additional profits by executing bets on various sectors of the economy, both macro, and micro. With the global economy still in recession, and susceptibility of the sector to both economic and financial shocks, ability of Goldman Sachs to yield value for investors in the short term remains undermined.

Goldman Sachs’ business model revolves around underwriting services, institutional client services, proprietary trading, and the brokerage business. In the current scenario when the broader index of all major economies is crashing, and there is uncertainty regarding the financial future of key Europeans states, possibility of Goldman Sachs to continue making money like pre-08 levels is minimal. Although the stock does provides long term value, but given its susceptibility to litigation, and regulatory risk – a long term positive call may be a risky proposition.

Latest quarterly results depict a net loss of USD393m, which is only the second quarterly loss in the last 12 years – possibly driven by drop in S&P500 and Euro Stoxx by 14%, and 23% respectively, which led to major write-downs in asset valuation. A drop in overall equity valuations yielded investment write-downs of roughly USD3bn in its merchant banking unit – which executes proprietary trading, as well as investments from clients (Goldman Sachs – Financials).

It is however essential to review the granular details of investment write-downs – with one-third of loss emanating from equity investments, a third from investment in ICBC (Industrial and Commercial Bank of China), and the final third from debt investments. Although the revenue in the division has attained growth over last year, but such massive write-downs certainly suggest sensitivity to broader market movements.

Notwithstanding the massive drop in equity and debt values across the board, Goldman Sachs’ ability to generate returns from its investments has been weak lately. It is surprising to note that over a period of last 4 years, the bank has only been able to generate an aggregate gain of USD0.8bn, on an investment portfolio of USD72bn. Although revenues in 2010 were able to recoup losses in 2008, but a marginal performance in 2011 has kept overall returns low.

Given Goldman Sachs recent experience with its investment, it can be clearly seen that value in the merchant banking division is correlated with overall macroeconomic growth – making the business division highly cyclical. Although it has yielded excessive gains via short sales, and betting against the market – but overall position of book remains susceptible to macroeconomic fundamentals. A prolonged recession, and flat (or declining) equity markets may not bode well for the firm’s star division. In such a scenario, the short term outlook is negative, as equity markets are not expected to resume their upward trajectory anytime soon – however solid long term potential does exist – but that is diluted by the risk of over regulation.

A review of the firm’s traditional business of raising capital, trading security, and providing advise depicts that, the ability of Goldman Sachs to make solid gains in this division is directly proportional to the ability of its clients to execute economically relevant (or irrelevant in certain cases) transactions – which are generally correlated with a growing economy, and positive macroeconomic fundamentals.

Keeping in view the state of the global economy, even though it is growing – but slowdown and increase in volatility certainly does not bode well for the agency business. Although revenue from the business stream has only contracted by 2% on a sequential basis – but it is down 17% on an annual basis and a whopping 58% from 2009 peak levels. Slowdown in economy continues to hamper ability to sustain or kick start an upward growth trajectory.

Depressed earnings and outlook for both merchant banking, and agency business necessitates an uncertain outlook for the stock in the near term. Another key division which is also exhibiting shrinking revenues and overall loss of luster is the FICC business. In presence of significant risk in competition over the last two years, and the structural reduction in many FICC products – in particular the highly structured products, the rosy days of 2009 (when FICC revenues were in excess of USD6bn a quarter) may not be seen in the near term. It is to be noted that that over the last seven quarters, FICC revenues have been consistently underperforming its peak.

In addition to marginal performance in its key divisions, even the international investment banking business may not provide some sort of buffer, despite presence in key emerging markets. But with intense competition in those markets, with presence of global financial bulwarks and local/regional institutions – ability of Goldman Sachs to carve out a niche for itself in the international arena may also not be possible.

Investment thesis for Goldman Sachs revolves around its ability to recoup its operations and return revenue levels to pre 2008 levels, but amidst global financial crisis that may not be possible. It is however noted that leverage levels and liquidity position of the company has certainly improved – which can be a sigh of relief for investors and bond holders who are strategic long term investors. Although earnings and stock price is suffering, but quietly the management is buffering up capital structure – and making Goldman Sachs ready for another shock which may result in massive capital shocks (and consequent injections).

It is interesting to note that key rating agencies, viz, S&P and Fitch have explicitly stated that external rating of Goldman Sachs may be too high, and a credit downgrade may be expected in the near term given its market sensitive operating model. As Goldman Sachs is now effectively a commercial bank, its leverage and liquidity (despite improvement), trails that of other large depository institutions, such as Wells Fargo, AMEX, and State Street. Goldman Sachs hence now treads on a fine line between an investment bank (focusing on proprietary trading, merchant banking, and agency business) and commercial bank (deposit collecting institutions).

Notwithstanding depressed earnings levels, and overall flat broader indices – key systemic risk can also be traced to regulatory risk, and litigation risk. Impact of regulation and litigation cannot be quantified under current circumstances, but nevertheless these two factors do pose a tangible threat. With the global economy still in doldrums, populist opinion of financial institutions like Goldman Sachs is negative. Although the bank does have political clout, but the possibility of strict regulations which may hamper the bank’s (and competitor’s) business model cannot be ruled out. A restrictive regulatory regime may severely constraint bank’s ability to generate returns and free cash, which may have an adverse impact on the stock price. Similarly, litigation charges and possible criminal indictment may certainly do not favor long term sustenance.

In view of strong negative public opinion against Wallstreet, and Goldman Sachs in particular – if the Department of Justice files criminal charges against the bank, it may well be the final blow. The possibility of such an event occurring is low, but the severity is massive – as that may led to major reputational issues, loss of secured financing, and a decreasing clientele. Although it cannot be said with certainty, whether such an event may happen or not – but such a tail risk cannot be fully eliminated, and it is essential that the investor is well abreast of the probability of realization of such an event, and the dire consequences.

Performance of Goldman Sachs’ stock over the last 12 months has been below par at best. The bank has lost roughly 44% of its value on a year-to-ear basis, while during the same period – S%P500 lost 2.5% of its value. After exhibiting substantial gains post 2008 crisis, the stock is slowly losing its steam, and there do not seem to be any positive fundamentals which may halt its downward slide, or provide investors with some respite. Furthermore, a beta of 1.39x makes it a highly market sensitive and cyclical stock – which is making the downward shocks more pronounced, as the broader index has been under a lot of pressure lately. On a similar note, on an average the financial sector has lost 29% of its value in the last 12 months, which is lower than the value lost by Goldman Sachs – clearly implying sensitivity of the bank to broader market and sector movements.

With peers trading at P/E in the range of 6-8x – Goldman Sachs is still trading at a P/E of 13.93x, which is the highest of the lot. Keeping in view the quantum of earnings and oerall market movements – it may be possible that the P/E of the bank reverts to sector average, which may result in considerable drop in the price of stock. Even after losing 44% of its value in the last one year, the stock still seems to be overvalued – and may see some price correction going forward (Google Finance – GS).

Ironic it may be, but no one could have expected such decrease in value of Goldman Sachs five years ago. The bank’s key money making divisions, although in the blue – are struggling to attain solid growth rates – but that may not be possible given the current macroeconomic circumstance. Goldman Sachs is a highly cyclical stock, as evidenced by its Beta, and it may not revert back to its earlier glory unless there is uptick in the overall economic scenario.

The outlook for the stock in the short term is bearish, given inability to maximize earnings from its key divisions, and high P/E levels – which may not hold on for long. The stock may see considerable decline in value, which calls for a SELL in the short term. Notwithstanding weak stock fundamentals in the near term, Goldman Sachs can also be a pure value play, if the investors have long term view, and an appropriate risk appetite. Once global financial crisis subsides, Goldman Sachs will be the first to capitalize on the recovery – and it is at that point that the stock may yield substantial returns for its investors. But under current circumstances, and a risk-averse view – recommendation for the stock is a SELL.

Please consult a financial, tax, and/or legal advisor for specifics to your situation.

Goldman Sachs – Financials. (n.d.). Retrieved from http://www2.goldmansachs.com/investor-relations/financials/index.html
Google Finance – GS. (n.d.). Retrieved from http://www.google.com/finance?cid=663137

 

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