Goldman Sachs (GS) hasn’t been getting a lot of love from investors lately. Some would argue that’s for good reason — after all, looming litigation costs and lower leverage make for a tough environment for the investment banking firm.
The newer, more rigid regulations and rules are limiting Goldman Sachs from the good ol’ risky, yet highly lucrative, bets that used to be the hallmark of GS Stock during volatile times.
Yet, the issues investors hold against GS stock are also the very issues that should play to Goldman’s favor — for instance, the one real risk, litigation, has already been priced in by the market.
GS Stock Risk Is Dramatically Lower
There’s no doubt that at one time Goldman Sachs carried risk. But risk in GS Stock has eased dramatically. Why? There are actually a number of reasons, which we’ll now delve into.
Volker Rule: It’s a fact that the Volker Rule hurt banks’ profit potential by forbidding them from engaging in high-risk proprietary trading in securities and bonds. Oddly enough, at the same time, it made banks much safer. For example, during the recent rout in Chinese equity markets, the risk of loss for Goldman was dramatically lower. That’s because all of those opportunities migrated to hedge funds and other unregulated institutions, leaving Goldman Sachs to be a more traditional bank. In such uncertain times, with volatility potentially on the rise, the Volker rule is a blessing in disguise for GS stock.
Leverage Is Drastically Lower: Once again, another factor that investors generally hold against GS is its falling leverage. When financial leverage falls on a banking stock it means lower relative returns. On the flip side, however, it also means lower risk. And under the current environment, when risk is on the rise, lower leverage for a bank stock makes it safer and thus a better investment. After all, would you want to own a bank that is highly leveraged just as China begins its meltdown? Of course you wouldn’t
Goldman’s Investment Banking Unit Is Resilient
According to Morningstar, roughly 28% of Goldman’s revenue comes from investment banking. Currently, the investment banking sector is in a state of turmoil. UBS (UBS) is pulling out of the business, Barclays (BARC) slashed investment banking jobs by the thousands and other investment banks are barely staying afloat.
Given that, it’s no surprise that investors are slamming GS Stock on the back of that weakness. But once again, when we examine the data, Goldman’s revenue from investment banking is on the rise. Moreover, as other competitors withdraw from the market those who intend to stay, like Goldman, are expected to enjoy the fruits of their labors with less competition and more revenue.
Litigation Costs? Already Priced In
Of course, litigations costs were a major constraint to GS Stock. Goldman earmarked a massive $1.45 billion for litigation costs in relation to its role in the mortgage bonds sale. In general, litigation costs tend to be investors’ biggest drawback for any stock. And that is especially true as it regards to the probe of the mortgage banking crisis, because litigation costs are so hard to predict.
But here’s the thing — at its current price, Goldman is trading exactly at its book value. Meanwhile, the rest of the financial sector, as indicated by the Financial Select Sector SPDR® Fund (XLF), is trading at 1.31 book value. Now, it’s possible that worse could come to worst and Goldman might have to write off another $1.5 billion. Yet that still wouldn’t justify why a high-profile, well-managed firm like Goldman Sachs would trade at book value while its peers trade at a 31% premium.
GS Stock Is a Solid Buy
Let’s take into account a few key factors. First, the worst is already priced in. Second, the company’s underlying business is doing well. Third, Goldman has a very capable management team with an aggressive philosophy. And fourth, GS stock is trading at a discount to the rest of the sector and at a multiple of 10.
Given all that, it’s clear that GS Stock is a buy. With Goldman Sachs you are getting a great company, with solid growth potential in its underlying business, at lower than fair price.
Simply put, that’s a great combination for any long-term investor.
As of this writing, Lior Alkalay did not hold a position in any of the aforementioned securities.
