By Matein Khalid: Chief Investment Officer and Partner at Asas Capital
Goldman Sachs shares traded at $190 when I wrote this article, way below its $52 week high at $245 making it a Cinderella in global investment banking at only 8.5 times forward earnings. It is obvious that Goldman’s involvement in the $7 billion 1MDB sovereign wealth heist in Malaysia has led to global outrage, demands for a $6 billion in punitive fine by Prime Minister Tun Dr. Mahathir Mohammed, a crisis in the bank’s relations with Abu Dhabi, a conviction of a Southeast Asia based partner for money laundering and a legal sword of Damocles in the US.
Goldman Sachs is also unable to deliver the 25% peak cycle ROEs it achieved in the pre-Lehman Stone Age of global finance (2002-07) due to far lower leverage ratios, the Volcker Rule, Dodd Frank, OTC derivatives reform and the Congressional outrage at the Abacus/Fab Four scandal. Goldman Sachs’s FICC division can no longer generate a $10 billion tsunami of proprietary book profits making markets in complex derivatives structures that are now anathema for Wall Street regulators.
The world has changed and Goldman, lampooned as the “great vampire squid” of finance, is no longer Zeus on the Mount Olympus of global investment banking, the ultimate boot camp for Ivy League Masters of the Universe. So many of my Wharton classmates ended up at “Death Star” (85 Broadway) or Peterborough Court in London, a literal cathedral of money on the Strand.
2018 was an “annus horribilis” for Goldman Sachs shares, down 35%, thanks to its mediocre ROE metrics and the shock waves of the 1MDB scandal. Goldman CEO, Lloyd Blankfein, retired thankfully at the right moment and was succeeded by investment banker David Solomon, who has moved swiftly to boost the bank’s tarnished reputation for excellence in ethical governance (yeah right). This is definitely not the trading room culture of Goldman London I knew in the 1990’s but a kinder, gentler PC focused place where officers and gentlemen do not strangle each other for a bigger bonus.
In any case, Goldman missed Wall Street’s revenue expectations in the last reporting quarter. Goldman generated $8.8 billion in revenues in 1Q 2019, below Street consensus of $8.97 billion. This means annual revenue growth is now less than 9%, mainly due to the malaise in fixed income trading and the fall in crude oil/metal prices since J. Aron is one of the world’s great commodities trading houses – it spawned Lloyd Blankfein and Mark Winkelman.
The inverted US Treasury debt yield curve and US-China trade tensions have also been catalysts for the malaise in the bank’s shares.
Yet I believe Goldman Sachs is undervalued on Wall Street. The IPO boom in Silicon Valley benefits Goldman and Morgan Stanley most. Goldman’s private equity, real estate and merchant banking business, its fabled lending/investing division, is a money-spinner, akin to Blackstone and KKR. Its digital bank has $145 billion in deposits and synergies with its wealth management division. Goldman Sachs Asset Management (GSAM) manages or supervises $1.6 trillion in assets and asset management revenues are now 20% of net firm revenues, a stable, recurrent, high ROE business that is simply ignored in current valuation metrics.
More by Matein: Strategy, central bank smoke signals and global equities
I doubt if Justice will force Goldman Sachs to enter a guilty plea in the 1MDB case. I expect Donald Trump to easily beat Senator Elizabeth Warren or former Vice President Joe Biden in the 2020 elections, reducing the risk of new draconian banking regulations.
Above all, I am convinced David Solomon, the classiest Goldman Sachs CEO since John Whitehead, will nudge the bank to a more recurrent, fee revenue model, boost its technology backbone and win market share raise fixed income, commodities, currencies (FICC) revenues from a current dismal 16% to at least 25% of global revenues. After all, in 2009, FICC generated $22.3 billion or 52% of global revenues. Goldman passed the Fed’s 2019 CCAR stress test so easily that he raised the dividend from 0.85 cents to $.1.25 a quarter. Goldman thus offers a 2.5% yield, nothing to sneeze at now that the 10 year Uncle Sam yield has tanked to 1.95%. Solomon also intends to raise revenue by $5 billion via new products and new client segments. This is quite possible since banks like UBS, Deutsche, Credit Suisse, RBS and Lloyds have basically exited global investment banking.
Solomon, with no ties to Goldman’s vast trading floor, has dialled back excessive risk-taking. He has expanded FICC’s client base beyond hedge funds to include asset managers, corporates, banks and brokers worldwide. Goldman Sachs has been creative in reinventing the bank’s global franchise. The online retail bank, the Marquee digital trading platform and the Treasury services business are all winners – and Goldman Sachs is a global market leader in cross-border M&A, corporate finance, Eurobond new issuance, oil & gas/TMT banking and FX/debt/equity derivatives.
In retrospect, the malaise in FICC trading in the past decade was not cyclical, as Blankfein argued – but secular, as Solomon now acknowledges. Goldman Sachs trades at a pathetic valuation at just below book value and 8.5 times forward earnings against a sector with 12 multiple. Goldman’s own five-year average multiple is 14 times earnings – so this is a case of hero to zero, Sophoclean hubris gone run amok (a Malay word, ironically). I see the risk-reward calculus as once again in my favour and will sell 190 strike January 2020 puts to collect a generous $14 premium. My worst-case scenario is thus to be delivered Goldman shares at $176, a level I will greet the shares with an ahlan wa sahlan (welcome in Arabic)!