Goldman Sachs: A Long-Term Play?
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Large investment banks like Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS) became bank holding companies in 2008 in order to qualify for bank bailout funds. But their underlying businesses bear little resemblance to traditional commercial banking. These companies are world leaders in trading and underwriting. They have emerged strongly from the depths of the recession, and just today have received passing grades under the Federal Reserve's Stress Tests, allowing room for share repurchases and dividend hikes.
Goldman Sachs is a global investment house and probably the best known and most reviled such company in America. Its alumni litter government and corporate leadership, But to many people, the company represents all that is wrong with corporate America in general and Wall Street in particular. That likely stems from the combination of huge taxpayer support, tens of billions of bonus dollars paid to employees, and revelations of such conduct as the Abacus litigation which involved Goldman's subprime mortgage bets against its own clients. We have gotten to the point where an entire website is devoted to nothing more than pointing out Goldman's shortcomings.
At the same time, within its industry Goldman is among the most respected investment houses in the world. Its breadth and talent are unparalleled. And beyond its control in 2011 were macro-economic conditions. Domestic economic stagnation, coupled with the European economy teetering on collapse, caused horrible conditions for investment banks as large stock and debt offerings pretty much dried up. This investment bank malaise did not just affect Goldman, but affected all its main competitors. It is just that unlike some large competitors, such as JP Morgan Chase (NYSE: JPM), Goldman has no large commercial bank to fall back upon to stabilize earnings.
I have written many times that investment banking is a cyclical business. In 2007, Goldman posted earnings of over $24 per share. The next year, earnings were a little over $4 per share. In 2009, earnings were back over $22 per share, and then in 2010, back down to about $15 per share, before settling back down to a little over $4 per share in 2011. That is as much of a roller coaster as it gets, and a purchase today will get you a price to earnings ratio of about 25, for a company every bit as cyclical as steel or auto stocks. The good news? The cycle is down, and will eventually rise again. The issue is, when.
Some hints were gleaned from the fourth quarter of 2011, when earnings were a shade over $1 billion, or $1.84 per share. While that amount was less than half the amount earned in the year earlier quarter, it was a substantial improvement from the sequentially linked third quarter of 2011, when it lost over $400 million, or $0.84 per share. Analysts see Goldman's earnings improving to over $11 per share this year, and over $13 per share in 2013. Yet, what I do not know, and what analysts do not know, is how many more rounds of investigations and litigation Goldman Sachs will go through on account of its behaviors last decade. I would not be at all surprised to see 2012 earnings come in well under expectations.
The 2012 elections will undoubtedly reinforce to all the role of Wall Street, and Goldman in particular, in the housing credit crisis and uneven economic recovery since then. It is difficult to place a value on negative publicity, other than to say it is another issue to overcome.
I like Goldman beyond 2012. I am confident that sometime within the next few years it will earn $20 or more per share again. The stock has run up about 50% since December, 2011, and much future earnings gains are already priced into the stock. If you can afford to be patient for three to five years, Goldman may well be the stock for you.
Morgan Stanley is Goldman's most direct domestic competitor. It also boasts a global footprint, and a diversified investment bank related business model, but it does not have as volatile an earnings history as has Goldman. It also struggled in the fourth quarter of 2011 with revenues, and due to a $0.57 per share litigation settlement, it posted a net loss of $275 million, or $0.14 per share. Revenues fell 42% from the third quarter of 2011, to $5.7 billion. For all of 2011, earnings were $1.12 per share, a substantial drop from the $2.44 recorded in 2010.
One does not see the public antipathy toward Morgan Stanley that one sees toward Goldman, and Morgan announced upon passing the Federal Reserve's stress test that is will not use its capital for dividend hikes or share repurchases, but will instead plow earnings back into its business. Right answer. I see capital markets improving enough over the next two to four years to allow Morgan Stanley's earnings to approach $8 billion, or just over $4.00 per share. Even at today's depressed earning level, the Morgan Stanley's stock is selling for less than half its book value. I believe Morgan Stanley is selling at a tremendous value, and encourage a closer look.
A third large investment banking operation is under JP Morgan's control. While it is hardly a surprise that JP Morgan passed the Fed stress test, its commitment to return to shareholders over 70% of anticipated earnings through a dividend hike and enormous share repurchase plan is a little bit surprising. JP Morgan is trading at a 25% premium to its tangible book value. Maybe management thinks more highly of the $48 billion dollars of goodwill carried on its books than I do, but a commitment to $12 billion or more of share repurchases in 2012 seems an unwise use of the money. I need to see JP Morgan's commercial bank make money without reserve manipulations assisting those earnings. Its investment bank will take care of itself on the cyclical basis.
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