Since the depths of the financial crisis, plenty of big banks such as Bank of America (BAC), Citigroup (C), and JPMorgan Chase (JPM) have managed to rebound nicely and beat the market.
However, pure play investment banks such as Goldman Sachs (GS) and Morgan Stanley (MS) have lagged the S&P 500 by large margins.
|Stock||Total Return Since March 3, 2009|
|Bank of America||381%|
Find out whether or not Goldman Sachs’ poor performance could represent a long-term buying opportunity or whether the poor stock performance is a sign of something rotten in this venerable financial institution.
In other words, is Goldman Sachs a classic deep value dividend growth stock or a value trap to be avoided? The company has rewarded shareholders with nearly 10% annual dividend growth over the past 10 years and has solid income growth potential going forward.
Let’s take a closer look at Goldman Sachs to see if it is the type of stock we would be interested in owning in our Top 20 Dividend Stocks portfolio.
Goldman Sachs was founded in 1869 and is one of the oldest and largest standalone investment banks in the world. It serves, private, institutional (corporate, hedge fund, pensions, foundations, endowments), and governments through four business segments:
- Investment Banking: advice for corporate needs such as IPOs, mergers & acquisitions, divestitures, defense against hostile takeovers, spinoffs, raising debt capital, private placements, and derivatives
- Institutional Client Services: acts as broker, clearinghouse, and market maker for major institutions such as hedge funds, ie actually executes trades and keeps tracks of institutional portfolios, dividends, tax forms, for markets such as: stocks, currencies, interest rate products, mortgages, and options
- Investing & Lending: originates and invests in long-term loans, investments, and real estate
- Investment Management: fee based advice, wealth management, and brokerage service
For the first 9 months of 2016, here’s how Goldman’s sales have broken out by segment.
|Business Segment||YTD Revenue||% of Revenue||YoY Growth|
|Investment Banking||$4.787 billion||21.3%||-13%|
|Institutional Client Services||$10.872 billion||48.5%||-11%|
|Investing & Lending||$2.596 billion||11.6%||-37%|
|Investment Management||$4.183 billion||18.6%||-10%|
Source: Goldman Sachs Earnings Release
As you can see, Goldman’s year-to-date results are hardly something to write home about. In fact, in terms of revenues through the first three quarters of the year, 2016’s results are the poorest since 2011.
Only Goldman’s most recent quarter showed any signs of a recovery in sales, though improvements in operating margin and EPS have been underway for three and four quarters, respectively.
That’s due in part to the bank’s strong emphasis on cost cutting. For example, in the last quarter expenses fell 26%, mainly due to non-compensation expenses declining by about 40%.
In addition, Goldman is attempting to diversify into more stable retail (i.e. consumer) banking thanks to a recent acquisition of GE (GE) Capital’s deposits that saw its retail banking deposits soar to over $100 billion, up from just $15 billion in 2007.
Source: Goldman Sachs Investor Presentation
However, while Goldman has managed to make good progress in diversifying its revenue streams and cutting expenses, there are two main problems faced by the bank that make JPMorgan Chase and Wells Fargo seemingly better long-term investments.
The first is that retail deposits, which serve as a cheap source of capital, despite their impressive growth, still represent a very small source of funding for the bank. In addition, retail banking is generally far more stable than investment banking because consumers continue to use retail banking services even during economic downturns while things like IPOs and mergers and acquisitions tend to fall off a cliff.
In addition, one of the biggest earnings growth catalysts for retail banks is the potential for rising interest rates. If the Federal Reserve’s current projection that interest rates will rise to 3.25% by the end of 2020 proves true, certain banks will be big beneficiaries.
Hybrid consumer/investment banks such as JPMorgan Chase, Citigroup, and Bank of America are very well situated to benefit from rising interest rates. That’s because the net interest margin, or difference between the cost of borrowing and lending to consumers, widens in a higher rate environment.
In fact, with just a 1% increase in short and long-term interest rates, Citigroup, JPMorgan Chase, and Bank of America stand to earn an extra, $1.4 billion, $3 billion, and $5.3 billion per year in profits, compared to just an addition $419 million for Goldman Sachs.
In other words, Goldman Sachs’ very small presence in retail banking results in higher costs of capital, more cyclical revenues, and less potential upside in the event of interest rate normalization.
In addition, the bank faces another competitive disadvantage relative to its rivals.
It’s a lot easier to cut costs at a retail bank because investment banking is more reliant on the skills of individual employees, which requires larger bonuses to retail top talent. This means that hybrid retail/investment banks such as Citigroup, Bank of America, and JPMorgan Chase have the potential for far larger margins and higher returns on shareholder capital than investment banks such as Goldman or Morgan Stanley.
For example, thanks to large bonuses, over the past two years roughly 40% of Goldman’s revenue went to employee compensation. Since investment banking profits typically rise when the economy and market are doing well, Goldman has little hope of cutting compensation expenses during good times, while its hybrid rivals are able to continue cutting costs at their retail operations and thus achieve superior economies of scale.
Or to put it another way, under today’s new, more regulated banking environment, Goldman Sachs has less profit potential than Citigroup, Bank of America, and JPMorgan Chase.
That’s not to say that there aren’t plenty of reasons to be bullish on Goldman Sachs. For example, in two very important metrics, the strength of its balance sheet and growth in tangible book value per share, the bank is doing well.
Specifically, tangible book value per share, which is the objective intrinsic (i.e. “liquidation”) value of a bank’s net assets, increased from $162.11 to $172.45, or 6.4%. Now, granted almost all of this was due to a 6.2% decline in share count courtesy of the bank’s massive buyback program.
However, when it comes to cyclical industries such as banking, financial engineering (i.e. returning profits to shareholders in the form of buybacks) is a legitimate means of boosting long-term intrinsic value. That’s especially true if done when shares are undervalued, as they currently seem to be at first glance.
Goldman has also made great progress in fortifying its balance sheet to ensure that another economic downturn doesn’t bring it to its knees as occurred during the financial crisis. This can be seen in its Common Equity Tier 1 capital ratio or CET1, which measures net asset values + retained earnings / risk weighted assets and currently stands at a record high of 14.0%, compared to the minimum 9.5% set by regulators.
In fact, this fortress-like balance sheet means that Goldman is very well prepared for the next potential financial crisis, as seen by the results of this year’s stress test. The stress test is an annual check of the balance sheet strength of the largest and most important banks in the world and simulates a “worst case scenario” consisting of:
- US GDP falls 7.5% (Great Recession only saw 5.1% decline)
- Unemployment rises from 4.7% to 10.7%
- Housing prices collapse 30%
- Stock market falls 51%
Federal regulations require that a bank’s CET1 remain above 4.5%, including capital spent on buybacks and dividends. During the 2016 stress test, Goldman’s CET1 fell from 13.6% to a minimum of 8.4%, far above the minimum safe limits. And it beat JPMorgan’s and Bank of America’s minimum CET1s of 8.3%, and 8.1%, respectively, though it fell short of Morgan Stanley’s and Citigroup’s respective 9.1%, and 9.2%.
In other words, in the event of a financial catastrophe worse than the great recession, Goldman shareholders likely won’t need to be worried that their shares might become worthless. However, there are still some risks to remain aware of.
The biggest risk for Goldman shareholders is that the investment banking industry is highly cyclical. While the bank’s largest business segment, Institutional Client Services, might not see a giant decline in revenue because high volatility during a market crash requires large market making and order executions, IPO, merger, and equity and loan origination would all suffer, as would the asset management division that would make less management fees due to portfolio losses.
And in the event of a severe global recession or another financial crisis, while the bank will likely survive, investors need to consider the fact that all major banks, including hybrids and retail banks such as Wells Fargo (WFC) or US Bank (USB) might see exceptionally high volatility.
In other words, because of how some banks fell by as much as much as 99.9% during the financial crisis of 2008-2009 (Citigroup fell from almost $600 to $1), banking stocks, including Goldman, might end up getting sold off to ridiculously low levels in a classic market overreaction (investors spook easily).
While that could make for a fantastic long-term buying opportunity, if you need to sell during this time to fund expenses, you could see your capital permanently decimated.
Finally, we can’t forget that Goldman Sachs has a history of unethical behavior that results in steep legal fines. For example, thanks to its role in selling toxic mortgage backed securities to clients, and then betting that they would fail, the bank was fined $550 million.
Or put another way, current investors are betting that the bank’s days of “being evil” are behind it and that it no longer attempts to profit at the expense of its customers.
Dividend Safety Analysis: Goldman Sachs
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.
Goldman Sachs has a Dividend Safety Score of 82, suggesting that the company’s dividend is extremely safe, primarily due to two factors.
First, the dividend payout ratio is very low, at just 21% of trailing 12 month diluted earnings per share. In addition, the bank’s rising capital ratios (i.e. its strong balance sheet), mean that it should continue to easily pass the annual Federal Reserve stress test.
That in turn means it is likely to get its annual Comprehensive Capital Analysis and Review, or CCAR, in which it requests permission to return cash to shareholders, approved by regulators.
It’s also worth noting that Goldman Sachs was able to maintain its regular common dividend during the financial crisis. The company’s payout ratio spiked in 2008 but remained below 40%:
Dividend Growth Analysis
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Goldman Sachs has a Dividend Growth Score of 88, one of the highest of any major bank, and an indicator that its payout may continue growing strongly for many years to come.
As seen below, Goldman Sachs has delivered double-digit dividend growth for many years. The company’s low payout ratio positions it well to continue rewarding shareholders with double-digit dividend growth in the coming years.
However, investors need to note that Goldman Sachs isn’t a company that raises its dividend on a yearly basis. For example, in the past it’s gone as long as three years with the same dividend, meaning that shareholders seeking either generous current income or annual dividend growth might want to look elsewhere.
The nice thing about bank valuations is that we have a fairly objective way of quantifying intrinsic value – tangible book value. Which means that not only can we get a sense of how undervalued a bank is at the moment, but we can also get a sense for how the market is valuing the quality of a bank based on the premium or discount to tangible book value, both relative to a bank’s median historical value and in comparison to other global banks.
In this case, Goldman Sachs is trading at right around intrinsic value and a steep discount to its historical norms. This makes sense given the difficulties that investment banks are likely to have raising their margins in this new, higher regulation world.
|Bank||Price / Tangible Book Value (P/TBV)||13 Year Median P/TBV||% Of Global Banks With Lower P/TBV|
|Bank Of America||1.02||2.67||40%|
In other words, Goldman’s price to tangible book value (P/TBV) may never again rise to its usual premium valuation, effectively capping its potential for capital gains. Combined with the second lowest yield of its peer group and the penchant for going years between raising its payout, this makes the stock, in my opinion, a far less attractive dividend growth investment than most of its rivals.
For example, Bank of America and Citigroup, both previously deeply troubled megabanks, are trading at the largest discounts to their historical norms. For Citigroup, I believe this is justified but possibly not so much for Bank of America given CEO Brian Moynihan’s ongoing cost cutting measures, rigid high lending standards, and industry best potential to profit from rising interest rates.
As for JPMorgan Chase, its premium valuation relative to its peers is justified by its world class leadership under Jamie Dimon, whose conservative approach to banking allowed the company to not just survive the financial crisis intact but also maintain profitability. JPMorgan was even helping the US Treasury stabilize the financial industry with its acquisition of failed retail bank Washington Mutual, thus coming out of the crisis larger and stronger than ever.
Dividend investors interested in owning banks, whether retail, investment, or a hybrid of the two, always need to keep in mind that this sector is prone to higher risk, courtesy of both more stringent regulations as well as the risk that derivatives on the balance sheet make their balance sheets “black boxes”.
In the case of Goldman Sachs, despite its leading position in investment banking, I think there are better options investors should consider. That’s due to Goldman Sachs’ lower potential profitability, more cyclical sales, earnings, and cash flows, and lower potential to benefit from rising interest rates in the coming years.
Meanwhile, JPMorgan Chase arguably represents the “best in breed” of hybrid banks, thanks to a conservative banking culture instilled by CEO Jamie Dimon that should allow it to easily survive even the most challenging future economic or financial calamities.
Regardless, investors should approach bank stocks with conservatism. Some of them appear to be high quality businesses with above average dividend growth prospects, but most fall in the “too hard” bucket for me. I’ll stick to my other favorite blue chip dividend stocks for now.