Late last year I purchased Goldman Sachs (GS) and touted it (along with Facebook (FB) ) as one of my two favorite large cap longs. GS was placed on my Best Ideas List at $169 in mid-December - and now trades north of $200/share. At the time these picks were really contrarian views!
Not so much anymore - as the shares of both GS and FB have soared from the late 2018 levels.
Holding a stock is always a function of (upside) reward relative to (downside) risk.
The near $35/share advance in three months resulted in my paring down of my GS holdings - which are now small-sized.
As mentioned in the most recent "Buy Levels" post, I would be an aggressive buyer at $185/share.
Back in mid-December, I outlined the case for a long term investment in Goldman Sachs:
"Certain members of the former Malaysian government and 1MDB lied to Goldman Sachs, outside counsel and others about the use of proceeds from these transactions... 1MDB, whose CEO and Board reported directly to the prime minister at the time, also provided written assurances to Goldman Sachs for each transaction that no intermediaries were involved..."
-- Michael DuVally, Goldman Sachs spokesman, on Monday
* Goldman Sachs remains "Best of Breed"
* Trading under $170 a share and down from $230 a share a month ago (and a one-year high of $275), Goldman Sachs shares have likely over-discounted the Malaysian problem
* We now face the unusual opportunity of becoming a GS "partner" at a discount to book value
* One of my 2019 Surprises is that GS management acts opportunistically and takes the company private at a premium
* I have placed GS on my Best Ideas List as a long
Several weeks ago, with GS trading more than $40 a share higher, I expressed concerns about Goldman's legal exposure to the capital raise of sovereign wealth fund 1MDB and that the media had been slow to highlight the potential liability to the brokerage, which is a holding of Jim "El Capitan" Cramer's Action Alerts PLUS charitable trust.
However, on Monday I moved GS off my Best Ideas List as a short to the Best Ideas List as a long as the market has fully -- and then some -- discounted the brokerage's Malaysian liabilities. Here was my post from Monday.
By means of background, back in 2009, the government of former Malaysian Prime Minister Najib Razak set up 1MDB. About $6.5 billion was raised through Goldman Sachs in three bond offerings. Subsequently, the U.S. Justice Department has estimated that a substantial portion of the capital raised was misappropriated by high-level fund officials and their associates.
GS shares are down by nearly 35% this year and have fallen from more than $250 to less than $170. As recently as mid-November GS shares traded at $235 a share!
Here is my investment rationale:
* For one of the few times since Goldman went public, investors can become a "partner" of Goldman Sachs at a discount to tangible book value. By my calculation, at the time its fourth-quarter results are reported, Goldman's book value will stand at about $187 a share compared to the current share price of $168 a share.
* Assuming a base case of $1.75 billion to $2.0 billion in reimbursement and fines for the Malaysian liability, the market has over-discounted its impact given Goldman's sizable capital base and strong earnings generation. The event likely does not pose an existential risk to the brokerage.
* On Monday Goldman Sachs fired back against the Malaysian government. I expect the litigation to be resolved sooner than later as both parties are incentivized, and there should be limited long-term impact on Goldman. Remember that the Malaysia government has a documented history of being notoriously corrupt.
* While Goldman's leverage has been administered lower by regulators, which has produced lower returns, the brokerage is still Best of Breed. Goldman's employee base is a talented and innovative pool. History has shown the brokerage's strong ability to strike a balance between risk and reward. The current management review of the company's operations (next year is Goldman's 150th birthday) will likely result in a thoughtful going-forward strategy that should improve current returns on invested capital.
* Goldman Sachs is a prime beneficiary of the business retrenchment of previously large, profitable, healthy and well-regarded but now-crippled European financial institutions (e.g., Credit Suisse (CS) and Deutsche Bank (DB) ).
* A reasonably high and sustainable profit growth picture lies ahead, absent the earnings volatility (from prop operations) of the past. Slower yet more stable and steady profit streams should be more valuable as the domestic economy matures.
* Goldman Sachs has beaten consensus EPS expectations over the last four quarters by 15.4%, 24.6%, 28.3% and 16.7%, respectively
* With a market capitalization of $62.5 billion, GS trades at only 1.7x sales, 0.85 of book value and 7.5x projected EPS of $25 a share. Goldman's return on equity (ROE) is about 13.2%. A rule of thumb I sometimes use with financials is that a 10% ROE justifies 1.0x book multiple, so a 13% ROE justifies a 1.3x book multiple, projecting to a value of $247 a share.
* With the share price so low, there is optionality that Goldman may go private. (See my 15 Surprises for 2019.)
As described above, GS shares are statistically inexpensive today. Trading at 0.85 tangible book value, the shares provide the unusual opportunity for investors to become a "partner" in Goldman Sachs at a discounted price.
While Goldman Sachs shares are not without risks, the market may have overly punished the brokerage's exposure to the 1MDB financing in 2009.
The Malaysian financing does not appear to pose an existential risk to Goldman Sachs.
In the fullness of time I expect that Goldman could be liable for the reimbursement of the approximate $650 million in fees earned on the Malaysian transaction. In addition, it is quite possible that a large fine may be imposed. The cumulative impact is likely to be under $2 billion, a manageable figure given Goldman's capital base. The key question is whether Goldman Sachs will be subject to criminal charges, which could jeopardize the company's franchise. Based on the information current available, it seems to me that GS partner Tim Leissner and members of the Malaysian government were likely rogue actors and that Goldman's exposure will be contained.
The Oracle of Omaha reminds us not to focus on short-term swings in price, but rather on the underlying value of our investments. (See the quote at the beginning of this post)
I value Goldman Sachs at about $245 a share; barring a going private transaction this is a reasonable two-year price target providing a compounded annual rate of return in excess of 20% a year.
Warren Buffett has taught us the value of being greedy when others are fearful. His stakes in American Express (AXP) (the olive oil controversy), Geico (near bankruptcy) and his numerous preferred investments during the Great Recession have proven to be enormously profitable investments and underscore the value of being an opportunistic long-term investor.
"Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years."
Though not as extreme as American Express and Geico, Goldman Sachs' current plight may be similar and Mr. Market has likely offered us in Goldman an unusual opportunity for investors with a long-term investment horizon and time frame.