In recent weeks I have been accumulating shares of Goldman Sachs (GS) for my clients, more so now than any other time since I began managing money. In a market environment where over the course of a single year most stocks have gone from severely undervalued to fairly valued, it remains pretty easy to make the case that Goldman stock is undervalued, despite a $20 increase just recently.
Why is the stock still cheap? No doubt due to the negative press coming from both political and consumer circles. Somehow Goldman Sachs is being made out to be a bigger problem for our financial services economy than sub-prime mortgage lenders and insurance companies that chose to insure everything on the planet without ever setting aside any money to pay future claims. Goldman Sachs never gave out mortgages like candy on Halloween and although they did benefit from the AIG bailout (their claims were paid out 100 cents on the dollar after the government bailout) people should be mad at AIG and the government long before blaming Goldman Sachs for owning insurance policies.
The investment case for Goldman stock, however, does not really involve a political or moral viewpoint (many of us will disagree on those points anyway). The real issue from an investor standpoint is that Goldman is the best of breed investment bank in the world ( this was one of the key takeaways from the credit crisis, in my view anyway), has seen many of its competitors go out of business or dramatically scale back operations, and yet at around $170 per share the stock still trades for less than 10 times estimated 2010 earnings.
Why do I think such a valuation is too meager? Well, all we have to do is rewind the clock back to before the credit crisis and recall what the investment banking landscape looked like. Back when the Big 5 investment banks were still in existence (Goldman, Morgan, Merrill, Bear, and Lehman) there was often a valuation discrepancy. It is actually very interesting to revisit how these stocks used to be valued by the market. Ever since it finally went public back in 1999, Goldman typically fetched a premium to the group (they have always been seen as the cream of the crop). Morgan Stanley and Merrill Lynch were very diversified and strong global franchises, and therefore were close runners up while Bear Stearns and Lehman Brothers were generally seen as less attractive, mainly due to an over-reliance on fixed income businesses for their revenues. They typically traded at a discount to Morgan and Merrill (about 10 times earnings versus 12 times) while Goldman often commanded a premium (15 times earnings or more).
This is interesting, of course, because the credit crisis essentially proved that the market was very accurate in its evaluation of the five large investment banking institutions. Bear and Lehman collapsed thanks to their heavy concentration in fixed income (many of those bonds and securities were backed by mortgages). Merrill Lynch and Morgan Stanley were on the brink but managed to find partners to help them back (Bank of America bought Merrill and Morgan got a large investment from overseas). Goldman, meanwhile, came through the credit crisis relatively unscathed (and would have been okay even if they had only gotten 80 or 90 cents on the dollar for their AIG contracts). For the most part, the market got it right.
Fast forward to today. We know that Lehman and Bear were the worst of breed and that Goldman is still tops. And yet Goldman Sachs stock today trades at a lower valuation than Bear Stearns and Lehman did pre-crisis. How does that make any sense? Has the credit crisis not proved that Goldman traded at a premium for good reason?
Going forward, I believe the valuation range we will see for investment banks will continue to be 10 to 15 times earnings. Maybe the lower end of the range is more likely near term as investors worry about political and consumer backlash. Maybe Morgan Stanley fetches a 10 P/E instead of 12 times, but Goldman should still command a premium to reflect their investment banking franchise. Granted, maybe that premium is only 12 times earnings.
Still, from my perch buying Goldman stock at less than 10 times earnings is a tremendously attractive risk-reward opportunity. The only way such an investment comes back to bite anyone is if either, one, the P/E drops significantly below 10, or two, Goldman’s earnings have peaked and will trend lower in coming years. Frankly, I see both of those possibilities as extremely remote, especially longer term. Instead, I think Goldman Sachs should be able to earn around $20 per share and after the policy fallout has passed longer term, the P/E ratio should rise to 12 or higher. In that scenario, Goldman shares would fetch $240 each, or about 40% above current levels.
Full Disclosure: Clients of Peridot Capital were long shares of Goldman Sachs at the time of writing, but positions may change at any time