If you’re a conservative investor or faint of heart, global investment bank Goldman Sachs (NYSE: GS) has not been the stock for you this century. Like financial services firms in general, GS’s business is cyclical, and from 2001 through 2013 the stock’s returns have been more than twice as volatile as the benchmark S&P 500, while barely outperforming it (a compound average annual return of 5.5 percent to the S&P’s 4.8 percent).
That outsized volatility showed up in net losses of more than 24 percent in three years, reaching 47 percent in 2011 and 59 percent in 2008, the latter at the height of the financial crisis. But that volatility also had an upside: years with positive returns of 23, 36 (twice), 43, 56 and – yes, the following number is correct – 97 percent. That was in 2009, the year immediately following the year with its deepest loss this century.
So, when it comes to investing in GS, it’s all about the timing. If you get in when the stock is overvalued, you might be in for a punch in the face. But if you get in when the stock is relatively undervalued, your chances of coming out smelling like a rose are better. And that’s where I see GS now: relatively undervalued and about to reward investors handsomely for the next few years.
To be precise, for GS a metric I focus on – the dividend-adjusted Price to Earnings Growth Rate, or PEG ratio – says it’s quite undervalued. As of July 18, it stood at 0.83, the lowest of any of the 30 stocks that comprise the Dow. My buy signal is a div-adjusted PEG below 1.2, and at GS’s number the stock is a strong buy.
This ratio divides the forward PE (for estimated 2015 earnings) by Wall Street’s consensus earnings growth rate plus the current dividend yield for the next five years. GS – which earned $15.46 per share last year – is estimated to earn $17.13 in 2015, and at its latest closing price of $171.47 (on Friday, July 19), it was trading at a forward PE of just 10.0. Meanwhile, the company is expected to grow earnings at the rate of 10.7 percent for the next five years, and its current dividend yield is 1.28 percent.
To put a fine point on, the stock price has the potential to climb as much as $36 in the next two years to $207, and more than $250 by 2018 (which would crack its all-time high of $229.27, set in 2007). With dividends, that’s a potential cumulative total return of 52 percent, or approaching 13 percent per year. That’s better than the long-term return of around 10 percent for the S&P 500, and that’s what I buy Dow stocks for.
So what accounts for these projections? Let’s start by taking a look at Goldman’s business. It operates four business segments: Investment Banking (18% of 2103 revenues,) where it earns fees from stock and bond underwriting and corporate advisory services, including mergers and acquisitions (M&A); Investment Management (16%), where it earns fees for managing about $1trillion in assets for mutual funds, pension funds, hedge funds, foundations and high net worth individuals; Investment Client Services (46%), a brokerage service in which it executes transactions for clients and makes a market in such securities as U.S. Treasurys; and Investing and Lending (20%), where it trades for its own account and makes loans to businesses.
Just a few days ago, Goldman surprised Wall Street with the announcement that it earned $4.10 a share in the second quarter of 2014, compared to the Street estimate of $3.05. The results were driven by a 46 percent jump in Investing and Lending revenues, a 15 percent increase in its Investment Banking revenues (led by a 20 percent increase in underwriting fees) and an 8 percent increase in Investment Management revenues. These gains more than offset a decline of 14 percent in Institutional Client revenues, owing to relative flat securities prices.
Goldman’s second quarter bright spots reflect the strong industry outlook for stock and bond underwriting, as companies take advantage of higher market prices and low interest rates. Large cash positions on the books of so many corporations have been spurring merger and acquisition activity, and is expected to continue to do so. These play to GS’s strengths: it is the industry leader in IPOs and M&A.
Meanwhile, GS management continues to control expenses, strengthen the balance sheet by shedding low-return assets, and focus on shareholder value. Over the last five years it’s grown the dividend by 21 percent a year. Last year , the firm bought back $6 billion of its shares, and through the first half of 2014, it bought another $2.95 billion.
I can’t tell you an investment in GS doesn’t pose any risk. If the market crashes, investors in the stock will be hurt again. What I am saying is that Goldman is one of the best-run companies in its industry, it has proven to be as resilient over that last 13 years as it has over its 100+ year history, and that the volatility from here looks like it’s going to be to the upside.
About Lawrence Meyers Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at [email protected]