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%
Citigroup 311%
JPMorgan Chase 290%
Goldman Sachs 137%
Morgan Stanley 102%
S&P 500 259%

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.

Business Description

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%
Total $22.438 billion 100.0% -15%

Source: Goldman Sachs Earnings Release

Business Analysis

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.

Goldman Sachs

Source: Simply Safe Dividends

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.

Goldman Sachs

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

1, 23  - View Full Page