We Like Goldman's Transformation

We’re positive on the strategic changes that Goldman Sachs GS is undergoing, but we wouldn’t be surprised if it takes two years for its efforts to be discernible. The company is in the middle of a front-to-back review of its business that aims to expand revenue on the front end, especially in newer business lines, and optimize expenses and capital of traditional business lines on the back end. The current Goldman narrative reminds us a lot of Morgan Stanley after its Smith Barney merger, where the company is on a trajectory of adding more stable, capital-light revenue streams but the market isn’t giving the company any credit for it. We think that Goldman’s digital banking platform and increasing emphasis on wealth and asset management will increase returns on equity, and that means that shares trading near tangible book value of $198.25 are attractive. We are maintaining our $257 fair value estimate for narrow-moat Goldman Sachs.

Given where we are in the capital markets cycle and Goldman’s investment cycle, it could take a while for the company’s initiatives to clearly show in the bottom line. Management sees 2019 and 2020 as investment years where the expense ratio may not show improvement from current initiatives. Layer on to these investment years that we’re arguably near the apex of this capital markets cycle, and any revenue gains from expanding into new areas could be offset by a cyclical downturn in the company’s traditional businesses. While we see a material probability that the next two years may have flat to down earnings, we are fairly confident that the company will eventually be able to harvest its initiatives into higher returns on equity.

Goldman’s first quarter was fine. Annualized return on tangible equity was 11.7%, and the company reported earnings per diluted share of $5.71. These were reasonable results, given the slow start to the year for investment banks due to macroeconomic uncertainty.

The new management team intends to increase disclosure of its plans over the next year, with a comprehensive strategic update by the first quarter of 2020. We imagine that the increased disclosure can only be positive for investors in the stock, as Goldman clarifies metrics for its new initiatives and sheds light on any areas that are underperforming, such as certain parts of its fixed-income trading operations. Transparency of meeting strategic milestones could also provide some relief if earnings fall with a cyclical downturn.

While consumer finance is competitive, the company’s strategies are reasonable, so we have confidence that they’ll be successful. Retail deposit funding, even if at online banking-type rates that are higher than deposits sourced from physical branches, should still be lower than the company’s historical funding sources. Management is aiming to increase deposits $10 billion or more annually with a 100-basis-point improvement from its traditional funding sources. The digital bank is also likely to become a more comprehensive digital retail platform with deposits, consumer lending, and investment management. Goldman Sachs has a much higher probability of success than financial technology startups with these initiatives, as it has brand recognition, can leverage existing capabilities from its other units (for example, it can use products from its asset-management unit in its wealth-management unit or source loans from its institutional business for the bank), and has the ability to form enviable strategic partnerships, such as the recent Apple credit card.