The "incredibly cheap" investment bank with higher ROE in the crosshairs

For this wire, I reached out Sam Ruiz from T. Rowe Price to get his take on the Wall Street icon. For Ruiz, it's not a question of whether the bank can increase ROE, but rather by how much.

Goldman Sachs (NYSE: GS) FY22 Q3 key results

• Net revenue of US$11.98 billion
  
• Net earnings of US$3.07 billion
  
• EPS of US$8.25
  
• Annualised ROE of 11%

In one sentence, what was the key takeaway from this result?

You have to recognise the benchmark was low heading into the result, but it was a beat to the market expectations, on an earnings per share basis they delivered about 6.5% against consensus expectations. For a predominantly capital markets facing business, the market was expecting those revenues, particularly from the global markets business and investment bank, to be lower than what they were.

The other thing that was impressive was the return on equity. There's a big debate about the stock and the volatility of the ROE. It delivered its 9th consecutive quarter above 10%. So printing an 11% ROE for the quarter was impressive.

What was the market’s reaction to this result? In your view, was it an overreaction, an under reaction or appropriate?

I think it was an appropriate reaction. The stock was up about 2.5%, or just shy of that, on a day the market was up. But clearly revenues from top line to bottom line were better than the market was expecting. Ultimately the market needs to factor in that this is a very volatile business. We didn't see a big re-rate and the market is still discounting the stock for what is a very volatile underlying business.

That said, I think that the market was held back from being too bullish on the result because they did announce a pretty big organisational reshuffle, which in their words is to align the business for better efficiency. But there was some changes there to one of the consumer businesses which was a part of our bull thesis, which was around an increase of recurring revenues and a more sustainable ROE profile over time.

Were there any major surprises in this result that you think investors should be aware of?

The major surprise was the reshuffle and the move away from the direct to consumer business, which was an exciting business for Goldman to scale.

There's a good short-term reason as to why they're doing it - to target near-tern profitability. But it just takes off the table what investors were waiting to see - whether they could scale these other businesses that would see the shift of Goldmans from a transaction-driven capital markets business to one that would have a higher proportion of this loan and deposit franchise, their wealth management business, etcetera.

Basically, the customer acquisition costs were really high for acquiring new customers. For us that's a net negative; shifting away from a strategy that should've been in our view a pretty simple business strategy of attracting low-cost deposits and lending them out to consumers and businesses, make a bigger spread. They've acknowledged that they really couldn't execute shifting the customer acquisition approach to 'let's just monetise existing customers'.

Would you buy, hold or sell Goldman Sachs on the back of these results?

It's a HOLD, where it is today. The stock's incredibly cheap. We think that they can bring their ROE profile higher, but the jury's still out on whether management can achieve that 15% target. But this is a business that's shown, following a white-hot market last year, that they can continue to gain share in their core businesses of investment banking and global market businesses, and they're a market leader there.

And seeing the sustainability of ROE above 10% now means that, whether it gets to 17% or 15%, the market can see that the volatility declines and they can start to compound. But even if they get a re-rating, the opportunity of the book-value compounding into the future is a good opportunity.

So it's a HOLD but there are just a few things we want to dig into before we say it's a buy. Namely, how they achieve those ROE targets now that they've dropped off that direct to consumer division.

What’s your outlook on Goldman Sachs and its sector over FY23? Are there any risks to this company and its sector that investors should be aware of?

We're more positive on financials, which feels a bit early and contrarian given we're going into what consensus is saying is a recession. For businesses like Goldman Sachs, there's still the big debate around where do we normalise in terms of capital markets revenues? Do we go back to pre-COVID, do you normalise higher because markets are growing and once some of the interest rate and economic concerns go away maybe the activity picks back up.

There's still a question mark on capital markets, but then with banks we think the market has been, particularly in North America, overly bearish around what this credit cycle would look like. We talk about provisioning of banks and credit costs. In our view the market is trading these banks down to historic trough multiples and valuation.

Where the opportunity is, is we think the market has been overly bearish about what this credit cycle would look like because the consumers and corporates are well capitalised, the impact of higher rates doesn't flow through the same as it does in Australia because they majority of homeowners in the US have 30 year fixed rate mortgages. So if what the market is pricing in for credit costs isn't actually as bad as what it will eventually be, then you have really good leverage to the expansion of net-interest income.

Everyone knows that these banks will earn more as spreads widen, but they're worried about how much they're going to give back on credit costs. So we don't think it's going to be that bad this credit cycle, and the starting base for net interest margins was really low this cycle. So the delta expansion of NIMS is going to be much wider here.

So even though we're moving into concerning times, we think the market has traded these banks down to recession levels, and we don't think it's going to be as bad as the market is predicting.

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