The Goldman Sachs Group, Inc. (GS) released Q2 2019 results on July 16, 2019. It also announced on June 27th an increase in its quarterly dividend from $0.85 to $1.25 effective with the Q3 dividend payment and a $7B share repurchase program beginning Q3 2019 and ending Q2 2020.

I am bullish GS and the Bull Put Option Spread I recommend in April 2019 is currently a profitable trade.

Summary

  • GS released Q2 results July 16th and has recently announced an increase in its quarterly dividend from $0.85 to $1.25 and a $7B share repurchase program beginning Q3 2019 and ending Q2 2020.
  • The $7.5B Malaysia 1MDB legal issue is certainly a matter to consider when investing in GS. I do not, however, envision GS having to pay the government of Malaysia this full amount to resolve this legal matter.
  • The Bull Put Spread option trade I recommended April 16th is currently profitable but anything can happen between now and the October 18th expiry.
  • As much as I view GS as being attractively valued I will refrain from adding to my existing position. I am monitoring other companies and am cautiously optimistic their valuation will retrace in 2019 to an acceptable level.

Introduction

When I decided to initiate a position in Goldman Sachs (GS) on November 19, 2018 for the ‘Side Accounts’ within the FFJ Portfolio I looked at how GS fared relative to its peers over the past couple of decades.

Although I look at a company’s potential return I am at the stage of my life where I am not prepared to take an outsized risk in which a permanent impairment to my capital is a real possibility. As a result, I looked back on my experiences during the Financial Crisis.

During the Financial Crisis I was a member of my employer’s Cash Management team. Being part of this team accorded me the privilege of being able to see just how dire circumstances became for many financial institutions when liquidity dried up; I distinctly remember the implosion of Lehman Brothers and Bear Stearns and their urgent requests that we return the billions of dollars they had on overnight deposits with my employer.

Although GS was not immune to what occurred during the Financial Crisis, hindsight proves that GS fared much better than many in its peer group. This is definitely something I took into consideration when I decided to initiate a position in GS late 2018.

Although I do not expect another Financial Crisis to happen anytime soon, I will never forget just how dire circumstances were. I fully appreciate not everyone has the same low tolerance for risk as me but I often wonder whether some investors truly appreciate/understand the risk aspect of their investment. I have no empirical evidence to support my opinion but I think many investors look at the return aspect of their investment but pay little heed to the risk.

Some of the investment recommendations I read might make sense when times are good. If things turn ugly very quickly, however, exiting these riskier positions could be problematic and a permanent impairment to capital is very likely.

In addition to passing on companies with credit ratings I deem to be unacceptable, I have also passed on investing in high quality companies because I considered their valuation to be far too elevated for my liking. This has resulted in me missing out on the rise in the stock price of many high quality companies. Tough! Such is the nature of investing….not every decision we make will be correct.

In my recent Alimentation Couche-Tard Inc. (ATD.b) article I quoted Monish Pabrai who, in my opinion, has hit the nail on the head when he says:

‘The biggest, the single biggest advantage a value investor has is not IQ. It is patience and waiting. Waiting for the right pitch and waiting many years for the right pitch.’

‘You don’t make money when you buy stocks. And you don’t make money when you sell stocks. You make money by waiting.’

I do not profess to be in the same league as Monish Pabrai when it comes to investing but ‘waiting’ is pretty much what I have also been doing the past few months.

Back to GS…..

Other than the occasional purchase, I have continued to reinvest dividends and have initiated the occasional option trade. I disclosed a GS Bull Put Option Spread trade in this April 16th article; GS was trading at $201.84 when I wrote this article

On June 27th, GS announced that the Federal Reserve Board did not object to its 2019 Comprehensive Capital Analysis and Review capital plan, which includes up to $8.8B of capital return beginning Q3 2019 and ending in Q2 2020. The capital plan provides for up to $7.0B in repurchases and $1.8B in total common stock dividends, including an increase in the quarterly common stock dividend from $0.85 to $1.25/share in Q3.

Following this announcement, GS’s share price has appreciated from ~$197 on June 26th to the current ~$215.50. The rise in GS’s share price has resulted in the Bull Put Option Spread working out well….so far. Anything, however, can happen between now and the October 18th expiry.

With GS having released Q2 2019 results on July 16th I now take a very quick look at GS’s valuation and outlook.

GS and Malaysia 1MDB Legal Issue

Should you be interested in initiating a GS position it would be wise to take into consideration the $7.5B restitution the Malaysian government is seeking from GS. GS has offered $241.73 million to compensate Malaysia for its role in the multi-billion dollar financial scandal involving a Malaysian state fund. The gap between these two amounts suggests that a resolution to this legal issue could be a protracted affair.

GS has likely accrued hundreds of millions to billions of costs related to this event, but it is entirely possible it could still incur billions more.

I am of the opinion that the overall fallout from 1MDB will be manageable and equivalent to perhaps 2 quarters of GS earnings. Anything, however, can happen when it comes to legal issues.

Q2 2019 Financial Results

The Q2 2019 Earnings Presentation which accompanies the Q2 Earnings Release can be accessed here.

After reviewing GS’s Q2 results and reviewing the transcript of the Q2 call with analysts I continue to be comfortable with my long position AND my Bull Put Spread option.

On the Q2 analyst call management reviewed its philosophy on capital. Its first priority continues to be to look for opportunities to invest in the business at attractive returns so as to improve shareholder returns.

When it comes to dividends versus buybacks, GS has indicated it aspires to have a higher dividend long-term. GS views its dividend as an important component of total shareholder return and it reflects management’s confidence in the ability to generate more recurring and predictable sources of revenue.

On the topic of share repurchases, GS has indicated that share repurchases allows it to be more dynamic with capital allocations based on the environment and business opportunities.

GS also places a great deal of importance in meeting/exceeding the stress capital buffer. Its Common Equity Tier 1 capital level of 13.8% as at the end of Q2 2019 is such that even following the $8.8B capital return, the firm should be well positioned to manage capital at appropriate levels.

Looking at page 12 of 14 in the Q2 Earnings Release, we see Total Assets of $945B which is a $20B increase from Q1. On the liability side, deposits increased to $166B which includes consumer deposits of over $50B – more than double since last year.

In Q2, GS experienced further progress migrating businesses into its bank entities to take advantage of their more diversified and lower-cost funding.

In addition to the above I am reassured that GS generated a ROE in excess of 11% and am also encouraged that GS reported record assets under supervision. Furthermore, GS was ranked #1 in announced and completed M&A and it was also #1 in equity underwriting; additional YTD Worldwide League Table Rankings can be found here.

Credit Ratings

A comprehensive recap of ALL of GS’s credit ratings, including those of its affiliates can be found here.

I pay close attention to the risk aspect of my investments, and therefore, I look at the credit ratings assigned by the major ratings agencies.

Moody’s and S&P’s (I monitor the ratings from these two companies more closely that the ratings from the other agencies) long-term credit ratings at the GS Group Inc. level are the lowest tier of the ‘upper medium grade’ category and are satisfactory for my purposes.

Dividend, Dividend Yield, and Dividend Payout Ratio

We see from GS’s dividend history that its quarterly dividend increased from $0.80/share to $0.85/share with the June 27th dividend payment. Earlier in this article I indicated that GS’s Board of Directors had approved an increase in the quarterly dividend from $0.85 to $1.25/share commencing Q3.

The March 28th dividend was $0.80 so with the new $1.25 quarterly dividend, GS shareholders have benefited from a 56.25% increase in GS’s quarterly dividend in less than a year. Not once in my entire career did I ever receive a YoY increase in compensation of this magnitude.

I fully understand how a 56.25% increase in a company’s quarterly dividend might raise the question as to whether a company’s earnings can sustain a dividend increase of this magnitude.

Looking at FY2014 – FY2018 Diluted EPS ($17.07, $12.14, $16.29, $9.01, $25.27), we see that GS has historically generated sufficient earnings to service the new $1.25/quarter dividend.

Servicing the dividend from a Free Cash Flow (FCF) perspective is a bit more problematic. During the same timeframe, GS’s FCF was -$8.61, $7.65, $3.63, -$21.41, $12.44. As you can see, FCF is all over the map.

I am, however, giving GS’s Board of Directors the benefit of the doubt that they would not be foolish enough to have increased GS’s quarterly dividend 56.25% over the past couple of quarters if there was any indication that this new $1.25/quarterly dividend was not sustainable.

I suspect many investors screen for investment opportunities which include the ‘dividend yield’ parameter. GS’s ~2.32% dividend yield (($1.25 x 4)/$215.5) likely doesn’t meet the ‘dividend yield’ set by most investors. We each have personal investment goals and objectives so I am not implying that overlooking GS on the basis of its low dividend yield is wrong. In my case, I seek a balance of safety, income, and growth and the sub 2.5% dividend yield is not a ‘deal breaker’.

Share Repurchases

The prudent repurchase of issued and outstanding shares is another area in which I pay particularly close attention.

Looking at GS’s historical Annual Reports I see that that the average diluted common shares outstanding in FY2002 was 525.1 million. Fast forward to the end of Q2 2019 and this figure has been reduced to 378 million; in Q2 2019, GS returned $1.57B of capital to common shareholders which included $1.25B of share repurchases (6.2 million shares at an average cost of $200.73).

GS has announced its intent to repurchase up to $7.0B in issued and outstanding shares between Q3 2019 and Q2 2020. Once again, I strongly suspect GS’s Board of Directors would not provide this authorization if it suspected GS’s financial position would be jeopardized.

Valuation

In my April 16th article I wrote that in FY2018, GS had generated basic diluted EPS of $25.53 and adjusted diluted EPS of $25.27. At the time of my January 17th article, GS had closed at $199.09 thus giving us a diluted PE of ~7.8 and an adjusted diluted PE of ~7.88.

GS does not provided earnings guidance but at the time of my January 17th article, the current mean adjusted EPS estimate for FY2019 from 25 brokers was $24.39. Using this estimate and the $199.09 stock price I arrived at a forward adjusted PE of ~8.16. This was not much different from the forward adjusted PE of ~7.9 as at the time of my November 18th article.

When I wrote my April 16th article I indicated that the mean adjusted EPS estimate from 24 brokers was $23.47. Using the $201.84 share price at the time of that article, the forward adjusted PE was ~8.6.

Multiple analysts now expect GS to generate adjusted diluted EPS of ~$22.82 in FY2019. With shares currently trading at ~$215.50 we get a forward adjusted diluted PE of ~9.44.

Regrettably, GS’s valuation no longer presents the same bargain as at the time of my more recent articles. I do, however, still view GS as being currently attractively valued.

Final Thoughts

When I initiated my bullish option trade in April I was of the opinion that the probability of GS exceeding $210/share come the October 18 2019 expiry outweighed the probability of it falling below $190. The vast majority of all the companies I analyze continue to be too expensive for my liking but in the case of GS, I think the current ~$215.50 share price is reasonable and shares will trade above the $210 strike price come expiry.

I have no idea what could be the outcome regarding the 1MDB legal issue but when I initiated a GS position in November 2018 it is because I was prepared to take my chances that the courts will find in favor of GS and that certain members of the former Malaysian government and 1MDB lied to it about how proceeds from the bond sales would be used. My line of thinking remains the same.

I am tempted to acquire additional GS shares at the current level but am endeavoring to remain disciplined. I have my sights set on other companies which I deem to be currently overvalued. I remain of the opinion there will be a broad market pullback in 2019 and am purposely keeping money on the sidelines to deploy should such a pullback occur.

I hope you found this article helpful and wish you much success on your journey to financial freedom.

Thanks for reading!

Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].

Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.

Disclosure: I am long GS.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.