Goldman Sachs: Buy The 7.3% Yield Preferreds

Summary:

• Goldman Sachs’ earnings have been declining, yet its stock has been rising. As a result, it’s one of the most expensive bank stocks in America.
• The company has a 2.47% dividend yield and a 5.9% earnings yield. Meanwhile, the Series A preferred shares yield 7.3%.
• Liquidation preference on the preferreds is $25, so investors would realize an 8.8% capital gain if they were called.
• In this article, I explain why I would buy Goldman’s preferred shares before buying GS.

Goldman Sachs (NYSE:GS) is one of the priciest major U.S. bank stocks. Based on the financials shown below, the stock trades at 16.7 times earnings, 2.86 times sales and 1.22 times book value.

• EPS: $22.87.

• Revenue: $46.275 ($133.75 per share).

• Book value per share: $313.

By contrast, the S&P financials index trades at 13.2 times trailing earnings, 15 times forward earnings, 1.89 times sales and 1.76 times book value. Goldman Sachs is more expensive on two out of three metrics, particularly the P/E ratio, which investors usually give the most weight. That’s really remarkable when you consider that S&P financials index includes the famously pricey credit card companies. Goldman trades at an even greater premium compared to its fellow banks.

Given its richer valuation than other banks, you’d think that Goldman Sachs must be performing better than its peers. As a stock, it is; and as a company, it has certainly outlasted the regional banks that failed last year. But when you compare Goldman to other large banks, you find very little to justify the premium.

Below, I have compared select growth and profitability metrics for GS, Bank of America (BAC), JPMorgan (JPM) and Morgan Stanley (MS). As you can see, Goldman is no outperformer going by these metrics.

	Goldman Sachs	Bank of America	JPMorgan	Morgan Stanley
Revenue growth	1.29%	1.93%	19.36%	0.42%
Earnings growth	-24%	-3.45%	34%	-15.7%
Net margin	18.8%	28%	34%	17%
Net interest income/interest revenue	9.3%	43.7%	52.1%	17.3%
Return on equity	7.45%	9.8%	17%	9.4%

Click to enlarge

As you can see, Goldman scores the worst out of the bunch on this collection of metrics, with the lowest numbers on earnings growth, net interest/interest revenue and ROE. In second last is Morgan Stanley, swinging misses on revenue growth and net margin. It makes sense that these two would fare the worst out of the four banks sampled, because investment banking results were poor last year. In 2023, M&A activity hit a multi-decade low as interest rates peaked around 5% following their fastest rise in modern history.

As Howard Marks writes in his Sea Change memo, declining interest rates were a major contributor to the rise in deal-making from 1990 to 2021. Lower rates made treasuries less desirable and companies less expensive to run-all of this heavily incentivized deal-making and IPOs. It follows from this that the 2022/2023 rise in interest rates was likely behind the decline in investment banking fees observed in the period, as it had the effect of making funds more costly. Another likely contributor was the rise of private credit. With high interest rates raising the cost of capital and private credit cutting into bond issuance, investment banking fees had nowhere to go but down. In the meantime, lenders did comparatively well as they collected higher rates on mortgages and related interest rate sensitive products.

Today, things are looking a little better for investment banks. Fees actually rose in the fourth quarter, after being down in the prior three quarters. Some think that interest rates will start coming down this year-if that’s the case then it could have a moderately bullish effect on dealmaking, although the expected decline in rates for the whole year is only 0.75 basis points.

There’s some basis for thinking that some AI-related deals are coming. Sam Altman is trying to raise $7 trillion-yes, 7 trillion dollars, not $7 trillion in implied valuation-for a group of chip companies. That will probably generate some fees if it materializes, although I’m personally skeptical that Altman will hit his target.

On the whole I think that investment banking fees will rise this year, but only modestly. First, the weakness in the base period makes modest single digit growth easily obtainable. Second, there is a broad consensus that interest rates have peaked and may even come down slightly this year. Third and finally, it is quite likely that there will be AI-related M&A in the year ahead-maybe not “$7 trillion” worth, but Q3 2023’s growth rate in AI related M&A (58%) could be reflective of the whole year ahead. However, the amounts we’re working with here (about $100 billion per quarter) are not enough to move the needle for a company of Goldman’s size in a truly major way. So I’m expecting Goldman’s earnings to grow something like 10% to 20% in 2024, significantly lower than what’s implied by 2024 earnings estimates.

If my estimate of Goldman Sachs’ 2024 earnings is correct, then the company’s large premium to the rest of the banking sector isn’t warranted. That would rule out investing in the common stock. As luck would have it, though, Goldman offers some very high yield preferred shares that appear very much worth the investment at today’s prices.

Goldman Sachs Series A Preferred Shares

Goldman Sachs’ Series A Preferred Shares currently sport a 7.3% dividend yield, and are callable at a price ($25) about 8.8% higher than the current price. The current yield beats the yield on Goldman Sachs’ common stock, as well as the 10 year treasury yield. Discounted at the 10 year treasury yield with no risk premium, the dividend is worth $38.83 (ignoring the callable feature). With a 3.2% risk premium incorporated, the dividend is worth about what it is now. It’s common for investors to use risk premiums as high as 6% on risky assets, such as common shares. Preferred shares, being bond-like instruments, merit lower risk premiums than common stocks. As long as Goldman Sachs remains solvent then the company’s preferred share dividends will be paid until they are called.

Will Goldman Sachs remain solvent?

By all accounts, yes, it will. The firm’s long term bonds have an A+ rating from Fitch. Its balance sheet has characteristics consistent with such a rating. The firm has more cash and liquid securities than it has debt. Its goodwill is a miniscule 5% of shareholders’ equity-when you back it out you get a fairly low price/tangible book value ratio of 1.29. Finally, although Goldman’s interest expenses grew faster than interest income last year, its rate of decline in NII was only 17.2%, and with interest rates having apparently plateaued, more declines probably will not occur in 2024. This isn’t consistent with a scenario where the company’s earnings enter a secular decline, requiring cuts to the common share dividend, followed by preferred dividend cuts. Preferred share dividends are likely to continue being paid.

Given the high quality of Goldman Sachs’ balance sheet, we would conclude that the company’s preferred share dividends are at low risk of being cut, justifying a low risk premium. This in turn supports the fair value estimates I gave earlier, which are above the current stock price using risk premia as high as 3.2%.

The Bottom Line

The bottom line on Goldman Sachs right now is that its common stock has a very rich valuation, but its preferred shares are very much worth the investment. Goldman’s shares trade at 16.7 times earnings, when multiples in the 9-11 range are more common for banks these days. Goldman is very strong in investment banking, but it isn’t outperforming large diversified banks as a class. It is exactly the type of company where a bet on the stock is a bet on positive earnings growth, which makes the preferred shares a much easier and safer play. Companies miss earnings estimates quite frequently, but solvency issues requiring preferred dividend cuts are fairly rare. If you buy GS.PR.A today, you’ll get a dividend worth more than what you’re paying for the stock, and if your preferreds get called, they’ll be called at a price higher than what you pay. It seems like an open-and-shut case.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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