Goldman Sachs: Critical Risks Assessed (NYSE:GS) (2024)

It is needless to say that there is an abundance of focus on the banking industry due to SVB Financial Group's (NASDAQ:SIVB) crash and the mainstream narrative surrounding a pending banking crisis. Unfortunately, I cannot predict the pending narrative from depositors or active investors. However, I can tell you a bit about The Goldman Sachs Group, Inc.'s (NYSE:GS) risk composition to assist you with your holistic investment strategy.

In this thesis, I discuss some of our latest findings pertaining to Goldman Sachs and its stock with an emphasis on pricing risk. Although short-term market behavior might phase out many of the facts mentioned in the article, we believe the long-term outlook on Goldman Sachs will adhere to many of the facts mentioned within the text.

Without further ado, let us get started with the analysis.

Goldman's Operations Assessed

First and foremost, it is necessary to look at Goldman Sachs' revenue composition. The bank generates approximately 16.2% of its revenue from interest-bearing activities. Additionally, the firm hosts various held-for-trading debt instruments via its non-interest-bearing segment.

All else being equal, trading revenue is considered the riskiest source of revenue for a bank, which needs to be considered in Goldman's case as approximately 20.8% of the company's asset base is categorized as trading securities. Although Goldman's trading segment adds risk to the bank's framework, its reliance on fee-based business phases out much of its risk as fee-based services are usually considered a low-risk source of income.

Balance Sheet Analysis

The current big talking point among investors relates to funding sources. Fundamentally, short-term funding sources such as deposits are considered riskier than longer-term funding, like debt instruments with residual maturity of more than a year. Based on Goldman's liabilities, the bank is heavily loaded with deposits, which span nearly 30% of its financial liabilities. However, investors must consider that the bank is an industry leader. Therefore, depositors might consider its liabilities more secure than those of regional or Tier-2 banks.

Furthermore, Goldman possesses a sound asset base with plenty of short-term securities available to collateralize their liabilities. However, investors must consider that the bank possesses a lot of long-term debt investments and loan originations, which might be priced as risky by investors seeing as the yield curve is not playing ball.

Let me explain the aforementioned concern about long-duration debt.

Banks typically lend and invest in long-duration contracts while funding their investments/loans with short-term liabilities. This is because long-duration debt typically possesses a liquidity risk premium, allowing for higher returns.

In order to take advantage of long-term risk premiums, debt investors require an upward-sloping yield curve. However, the current yield curve is currently sloped downward due to recession risk, meaning that Goldman Sachs' debt portfolio is in danger of generating losses unless it is actively managed to compensate for fluctuations in the yield curve.

Provisions and Charge-Offs Have Increased

According to Goldman's latest income statement, the firm's net earnings were lower in 2022 than in 2021. In isolation, this is fine as Goldman runs a cyclical business, meaning its profitability is normally distributed with sporadic negative drawdowns. However, we are worried about the company's increase in loan provisions, which suggests that the entity's management is anticipating more non-performing and uncollectible loans in the coming quarters.

In our view, the increase in provisions is inherent to cyclicality and is conveyed by the inconsistency of U.S.-based credit spreads. Unfortunately, there is no way to justify Goldman's loan provisions.

Non-Credit Business Segments

As mentioned before, Goldman operates various non-credit-related businesses. Even though services are usually considered less risky than trading and debt origination, last year's bear market caused a significant drawdown in Goldman's market-based revenue because IBD activities stalled.

Global IPO market data illustrates that public offerings and underwriting remains stagnant. However, we think a turnaround is en route, as factors such as the leveling in U.S. inflation and a year-to-date rise in global stock markets provide the opportunity for issuers to benefit from an improved capital structure environment. Moreover, the recent increase in demand for equity securities means IPO floatation costs could reignite.

Pricing The Stock's Risk

Bird In Hand Theory

Even if Goldman falls subject to rising systemic risk, its dividend profile attaches a countercyclical trait to its stock. The "bird in hand" theory suggests that investors are more inclined to onboard risks from assets that pay dividends than assets that are pure price speculation plays.

Goldman's stock aligns with the "bird in hand" theory, as its dividend profile is something to admire. While presenting a forward yield worth 3.10%, Goldman's dividend is backed up by 11 years of consecutive growth and a dividend coverage ratio of 3.31.

Scenario Analysis

A backward-looking scenario analysis shows that Goldman's stock exhibits excess volatility compared to the broad-based stock market. A hypothetical banking crisis 2.0 draws proximities to 2008's crisis, and if the backtested chart is anything to go by, another banking crisis will cause Goldman's stock to underperform the S&P 500 (SP500) by more than 50%.

Despite the technique's helpful application, scenario analysis should always be looked at in tandem with other influencing factors, as a hypothesized event is unlikely to resemble a past event.

Final Word

Based on our findings, a structural break in the economy might adversely affect Goldman Sachs' stock. Although we are not bearish on Goldman Sachs, we urge investors to consider critical risk factors such as the bank's long-duration asset base, increasing loan provisions, and its stock's negative showing in our scenario analysis.

Although features such as a "bird in hand" dividend policy and improving fee-based business prospects phase out some of The Goldman Sachs Group, Inc. risks, we believe a structural break in the economy would significantly damage the bank's operations and assign an unwanted risk premium to its stock.