Northstar’s quality-driven approach means that we tend to avoid investing in banks owing to their capital intensive nature, inherent leverage and limited evidence of any sustainable competitive advantage.
However, in the midst of the recent market correction, we had the opportunity to introduce Goldman Sachs, the global investment bank and financial services company, as a holding in our Global Flexible Fund.
The reasons for this apparent change in approach is that we see a number of signs that Goldman Sachs is shifting its business model in a direction that we see as positive, including reducing leverage, shifting into more capital light businesses and leveraging their strong brand in the consumer space. These changes support their drive towards a higher return on equity (ROE) target and give us confidence they can achieve it.
Ambitious three-year targets appear achievable
Late in January, Goldman Sachs held its first ever investor day. The Group’s new management set out its strategic direction and objectives, which are:
- To grow and strengthen existing businesses – to ensure greater market share.
- To diversify products and services – to ensure more durable or less volatile earnings.
- To enhance operational efficiency – to ensure greater profitability.
Their overarching financial objective is to add an additional $4 billion to $5 billion in annual revenues over the next three years and to achieve a ROE target of 13%, from 10% in their 2019 financial year.
Their plan to achieve the ROE target focuses on increased scale, lower funding costs and growing more profitable businesses.
Our investment thesis rests on the ROE target being met, although the downside risk is limited by the attractive valuation opportunity presented in mid-March, when the share traded on a price to book (P/B) ratio of 0.58 times. This compares to an average P/B ratio of 1.45 times over the past 20 years and 0.98 times since the global financial crisis (GFC).
Chart 10: The Goldman Sachs Group Inc. price to book ratio and normalised return on equity
Source: Bloomberg, Northstar (June 2020)
The shares have rallied from their late-March low of $134 to $209 currently and therefore the margin of safety afforded by the simple valuation opportunity has closed. The P/B ratio is back at 0.9 times, in-line with the post-GFC average and at a fair ratio for a business generating an ROE of 10%. Retaining the investment therefore requires confidence that the ROE target of 13% or more is achievable.
We had the opportunity to engage with Goldman Sachs COO, John Waldron, last month and came away from the discussion encouraged by the progress they are making in meeting this target and delivering on the strategic objectives set out above.
Excellent opportunities to leverage the Goldman Sachs franchise
Goldman Sachs has an unquestioned leadership position in investment banking and regularly tops industry ranking tables for merger and acquisition (M&A) transactions and equity and debt underwriting. As competitors in this space restructure and exit businesses, there is scope to grow market share incrementally in certain niches. But little to no durable competitive advantage exists in investment banking, which remains highly competitive and cyclical.
We are therefore more encouraged by progress being made to diversify products and services, and to leverage the Goldman Sachs franchise and intellectual property.
The business is on track to meet its five-year/$100 billion third-party fund-raising target in alternative asset management, which should generate stable management fees that, by nature, have high return on capital. This move takes advantage of the bifurcation in the asset management industry away from traditional active managers to passive managers on the one hand and the uncorrelated returns offered by alternative asset management firms on the other. Blackstone Group, another *Northstar Global Flexible Fund holding which I wrote about earlier in the year** , has been able to raise $250 billion over the last 24 months, and Goldman Sachs has the brand, the knowhow and the people to be competitive in this space. If they can be even a fraction as successful as Blackstone, their ROE target will be well within reach.
Scale matters in transaction banking and Goldman is well on its way to achieving its $50 billion, five-year deposit target, prior to the official launch of its digital platform later this month. By early May it had raised $20 billion in deposits from 175 clients, up from $2.5 billion from 25 clients at the end of December 2019. Goldman is also extending its reach into consumer banking through its digital platform, Marcus, and has raised $72 billion in retail deposits – a valuable and diversified source of funding for the Group.
In fact, another aspect of the investment case we find attractive is the changing nature of the balance sheet. Gross leverage has reduced from 26 times in Q4 2007 to 11.8 times in Q1 2020, while deposits have increased from $15 billion to $220 billion. Deposits have increased from 3% of total funding during the GFC to 31% currently.
While lower leverage dilutes returns, it also meaningfully reduces risk and enhances the quality of the “unlevered” return. In theory, if sustainable, this should warrant a higher P/B multiple, in our opinion.
Improving fundamentals and attractive valuation
At Northstar, our investment approach is built around a strong valuation discipline. We spend time assessing companies, identifying positive fundamentals and looking for evidence of changes that can unlock value. When our analysis suggests that improving fundamentals are not demandingly valued, we are comfortable to move beyond the first derivative of what is generally considered quality. This includes investing in cyclicals at the right point in the cycle where there is evidence of a competitive advantage, even when this may be nascent.
The investment in Goldman Sachs illustrates our focus on improving fundamentals, which when combined with a strong value discipline, generally leads to good investment outcomes.
* Northstar Global Flexible Fund referenced in this article refers to the following funds: SA Domiciled: Northstar SCI Global Flexible Fund and Northstar Global Flexible Feeder Fund and Offshore Domiciled: Northstar Global Flexible Fund. SCI refers to Sanlam Collective Investments. Refer to returns on the fund information page.