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A Thinning Pool Floats Goldman's Boat

By Alex Dumortier, CFA - Apr 16, 2013 at 10:15AM

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Return on equity is looking up.

After suffering their worst single-day decline since Nov. 7 yesterday, stocks are bouncing back this morning, with the S&P 500 (^GSPC 0.01%) and the narrower, price-weighted Dow Jones Industrial Average (^DJI 0.03%) up 0.76% and 0.73%, respectively, at 10:05 a.m. EDT.

Goldman: More for me!
On Feb. 12, Goldman Sachs (GS -0.45%) CFO Harvey Schwartz intimated at an industry conference that the firm was not satisfied with its return on equity of 10.7% in 2012, but he suggested that better days were on the horizon. "The industry will migrate to higher returns because it has to," he said, suggesting that part of that process would occur through capacity -- i.e., competitors -- leaving the industry.

Earlier this month, Goldman COO Gary Cohn confirmed that this shift was already underway. "We are seeing the big international banks, outside of ourselves and JPMorgan, really taking pretty substantial steps back from the market, and we haven't seen that in the entire history of banking," Cohn said at an investment conference.

A single quarter does not a trend make, but Goldman's first-quarter results, released this morning, suggests that Messrs. Schwartz and Cohn may be onto something. Indeed, the bank managed to boost its ROE to 12.4% by continuing to manage compensation costs (the ratio of compensation and benefits to net revenue fell to 43% from the year-ago period) and growing total revenue 9% to $10.1 billion. The Financial Times reported that "an uptick in corporate debt issuance offset a decline in trading revenues." I'll simply note that UBS -- one of the firms Cohn mentioned specifically -- has essentially withdrawn from the fixed-income business, which includes debt issuance.

If Goldman can achieve mid-teen ROE -- the bank dropped its public ROE target after the financial crisis, but management reportedly considers a 20% return on tangible equity achievable -- then paying a 9% premium to tangible book value looks pretty appealing. However, it may not be so straightforward; as I highlighted in this column, Warren Buffet's renegotiation of his Goldman warrants suggests he is not all that bullish on the bank's fundamentals.

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Stocks Mentioned

Dow Jones Industrial Average (Price Return) Stock Quote
Dow Jones Industrial Average (Price Return)
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The Goldman Sachs Group, Inc. Stock Quote
The Goldman Sachs Group, Inc.
$306.80 (-0.45%) $-1.40
S&P 500 Index - Price Return (USD) Stock Quote
S&P 500 Index - Price Return (USD)
$3,901.36 (0.01%) $0.57

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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