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3 Reasons Goldman Sachs Stock Could Rise

By John Maxfield – Mar 3, 2016 at 4:40PM

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Goldman's stock is currently trading for a meaningful discount to its book value. This won't last long.

Shares of Goldman Sachs (GS 0.68%) have fallen sharply this year as concerns about the global economy weigh heavily on several branches of its business. I took advantage of the drop by buying shares of the storied investment bank based on the belief that its stock price will recover.

Here are three reasons to think that it will.

1. Improvement in the global economy
Making markets is Goldman Sachs' single largest business line. It consists of buying and selling securities for the investment bank's institutional clients. In 2015, it generated $9.5 billion in revenue from the activity, handily outpacing its second-largest business line, investment banking, which brought in $7 billion in revenue.

An important aspect of market making is that it varies with the underlying conditions in the markets. When things are going well, causing investors to rapidly trade in and out of securities, Goldman makes a lot of money. But when its clients get scared, they reduce their trading volume, which impacts Goldman's top line.

This was the case in the latter half of last year, as Goldman explained in its 2015 10-K:

[In the last three quarters of 2015] concerns about global growth and uncertainty about the U.S. Federal Reserve's interest rate policy, along with lower global equity prices, widening high-yield credit spreads and declining commodity prices, contributed to lower levels of client activity, particularly in mortgages and credit, and more difficult market-making conditions.

If these concerns were to diminish, it's reasonable to assume that Goldman Sachs would earn more revenue from making markets. All else equal, this would lead to higher profits and thus, presumably, a higher stock price.

2. Higher interest rates
Although Goldman Sachs generates the majority of its revenue from noninterest income, it also has a sizable lending operation that earns interest income. Last year it generated $3.1 billion in net interest income, which was down from $4.1 billion in 2014. The drop explained why Goldman's overall revenue declined on a year-over-year basis by $700 million.

Revenue Line Item

2015

2014

Market Making

$9.5 billion

$8.4 billion

Investment Banking

$7.0 billion

$6.5 billion

Investment Management

$5.9 billion

$5.8 billion

Trading

$5.0 billion

$6.6 billion

Commissions and Fees

$3.3 billion

$3.3 billion

Net Interest Income

$3.1 billion

$4.1 billion

Data source: Goldman Sachs' 2015 10-K, page 55.

Consequently, just like a commercial bank, Goldman Sachs should earn more revenue and income once interest rates rise. It's impossible to say when this will happen, but the bottom-line boost to Goldman's income statement once it does should translate into a higher share price in the same way that improved market-making activities will.

3. Lower systematic risk
When you consider that the broader market has dropped since the beginning of the year, one the biggest anchor weighing on Goldman Sachs' stock right now is systematic risk. This is the risk inherent in the entire market, irrespective of any stock in particular.

Investors are legitimately concerned right now about multiple economic headwinds. Economic growth in China is decelerating. The country's GDP increased by only 6.9% last year, the slowest pace in a quarter-century. The price of oil remains depressed, spreading fear that a wave of corporate defaults will wash over the oil patch. And the United Kingdom has scheduled a referendum for its citizens to vote in June on whether to remain in the European Union.

The combination of these factors drew the nearly seven-year bull market in the S&P 500 to a close at the beginning of 2016. Goldman Sachs was merely one of hundreds of stocks that have been affected, as its shares are currently trading for a 10% discount to book value. It seems reasonable to assume, in turn, that this discount will evaporate when the dust settles in China and Europe, as a company of Goldman's caliber should, under most scenarios, trade for a premium to its book value.

John Maxfield owns shares of Goldman Sachs. The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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