Malaysian Scandal Will Weigh Heavily On Goldman Sachs' Q4 Earnings Report

New York-based Goldman Sachs Group Inc. (NYSE:GS) is currently embroiled in such a situation. In fact, the global investment bank is facing one of the worst financial scandals in the institution's 149 year history. Authorities in Malaysia have implicated two former Goldman Sachs employees in bond deals done on behalf of a Malaysian state fund, known as 1MDB, alleging that proceeds were diverted to benefit individuals.

Malaysia’s new government is seeking fines in excess of $3.3 billion, to cover, among other things the funds allegedly stolen by the two former Goldman bankers and a Malaysian financier named Jho Low, whom U.S. prosecutors accuse of conspiring to defraud the fund. The U.S. Justice Department in November charged the ex-bankers, Timothy Leissner and Roger Ng, and is investigating Goldman itself. Just yesterday, the New York Times reported that the government of Malaysia said they were pinning the blame squarely on the investment bank and are "seeking $7.5 billion in compensation...adding to the mounting pile of penalties against the bank."

In situations like this, banks usually suffer on two fronts: their reputation takes a hit and their earnings outlook becomes uncertain on concerns any large fines imposed will eat up any future growth. Goldman looks to be facing penalties on a variety of fronts in both Malaysia and the U.S.: for missing red flags; for the alleged bribes paid by at least one of its employees; for clawbacks by the Malaysian government to losses from the state-owned fund itself and for any additional fines leveled against the bank as a result of civil and criminal investigations that are still ongoing.

Pressured by these concerns, Goldman Sachs was the worst-performing of America’s big banks during 2018. Over the past three months, shares have fallen 18%, underperforming the KBW Nasdaq Global Bank Index, which is down half that amount. The group’s earnings estimates for the fourth-quarter have been cut by 27% to $5.61 a share.

In our view, when it reports on Wednesday, GS will try to calm investor worries by announcing it is setting aside a good chunk of money to cover any potential fines and obligations. The aim is to help investors quantify the impact of the scandal as well as the legal reserves needed by the bank to deal with the situation.

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Irrespective of the weight of the current crisis that GS is facing, banking stocks overall aren’t among our recommended trades for 2019. They are neither immune to the uncertain economic outlook nor to any possible slide in trading volumes this coming year.

Though Goldman Sachs' diversified global operations make it a strong candidate for longer-term buy-and-hold portfolios, until it can get past its legal challenges, the bank's shares will continue to lag other sector players in the short-run. As well, the visibility of this Malaysian scandal, which helped bring down the previous government in that Asian country, means Goldman may also lose business to competitors in the region. As it tightens its internal controls in a bid to impress financial regulators and regain credibility, Goldman Sachs could easily be counted out as a business partner by emerging-market sovereign and semi-sovereign issuers world-wide.

Bottom Line

Trading around $179 a share with a trailing price-to-earnings multiple of 13, shares of Goldman Sachs aren't cheap when compared to its peers. Plus, given its current legal troubles, its fundamentals don't warrant bargain hunting. Our advice: stay on the sidelines and let the scandal run its course.