Built to win

Alone among its peers, Goldman Sachs came through the financial crisis of 2008 intact, while its counterparts on Wall Street were transformed by choice or circumstance.

 

Lehman Brothers failed. Morgan Stanley has pivoted toward wealth management, its commitment to institutional trading wavering at times. Citigroup has staked its future largely on its international banking franchise. The European universal banks' ambitions have been trimmed by market stress and regulatory aggression. JPMorgan Chase, in many ways Goldman's most important competitor, emerged stronger, but took on Bear Stearns and Washington Mutual along the way - in rushed marriages that changed its business mix.

But Goldman, remains, as before the crisis, the largest pure investment bank and institutional broker in the business, serving big companies and asset managers in raising capital and moving it around the world. Sure, the company hurriedly filed paperwork in late 2008, along with Morgan Stanley, to convert to a bank holding company. But this was a change in legal status, meant simply to enable possible help from the Federal Reserve, not an alteration of Goldman's business endeavors, which remain more lucrative than most others in the financial services industry.

What has changed since before the generational asset value collapse of 2008 is the market's perception of Goldman, and the way it has been converted into the valuation of the company's shares.

In the boom years, encompassing 2006, when Barron's last took a close look at Goldman in an admiring cover story ("Minting Money: The Goldman Sachs Way," April 10, 2006), the company was viewed as a can't-miss money machine, and slandered as a hedge fund in investment banking disguise, for its tendency to win the greatest spoils in a spoiled era. Its shares traded at a heady premium to the broader financial sector, and routinely fetched more than 2.5 times tangible book value.

Today, in contrast, Goldman is viewed as an exemplar of Wall Street's hamstrung, post-crisis fate: forced to carry more inert capital, unable to trade as much for its own book, embarrassed by criticism of some past sales practices, hampered by lethargic trading and merger volumes, and tangled in a regulatory regime whose only certainty is that it will be more onerous than what came before. The shares, which closed Friday at $113.68, are well off their 2007 peak of $248, and below tangible book value of $126.

Granted, all major bank stocks trade below book, and none would be immune to another financial scare. But the negative perception of Goldman is far more dour than the reality justifies. The company maintains an abiding leadership position in most of its activities, and is financially sturdier and less burdened by irrational competition than it was a half-decade ago. Based on the likely outlook for capital markets activity and Goldman's ability to continue growing its book value, it is easy to conclude that the shares could rise at least 25% within a year.

Mike Mayo, an analyst at CLSA known for his apt skepticism toward many bank strategies and stocks, recently upgraded Goldman's shares to Buy, with an upside target of $142. He argues that the company is less financially risky than it had been when its stock was much higher, and that it remains "one of the more adept financial firms at dynamically allocating capital."

Goldman has been building its capital cushion carefully, while buying back as much stock as is prudent, and maintaining its leading role in advising companies on mergers and in helping them raise capital.

As of June 30, its "global core excess" - the trove of equity capital and cash-like instruments that is the foundation of its balance sheet - hit $175bn, up from $111bn at the end of 2008. Total balance sheet assets are down to $950bn from $1.1 trillion, and leverage - the ratio of assets to equity capital - is now 13 times, versus a peak around 26. Goldman is better capitalised than most large peers, and well on its way to meeting the global Basel III capital standards that take effect in 2019.

While most banks issued large amounts of stock and slashed their dividends in the crisis, Goldman has bought in 7% of its shares since the end of 2009 and continues to buy its stock below tangible book value. It never cut its dividend, currently at $1.84 a share. The stock yields 1.6%.

Keeping all that capital on hand has punished profitability. Return on equity, the key measure of a securities firm's earnings, has hovered in the high single digits for the past year and a half. On some level, this represents a decision by management to "under-earn" for a time as regulatory rules and market conditions sort themselves out, while simultaneously taking costs out of the firm.

Goldman is in the midst of a $500m expense reduction program on top of $1.4bn last year, relying in part on relocating support functions to lower cost venues, such as Salt Lake City and Dallas.

Says Glenn Schorr, an analyst at Nomura Securities in New York: "Goldman has been more aggressive than most . . . [in] reducing head count at higher levels" to ensure both that it can make an adequate return at low activity levels and retain operating leverage in the event markets heat up. Thus, it's playing defense without sacrificing its ability to get aggressive as opportunities arise, a tack echoed by senior Goldman executives in recent conversations.

The bear case on Goldman, and by extension all firms operating by the traditional rules of Wall Street economics, is that regulation, lower financial leverage, reputational damage and a long-lasting ebb in capital market volume will prevent the firm from earning an acceptable rate of return on shareholders' capital, even as it continues to overpay teams of trading cowboys to take undue risks. Each point can be countered, at least enough to suggest that Goldman's share price currently discounts them.

To be sure, lower leverage will dampen absolute levels of profitability: the bank is expected to net $6.5bn, or $12.55 a share, in 2013, below its pre-crisis peak of $11.4bn. But not all the profits of the pre-crisis period owed to leverage.

What's more, in this year's first quarter, in a modestly better environment for client risk-taking and deal-making, Goldman notched a 12% return on equity, respectable enough to keep book value and the stock price rising nicely if it becomes the new norm. Plus, Goldman's valuation reflects barely, if at all, the value of Goldman Sachs Asset Management, one of the world's top 10 investment firms, whose performance recently has revived, and which provides steadier revenue and earnings than the market-sensitive businesses.

As for regulation, no one knows what its precise impact will be. But the Volcker Rule prohibiting proprietary trading has mostly been implemented at the firm level. And, contrary to the popular view, pure "prop" trading was never a major source of profit at Goldman and other firms. Goldman has been resolute in assuming it still will be able to post its own capital in the service of client needs for liquidity, hedging, and market positioning, which in truth has been the basis for its dominant fixed income, currencies, and commodities business for decades.

Trading and deal volumes have been undeniably soft. Global wholesale market-related revenue across the industry, encompassing investment banking, equities, credit trading, foreign exchange, commodities, and interest rate trading, was down 21% last year from 2006 levels, according to consultants Oliver Wyman.

Discussion at many a post-close Wall Street happy hour revolves around how much of this reduced trading and deal flow is cyclical, and how much is a long-lived response to the financial crisis and an impaired financial industry. Likely, it's a bit of both. But the long-term backdrop continues to suggest that global capital flows will quicken again.

McKinsey & Co. says that global financial assets totaled $219 trillion last year, with 22% overseen by professional asset managers. Capital will continue to move around in search of good returns. And emerging market economies will produce plenty of capital raising and conglomerate building activity, and the long-tenured Western banks will remain in the middle of the action.

All this bodes well for Goldman, among the first firms to bet on emerging markets growth. With professionals on the ground in developing nations and financial capitals, it could see an outsized portion of the global underwriting and investing business, especially with the Swiss universal banks retrenching and Britain shortening the leash on its largest institutions.

In risk management, Goldman operates via institutionalised paranoia. Even in 2006, carefree times in the markets, outgoing chief financial officer David Viniar, who has held the job for 13 years, would begin discussions of the firm's performance by noting his zeal for maintaining far more capital and liquidity than Goldman was likely to need. The company promotes executives known for risk management, including chief executive Lloyd Blankfein and his odds-on successor, president Gary Cohn, who are both revered for such.

Goldman keeps its trading inventory fresh, turning over 50% of assets every 45 days and 80% every six months, while marking nearly everything to market. The firm charges its trading desks the full cost of financing positions, and makes traders pay for the cost of insuring the liquidity they use.

No investment bank can sidestep every market hazard, but Goldman has come closer to doing so than most. That's why an investor paying 90% of current tangible book value, and about 75% of what book value likely will be in a couple of years, looks like a pretty good risk manager, too.

- By Michael Santoli