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Posted by: Jerry Zhao (IP Logged)
Date: May 23, 2012 04:09PM
Goldman Sachs (GS) is the premier Wall Street bank on sale. Financials have taken a serious and prolonged beating since the housing debacle started unfolding in late 2007. Why Goldman? Why now?
Goldman is best in class.
Goldman has been a popular target in the media in the last few years, epitomized by the portrait of a giant blood-sucking vampire squid in Matt Taibbi’s scathing piece in Rolling Stone. Yet, if you ask any Wall Street bank who is the one bank they want to beat, the answer 9.6 out of 10 times would be Goldman. Charlie Munger, for instance, has repeatedly singled out Goldman as the best investment bank (see video here). Wilbur Ross also has had some very positive things to say about Goldman when interviewed on the topic.
Such a sterling reputation belies a stunning transformation from the humble shop trading commercial notes in the 1800s. Goldman’s success has continued as a public company since its IPO in 1999. Its book value per share has compounded at more than 16% per year from 1999 to the first quarter of 2012, while averaging a highly satisfactory 18.5% ROE and 31% pretax margin. Remarkably, Goldman never suffered a loss in any given year as a public company. Its track record compares favorably to its Wall Street peers (they are at least comparable to Merrill Lynch and far better than Morgan Stanley MS).
According to various accounts, Goldman has always been obsessed with excellence. So what have been the pillars of Goldman’s success? Will they continue? According to the books and articles on Goldman that I’ve read, its success boils down to two things: its people and its system.
First, its people. Goldman typically gets the best recruits. Charles Ellis gives a pretty good description of the grueling and lengthy recruitment process in his book, "The Partnership," (given his close ties with the firm, one may reasonably suspect some airbrushing in his account, but his descriptions are generally consistent with those of first-person accounts). Typically, Goldman only recruits from the top 5% of a handful of select top schools, and senior management is heavily involved in the recruitment process. Moreover, corporate values are instilled in the new recruits through the compensation systems: Behaviors that are consistent with corporate values are encouraged, and those not consistent with corporate values are strongly discouraged (Ellis offers plenty of anecdotes on those things). This recruitment and training system ensures a strong sense of identity with the firm and the continuity of corporate culture. No wonder most Goldman senior managers have stayed with the firm forever.
In addition, former employees tend to stay in close contact with the “mother ship,” and mostly have good things to say about the firm (although William Cohan has a somewhat different take on that). Speaking of Goldman’s culture, one has to talk about Cohan’s book, which for the most part dwells on the dark side of Goldman. The political intrigues and behind-the-scene stabbing are all interesting fodder, but they are far from unique to Goldman. The amazing thing is that Goldman has managed to succeed despite all that infighting.
Any discussion of Goldman has to mention its über-powerful alumni network, arguably the most powerful among the investment banks. It features two current central bank governors, two former treasury secretaries, and many former high-ranking government officials and CEOs. Investment banking is about relationships. Having such a high-powered rolodex certainly doesn’t harm Goldman’s prospects.
Second, its system. Having the best people is no guarantee to continued success. The way the company is managed also matters. Despite the outsized personalities (for some reason Wall Street seems to be the magnet for such personalities) under the same corporate roof, Goldman has somewhat found a way to get them to work for the common goal.
Two features of the system are particularly relevant: risk management and its ability to adapt. Its sophistication in risk management can be seen in these two anecdotes. For one, Goldman steered through the 2008 financial crisis remarkably well (it posted a trading profit, excluding corporate and real estate investment writedowns). The culture of risk management at Goldman is highlighted in a New York Times article,It’s Lonely Without the Goldman Net, in the wake of the MF Global debacle.
Clearly, Goldman’s success goes beyond the caliber of its people. Goldman has always been evolving and adaptive. In fact, Goldman’s history is punctuated by several bold and successful transformations. Its stature as a premier investment bank was established by Sidney Weinberg in the '40s and continued under the two Johns into the '70s. Yet it later emerged as a trading powerhouse as well as one of the largest asset managers in the 1980s.
Granted, Goldman has been successful in the past, but will that continue in the future when it’s not even clear what the future will hold? As Warren Buffett often says, the future is always uncertain. It makes no sense to dwell on the future unknowables; focus on what we do know — if you believe as I do that these pillars of success will allow Goldman to (once again) evolve and succeed. Remember, regulatory tightening affects everyone in the business, and when the going gets tough, the strong will survive and thrive and the less strong will fade. Goldman is the best in class.
The shares are cheap, weighed down by regulatory overhang and Euro anxiety, among other things. At roughly $96 a share (approximately $51 billion in market cap), you can buy this premier franchise for 71 cents for each dollar of book value or 77 cents for each dollar of tangible book value. Of course, it may never repeat its history of double digit increase in book value and high-teen ROE under the new yet-to-be-determined regulatory regime, but at the current depressed prices, investors don’t need such blue-sky scenarios to realize attractive returns. If GS grows its book value per share at 8% for the next five years and earns ROE of 12%, the shares could easily triple in five years, earning a 25% CAGR. Are these pie-in-the-sky assumptions? Between 2008 and 2011, a period that included the devastation of the Great Recession, it had CAGR of 10% in book value per share and average ROE of 11.2%.
We can also look at GS valuation in a different way. GS operates in four divisions: investment banking, asset management, institutional client services (a.k.a. trading), and investing and lending. Their pretax income between 2009 and 2011 is given in the table below. The first two businesses are stable high-multiple businesses, whereas the latter two are more volatile and the source of the overhang over the shares.
Let’s value them separately. Between 2009 and 2011, investment banking and asset management earned, on average, $2.4 billion in annual pretax income, so they can easily be worth $24 billion (or, 10x pretax income). For comparison, both Lazard (LAZ) and Evercore Partners (EVR) carry multiples of 12 or above, and asset managers have an average multiple of around 12 times pretax income.
Let’s assume that the investing and lending division is dumped in a garbage can (while it actually earned about $1 billion pretax per year). How much is the trading business worth, knowing that it earned $10 billion pretax a year, on average, between 2008 and 2010? Even if we use the 2011 figure ($4.6B), which was the worst since 2008, a multiple of 6 seems very depressed.
As one fund manager observed on Bloomberg TV, the dream of Goldman folks is work hard for years to become partners so they can buy the shares at book. Now ordinary investors can buy the same shares for well below book. A sweet revenge on the Goldman 1%?
Disclosure: Long GS.
Posted by: yaronguru (IP Logged)
Date: May 23, 2012 10:45PM
Have you ever heard of the Volcker rule my friend?
Posted by: sjzhao2003 (IP Logged)
Date: May 24, 2012 11:09AM
It'd be really helpful if we know exactly what the Volcker rule really looks like and what it entails for the Wall Street firms. We don't. It's still being written as we speak, and implementation details will take a couple of years to finalize.
So two things I want to point out: 1) Wall Street firms will lobby aggressively on how the rule will be written and implemented, and they'll have time to adapt; a sudden surprise decree that totally disrupts the working of the financial system doesn't help anyone. This will be a drawn out process, not the least because it's next to impossible to separate market making activities from prop trading. And 2) with this regulatory uncertainty, market tends to assume the worst, so that's been priced in the shares.
What's a likely worst case scenario? A stricter form of Volcker rule, however that is defined, is implemented, and GS is forced to break itself up into two companies: good bank with the investment banking and asset management business, and the "bad" bank with the trading operations. The good bank is an asset-light business and will fetch a higher multiple. With 12x pretax income, that'll be worth $54 per share. The "bad" bank still performs the essential function of market making, and I believe a 6x multiple is quite low.
Of course, there's always the chance that the final rules are not nearly as onerous as expected. So the shares may actually see a rally with the resolution of the regulatory overhang. Just my two cents.
Posted by: cm1750 (IP Logged)
Date: May 28, 2012 12:48PM
Obviously, with new regulation and less aggressive leverage, GS will never have normalized ROEs over 25% as they did in the 2006-2007 period.
But accounting for less leverage and moderate capital markets, GS should be able to sustain a 10-12% return on tangible book. Assuming $126 tBV in June and applying an 11% return on tBV gives a normalized EPS of almost $14.
Thinking as a "limited partner", I would like for GS to earn me 15% on my capital, so am willing to pay $93/share ($14 EPS/15%) or just .75x tBV.
Buying 2/3 now at $97 and averaging down seems like a great way for Goldman to manage my capital. It seems fears about Europe and the JPM $2-5Bn loss has Mr. Market providing a great buying opportunity for long-term investors.
For shorter-term investors with more risk aversion, you can buy a Jan 2013 95/120 call spread and short a Jan 2013 85 put for a $1.25 net cost (breakeven $96.25). The $85 put strike is just 0.6x expected tBV (EOY2012).
Posted by: gs271 (IP Logged)
Date: May 30, 2012 06:57PM
Correct me if I'm wrong, but ROE doesn't seem to be too applicable to a bank.. a) net Profit is not really a good indicator for a bank and b) the book value of equity might again be a very bad estimate (valuing the assets of goldman sachs... a near impossible task! very dependent on (old?) market valuations)
One is soo dependent on their asset values.
Of course the big banks generate huge administration fees through the large amount of assets they administrate/lend, and that brings some stability to income. And their fixed income investments are probably quite solid, hedged (?) etc.
Personally, I simply shy away from financials as long as there are good e.g. consumer goods companies to invest in. I don't get them!! The total assets of Goldman amount to app. 1 tr $, diversified through a huge amount of investments in x hedged with xy, loans to z for the purpose of y, and i don't know what. What I do know, is that they are involved in investments that I personally wouldn't make. But I get your point, very diversified investments (?), powerful network, a business model thats fundamentally profitable and a balance sheet BV that might reflect crisis/undervalued values. So mb at this price it has more margin of safety than a bank normally has. But there must be better.
Posted by: coda (IP Logged)
Date: September 12, 2012 05:13PM
Well written, I like the qualitative. I think the Volcker rule would never depress the ROE below 10%, you don't hit this much the financial sector which is essential to economic growth. Although you might not even get much more than that, a 12-15% would be fine for who's buying at 100 bucks. Don't forget that back in the 30s banks were going to disappear but....no matter how long it takes.....the "bastards" always come back stronger. On the high end I would certainly exclude the crazy 25-27% of when they were selling garbage but long term shareholders could even see a 20% popping out somewhere in the next 5-10 years, with Goldman you never know! They're good at it.