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A Value Investing “Who’s Who” Have Decided to Invest in a Black Box (Goldman Sachs)

September 21, 2011 | About:

Most value investors have several different tools in their toolbox. What I mean is that they force themselves to understand companies in a variety of industries with businesses that make money in very different ways.

Buffett of course is the ultimate example. Over his career he has invested in a wide variety of industries (other than technology) and also a wide variety of types of investments (bonds, stocks, currencies).

The hard part in doing this is being willing to put in the time to continually learn new businesses and learn new companies. Because that takes a lot of time and effort.

One company that I always thought was virtually impossible to truly understand is Goldman Sachs (NYSE:GS). I think of Goldman Sachs being a bunch of really smart, extraordinarily driven people working inside of a black box that spits out earnings. How they really create those earnings is a bit of a mystery.

But I keep coming across Goldman Sachs in the portfolios of value investors that I follow indicating that they think they understand how Goldman does what it does and also understand what it will continue to do in the future.

Here is a short list of value investing luminaries who manage concentrated portfolios who are holding Goldman in some form:

Warren Buffett

Mohnish Pabrai

Bruce Berkowitz

Sequoia Fund

Whitney Tilson

The two most recent additions to this list are Tilson and Sequoia.

Tilson provided a short blurb on his thinking in his August investor letter:

We think the market is completely misreading Goldman’s Q2 earnings, which were below expectations and thus perceived negatively. We have the opposite view: we’re delighted that earnings were weak because it likely means that Goldman was reducing risk, which we now know was precisely the right thing to do in light of the recent market turmoil.

Goldman has plenty of short-term issues that create dramatic headlines – for example, CEO Lloyd Blankfein recently hired a lawyer – but we think when all is said and done, the company will remain the premier investment bank in the world and will trade at a meaningful premium to book value, which we think is likely to grow nicely, so we were delighted to invest at a 10% discount to book value.

I have to say that is a pretty simple explanation. I wonder how much work went into investigating what assets and liabilities support the book value that the valuation is based on?

The Sequoia Fund held its recent investor day presentation which included a question and answer. This is how they addressed an old school value firm like Sequoia investing in a magic black box like Goldman Sachs:

Question: One of your new investments is Goldman Sachs — there’s a fair amount of controversy about Goldman these days. I’m wondering what the thesis is and how you’re looking at the investment.

Jon Brandt:

Goldman is definitely not a fun stock to own if you want to read the newspapers or magazines like Rolling Stone. But we still think it’s the preeminent investment bank. Goldman has franchises in mergers and acquisitions, and in stock underwriting, which we think are still very strong. Right now the price to tangible book is about 120%. Goldman has compounded its capital since going public at 20%.

It has been investing a lot in emerging markets over the last few years, hiring a lot of people, building technology infrastructure. If I had to guess I’d say maybe 15% − 20% of its revenues are coming from those territories that are growing so much and where the company has strong positions. Because it has been investing so much, there hasn’t been a lot of profit dropping to the bottom line; so over the next few years you may see greater profitability in those countries. Right now it is very overcapitalized and the company has tremendous amounts of liquidity that are penalizing near term earnings while management waits for some regulatory clarity on some of the issues like the Dodd-Frank bill in Congress and the Basel capital standards internationally.

Obviously Goldman had some business practices that came under the microscope during the crisis and continue to be under the microscope. Senator Levin in Congress has referred his recent report to the Justice Department. The Justice Department looked at all these trades the company did in ’07 − ’08,— ’06 maybe more to the point — last year, and Justice decided not to do anything about it.

Goldman paid $550 million to the SEC to resolve some of the issues. There’s the ability for the government to reopen these issues if there’s new information. Goldman, for what it’s worth, says there’s no new information. I think everyone knows Goldman sold some CDO products that the company wishes it had back. But Goldman has a new business practices report outlining how it’s going to change its practices so that people are going to pay more attention to suitability. I think you’re going to see a new Goldman Sachs going forward. People are still going to yell and scream over all the money lost during the crisis, but Goldman’s are far from the only people who would like to have some things back —notably the Senator’s report had nothing about Freddie and Fannie. The government’s going to lose a lot more on those two entities than it will on anything coming from TARP or any of the guarantee programs.

Goldman is definitely not your typical Ruane Cunniff stock. You cannot forecast its earnings quarter to quarter— not that that’s true of all our companies, but there’s an unusual amount of volatility in its results. But I think we’ve always felt that a lumpy 15% or even a lumpy 13% is better than an 8% or 9%. Goldman has $65 billion of tangible equity. If it could earn a 13% return on all $65 billion, the stock would be very rewarding at current prices. However, it is unclear whether Goldman will be able to deploy all $65 billion in the business productively. If it can’t do so, it may have the opportunity to deploy the excess capital in share repurchase at acceptable rates of return.

At this point I think that it is unlikely that many more skeletons are hiding within the asset ledgers of financial entities. Even in the midst of the panic Goldman really didn’t have many problems with its assets; the concern was on the liability side of the ledger and making sure funding wouldn’t disappear.

And this is where value investing gets fuzzy for me. Investing in a company like this requires quite a leap of faith that they will keep making lots of money and that their balance sheet value is what book value suggests it is. Because in my opinion very few people can really understand how Goldman is making money and what is really on its balance sheet.

I’m considering a basket of financials like Goldman, Bank of America (NYSE:BAC), AIG (NYSE:AIG), Wells Fargo (NYSE:WFC), etc. I’m just concerned that if I do invest that way it will be more because I’m buying what is down, and not really buying what I know is undervalued. Because to be able to really know it is undervalued, I’d have truly understand it first.

At least with Goldman, I’d be investing alongside some very good company.

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Rating: 4.5/5 (14 votes)


Zwiphy - 6 years ago    Report SPAM

Great post! I have exactly the same problem: I guess it's cheap, indicators show it but I don't really know how to value it. I can't risk permanent loss of capital.
Adib Motiwala
Adib Motiwala - 6 years ago    Report SPAM
Maybe find companies that you understand and that are undervalued as well...

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