July 12, 2012 (TSR) – Among those who believe that Goldman is basically the devil’s spawn, there’s of course only one answer to the above question: Yes! But there’s another group that seems to be asking the same question, and that’s investors.
Consider that in the past year, Goldman’s stock has fallen some 30 per cent. It trades for just 0.7 times book value, which says that investors either think that Goldman can’t earn enough to cover its cost of capital, or that its assets are overstated or liabilities understated. Consider this: Except during the financial crisis, Goldman’s market capitalization was last around $50 billion back in the fall of 2005. Back then, Goldman had $670 billion in assets, and $27 billion in shareholders’ equity. Today, Goldman has $951 billion in assets, and $72 billion in shareholders’ equity.
Another way to think about Goldman’s valuation is that the firm effectively has $300 billion in cash and close cash equivalents on its balance sheet. You can get to that figure by adding cash, Level 1 assets, and Level 2 assets that could be easily liquidated. Goldman has total long-term and short-term debt of $220 billion, and a market value of $50 billion. In other words, the market is giving Goldman very little credit for the ongoing earnings of its business, and Goldman has a lot of dry powder relative to the opportunities it has. (A caveat: Goldman’s immense derivatives business would gobble up lots of cash were the firm to be hit with credit downgrades.)
Among its banking brethren, Goldman isn’t unique or even the worst off – Bank of America trades at about 60 per cent of book value and Citigroup at just over 50 per cent. Analysts question whether these banks can earn their cost of capital. Last month, Philip Purcell, the former CEO of Morgan Stanley – and the architect of the megamerger between Morgan Stanley and Dean Witter – wrote a piece in the Wall Street Journal arguing that shareholders would get better value if the big banks broke themselves up. He chalked the sinking stocks up to the “mismatch” between volatile investment banking and trading businesses on the one hand, and “safer, more client-centric businesses” like asset management and banking and credit cards on the other hand. Others who have called for a breakup of the big banks cite the essential unmanageability of these giant, risky firms.
But Goldman hasn’t suffered the blatant management missteps of its peers, at least from a bottom-line perspective; moreover, it’s hard to see how splitting up is an option for Goldman. Unlike a Citi or a BofA, Goldman lacks the pieces in which to break. Although Goldman is now officially a bank, it doesn’t do much that resembles banking as we know it. True, Goldman does have an asset management business, but it has succeeded despite less-than-stellar performance. A good chunk of its value is precisely because it’s part of Goldman Sachs.
So what’s the problem, and is there a solution? One view is that Goldman has always been run for the benefit of its employees, rather than shareholders – over the years, many of the former have gotten rich, while some of the latter have lost a lot of money – and shareholders have finally wised up. In this view, it doesn’t matter what Goldman earns because ultimately that wealth will be transferred to management, not shareholders, through ever-larger compensation packages. So Goldman should take itself private and stop pretending that shareholders are part of the equation.
But there are also a number of more constructive theories, all of which could be true. One possibility is that the black-box nature of Goldman Sachs is no longer acceptable to investors, in which case Goldman could work to make itself more transparent – a Lucite box! Another is that the ongoing threat of legal liabilities, in particular, the Department of Justice investigation into Goldman’s behavior during the crisis, is weighing down the stock. A third is that given the myriad uncertainties in world markets, of course Goldman’s stock is going to suffer. Market participants say that Goldman is no longer taking risk the way it once did. But as soon as the clouds lift, normalcy – i.e., the risk-taking and the mega-profits of the pre-crash years – will return.
Yet another possibility, though, is that the world has changed, and Goldman either needs to shrink – or show investors how it can reinvent itself. New regulations are one reason. Despite frenzied lobbying, regulations from higher capital requirements to whatever iteration of the Volcker Rule emerges from the murk of D.C. will add cost and lessen opportunities. But the more important reason is that Europe, Japan and North America, which analyst Meredith Whitney wrote in a report accounted for 80 per cent of Wall Street’s revenues over the last decade, are all in a massive, lengthy deleveraging process. Yet during that period, over a third of Wall Street’s revenues came from debt capital markets, and in turn, over 40 per cent of that came from the issuance of financial debt. Even more, at the big banks, a huge per centage of the debt they sold at the peak was their own. (In Goldman’s case, Whitney says, 40 per cent of its total debt capital markets business in 2006 was the issuance of its own debt.) Less debt equals less profit. (Goldman says it doesn’t make money issuing its own debt.)
Goldman gets a bigger chunk of its profits from outside the US and Europe than others do. But while Asia and Latin America are growing quickly, they are still relatively small. And it’s hard to tell how much of Goldman’s derivatives business, which has been a huge chunk of its profits, was tied to the issuance of debt. In a world where debt in the developed world has to decrease, a world where everything can’t be turned into a derivative, maybe the robust return on equity Goldman produced is a thing of the past.
While Goldman people are the first to say that there is no certainty about anything today, the firm – not surprisingly! – rejects the idea that the market wants it to liquidate. You can see the firm’s optimism in its headcount, which is now about 32,000. True, that’s down some 8 per cent from last year (and Goldman has cut costs more aggressively than headcount reflects), but it is still up about 9,000 from the end of 2005. Goldman executives have argued that even if Europe – European banks in particular – do need to delever, there could be a silver lining, which is that companies in Europe, which traditionally have relied upon loans from banks, will now instead sell debt in the capital markets, thereby spelling opportunity for firms like Goldman. There’s also an argument that while Goldman’s return on equity of 12 per cent in the first quarter (which, in fairness, was a big improvement on the 3.7 per cent Goldman posted in 2011) is a fraction of the stunning 40 per cent returns it posted at the peak, a 12 per cent return on equity, if sustainable, is not so terrible in a zero-interest-rate world.
If you look at the firm over the decades, its real business model has been to be wherever there’s money to be made, to turn on a dime to get there, and to find a way to adapt and prosper no matter what the conditions. But even Goldman admits that in the meantime, investors have to be patient – and patient is one thing that most modern investors are not.
What about you? Tell us what you think.