I am in awe of the way
Goldman Sachs (NYSE: GS) makes money. I also
think that, hands down, some of the best and brightest minds
in the world end up at Goldman.
A few weeks back,
I highlighted Goldmanas my pick among the big boys in the
banking sector, and I still think that the company's stock
could be attractive for the very near term. However, I also
have serious concernsabout the business and can't help
but wonder if investing in Goldman is worth the risk.
Of course, to figure that out, we first need to figure out
what exactly makes Goldman tick.
Lifting the curtain on the money machine
What makes it rain at Goldman Sachs?
If you said investment banking or asset management, I hate
to break it to you, but you're dead wrong. In 2006 and 2007
the trading division accounted for more than 70% of Goldman's
operating income, and in the most recent quarter that
division accounted for nearly 93% of operating income.
So we must understand that trading division. We can break
it up into three main categories:
Commissions-based trading. This is the
easiest part to understand. The company simply acts as a
middleman for its clients and collects a fee for its
services. Simple, easy, dependable. In fact, even as
Goldman's overall trading segment melted down in 2008, its
equities commissions business was up 9%.
Client-driven activity. This is probably
the most important portion of Goldman's trading activity.
The company acts as the counterparty for its clients and
will buy and sell directly with its clients. One of the
main ways the company makes money here is by exploiting
bid-ask spreads, which is the difference between what
buyers are willing to buy for and what sellers are willing
to sell for.
Principal trading. The company makes money
in this division by putting the company's own capital on
the line to try and take advantage of any number of ideas,
including
arbitrage,
market direction, and valuation anomalies. While this part
of the trading business can bag huge scores, wrong-way bets
from these gamers likely played a big part in the trading
segment's 2008 pre-tax loss.
Can the money machine keep it up?
Now that we have at least a little better understanding
of what's driving the massive profits at Goldman, we can ask
the next logical question, which is whether the
money-printing activities of the trading segment can
continue.
We should be able to count on a certain amount of business
from this segment. But, just as it would seem silly to count
on a return to the high-volume, frothy days of 2007 and
earlier, there are at least a few good reasons to be
skeptical that more recent results can be forecast into the
future. Let's take a look at three primary tripping
points:
Risk. Taking big risks can lead to big
scores for Goldman and its investors, but it can also lead
to big meltdowns like we saw at Lehman Brothers and Bear
Stearns. If Goldman throttles back on its risk-taking,
investors may have to settle for lower profits, while a
continued appetite for risk means investors have to be
ready for eventual losses.
Federal largesse. Goldman has been
benefitting in a big wayfrom the easy-money environment
that the Federal Reserve has created. With borrowing costs
near zero, making money is so easy that even a caveman
could do it (sorry, GEICO). If I'm sure of anything, I'm
sure that the Fed can't leave rates this low forever.
Competition. Remember what I said about
bid-ask spreads? Well, when competition disappears, as it
has in the past few years, those spreads widen and the
profits for certain trading activities explode. If those
spreads stay wide, you can bet your right foot that
financial institutions will bulk up their trading
activities to take advantage, and we might even see new
companies pop up to join the fray. As competition comes
back, wide spreads will start to fade.
In short, if you're trying to value Goldman's business by
assuming growth on its recent results, you may find yourself
grasping at strawsdown the road.
Is it worth it?
Looking at Goldman
with an investor's eye, we have to consider whether the
potential rewards are worth the risk that we face from its
massive trading operation.
Though Goldman has made plenty of headlines for being
generous to its employees, the company has also been fairly
magnanimous with its shareholders. From 2005-2007 -- when a
lot of the big money was being made -- Goldman returned
nearly 96% of its profits to shareholders through share
buybacks and dividends, which was notably better than
competitors
Morgan Stanley (NYSE: MS) and
JPMorgan Chase (NYSE: JPM). In fact, when it
comes to returning profits to shareholders, Goldman bested
quite a number of major companies:
Company
Total Returned
to Shareholders
As a Percentage
of Revenue
As a Percentage
of Net Income
Goldman Sachs
$26 billion
23.5%
95.8%
Coca-Cola (NYSE: KO)
$15 billion
19.8%
94.4%
ExxonMobil (NYSE: XOM)
$102 billion Continued... |