Is Goldman a Buy?

Goldman Sachs (NYSE: GS  ) is arguably more visible today than it has ever been its history (or than it has ever wanted to be; the firm has traditionally valued a low public profile). Outstanding results this year highlight a firm that has pulled away from its closest competitors in the credit crisis. (Morgan Stanley (NYSE: MS  ) is still recovering, and Merrill Lynch has been absorbed by Bank of America (NYSE: BAC  ) .) Add to that the prospect of the most significant regulatory reform to hit the financial services industry since the Great Depression, and many investors are surely now asking themselves: "Is Goldman a buy?"

Long-term is name of the game
I'm tackling the topic from the perspective of a long-term investor; if you want to know what the shares will do next week, I can't help you. Before we look forward, let's take a look back at what Goldman shares have done for investors since they began trading:

Company

Annualized Total Return Since GS IPO (May 4, 1999)

Goldman Sachs (NYSE: GS  )

10.2%

S&P 500 Total Return

(0.4%)

Source: Author's calculations, based on data from Capital IQ, a division of Standard & Poor's.

Surely, these must be fantastic returns. Goldman has crushed the S&P 500, with a margin of outperformance of nearly 11 percentage points on an annual basis. But here's another way to think about the firm's return: Of the 428 S&P 500 components for which one can calculate total returns over the same period, 102 -- nearly a quarter! -- bested Goldman's return. The table below contains two of these.

Goldman Beaters

Industry

Annualized Total Return Since Goldman IPO

Apple (NYSE: AAPL  )

Technology

30.9%

UnitedHealth Group (NYSE: UNH  )

Sector

12.9%

Source: Author's calculations, based on data from Capital IQ, a division of Standard & Poor's.

This comparison is far from perfect, because the companies in the S&P 500 aren't all at the same stage in their life cycle; Goldman Sachs had been in business for 130 years by the time it went public, and it was already a very large, mature company. Neither am I suggesting that it was easy to predict which companies would produce superior returns to Goldman's. Many of those that did were high-risk companies; Celgene (annualized return: 40.6%), Biogen Idec (15.7%), and Gilead Sciences (29.9%) come to mind. There could be no guarantee of earning these sorts of returns.

Risky business
On that topic, it's worth remembering that Goldman common shares are a very high-risk proposition -- much higher than the $5 billion in preferred shares that Warren Buffett purchased on behalf of Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) . A 10.2% annualized return is, to my mind, inadequate to compensate the shareholders of a company that came extraordinarily close to wiping them out within 10 years of going public, and which has already flirted with bankruptcy twice before, in the Penn Central and Goldman Sachs Trading Corporation fiascoes.

To hammer this point home, I should point out that 10.2% is not much above the historical average equity return in the U.S. What is the risk of the value of the S&P 500 being totally and permanently wiped out?

Where are the shareholders' yachts?
Goldman shareholders should require higher returns. Apart from some "hiccups" along the way, the last 10 years have been very favorable to the bank, which rode a roaring growth cycle in an oligopoly industry that generates large excess profits for its participants. (Unfortunately, even that wasn't enough for bankers, who securitized every golden egg the goose would lay, some of which turned out to be rotten.) However, investors don't appear to have shared in the company's success to the degree that many other companies' investors did.

During the prior 10 years, Goldman beat out nearly two-thirds of S&P 500 components in terms of revenue growth. However, profit growth isn't anywhere near as impressive -- with respect to net income, Goldman beat only 1 in 6 companies (the figure for diluted earnings per share before extraordinary items is similar). The trouble is that Goldman has enormous variable costs; with employees typically devouring more than 40% of total revenue in compensation before outside shareholders even get a seat at the table.

Looking forward
Will Goldman Sachs outperform the S&P 500 over the next five- to 10-year period? I think the odds favor it, but 1) that's a relatively low hurdle, given the index's current overvaluation, and 2) the range of possible outcomes looks very wide, encompassing "utterly disappointing" to "satisfactory."

Over the last decade, Goldman grew its book value per share at rate of around 19% per year, well ahead of the rate of share-price appreciation. That type of growth is very unlikely over the next decade, particularly since we can expect higher capital requirements for Goldman and other institutions that are "too big to fail," which would damp profitability.

Don't look at the multiple for help
I don't foresee any help from the price-to-book multiple, either. Sure, the multiple is lower than its average value going back to July 1999, and quite a bit lower than it was around the time of the IPO. However, as Goldman reduces its leverage, its returns on equity must fall, which will weigh on the price-to-book value multiple.

Multiple

Current

Average (July 1999 – Oct. 2009)

July 12, 1999*

Price-to-Book Value

1.81

2.36

3.85

Price-to-Tangible Book

2.03

2.67

3.85

*First day on which it is possible to calculate book value-per-share with some accuracy.
Source: Author's calculations, using data from Capital IQ, a division of Standard & Poor's.

The bottom line
Where does that leave us? On considering the evidence, Goldman shares simply don't look too compelling right now: Take a business that is intrinsically high-risk in an industry that is undergoing radical restructuring, and I would require a gargantuan discount on the shares before considering a purchase (besides the fact that I refuse to buy the shares of an investment bank until there is some evidence they are run for the benefit of anyone other than the employees.) I won't pretend that I can calculate this discount with precision (that's an exercise in black magic), but my analysis doesn't suggest to me that it is large enough -- if it exists at all.

P.S. Beyond Goldman
If you're a stockpicker and you're interested in financial stocks, my recommendation is to look outside the group of megacap banks that monopolize the headlines. Uncertainty in the financial services industry has created opportunity for investors across the capitalization spectrum, and small and mid-size banks are easier to understand and under-researched compared with the "too big to fail" set.

There's more to China than the red-hot coastal regions. Motley Fool Global Gains co-advisor Tim Hanson puts his finger on the next great place to invest.

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Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. Apple, Berkshire Hathaway, and UnitedHealth Group are Motley Fool Stock Advisor recommendations. Berkshire Hathaway and UnitedHealth Group are Motley Fool Inside Value recommendations. The Fool owns shares of Berkshire Hathaway and UnitedHealth Group. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.


Read/Post Comments (10) | Recommend This Article (8)

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  • Report this Comment On November 02, 2009, at 10:33 AM, dudemonkey wrote:

    If you think that the management of Goldman thinks of the shareholders as anything more than chumps, feel free to explain your reasoning.

  • Report this Comment On November 02, 2009, at 11:01 AM, Dbraem wrote:

    Why buy Goldman Sachs when you can buy Berkshire Hathaway? Since Berkshire will own a nice chunk of thee company, there is no advantage on a risk/reward basis.

    In my mind, I would prefer the company that can bail out GE and GS, not the shadow banks.

  • Report this Comment On November 02, 2009, at 11:16 AM, jrmart wrote:

    THIS IS A FAIRY TALE STORY FROM MY VIVID IMAGINATION ABOUT A HEDGE FUND CALLED GOLDEN SLACKS.

    IT STARTS LIKE THIS. ONE PART OF GOLDEN SLACKS HEDGE FUND SOLD LOADS OF BAD PAPER INVESTMENTS WORLDWIDE DURING 2008, WHILE ANOTHER PART OF GOLDEN SLACKS HEDGE FUND SHORTED THE MARKET AND MADE BILLIONS IN PROFITS DURING THE LAST QUARTER OF 2008. ALL DURING THAT TIME, LOTS OF GOLDEN SLACKS' ANALYSTS WERE DOWNGRADING COMPANIES WITHOUT PROVIDING ANY DOCUMENTATION BECAUSE THEY SAID IT WAS PROPRIETY INFORMATION. AT THE SAME TIME THE TRADERS AT GOLDEN SLACKS WERE SHORTING THE MARKET CREATING ONE OF THE BIGGEST FINANCIAL DISASTER SINCE THE GREAT DEPRESSION.

    THE FAIRY TALE STORY CONTINUES IN LATE 2008 WHEN LOTS OF GREEDY INVESTORS SHORTED ONE OF GOLDEN SLACKS' BIGGEST COMPETITORS, PUTTING THEM OUT OF BUSINESS. SHORTLY THEREAFTER ANOTHER LARGE GOLDEN SLACKS' COMPETITOR WAS ALSO ALLOWED TO FAIL.

    THIS FAIRY TALE STORY STILL GETS BETTER. A COUPLE OF MONTHS AGO IN 2009, GOLDEN SLACKS REPORTED THAT SOMEONE STOLE A GOLDEN SLACKS COMPUTER PROGRAM. WHEN IT HAPPENED GOLDEN SLACKS SAID THAT THIS PROGRAM COULD ACTUALLY CONTROL THE STOCK MARKET. WOW, CAN YOU IMAGINE THAT?

    TO MAKE MATTERS MORE INTERESTING, THIS HEDGE FUND CALLED GOLDEN SLACKS HAS BECOME A BANK. BY DOING SO, IT GETS ALL THE PROTECTION OF THE US GOVERNMENT AND IS GUARANTEED A BAILOUT BY ALL THE UNKNOWING DUMB TAXPAYERS.

    BOY, IF THIS GOLDEN SLACKS' FAIRY TALE WERE TRUE, IT WOULD MAKE BERNIE M. LOOK LIKE A PENNY ANNIE CROOK. THANK GOD IT IS ONLY A FIGMENT OF MY VERY CREATIVE MIND.

  • Report this Comment On November 02, 2009, at 3:30 PM, wessew wrote:

    I couldn't disagree with the analysis more: 1) the company's performance is 10.6 relative percentage points greater than the market during the period in question which is exceptional given the market return of essentially zero; 2) Goldman is extremely well positioned to take advantage of gradual cyclical recovery in the financial markets and the capital cycle including the return of M&A; 3) Goldman is very well positioned relative to other "TARP" companies to attract and retain talent and expand market share; and 4) Goldman is well managed. This is the ideal time, before the FED hikes rates (sometime later next year) to own companies like this. We are at the very beginning of the recovery cycle. Warren Buffet got in early but he did not get this one wrong.

  • Report this Comment On November 02, 2009, at 3:43 PM, TMFAleph1 wrote:

    wessew,

    Thanks for your feedback. On point 1.): Relative to the S&P500, the shares have done very well since their IPO, but my point is that the return did not properly compensate common equity holders for the risk they incurred.

    I wouldn't argue with you regarding points 2.), 3.) and 4.), but this won't necessarily translate into attractive share returns.

    Finally, Warren Buffett made an investment in Goldman preferred shares that pay a 10% annual dividend and received warrants with a strike price of $115 as a sweetener. As I pointed out in the article, there is no comparison between his investment and that of an individual investor purchasing common shares on the open market.

    Alex Dumortier

  • Report this Comment On November 02, 2009, at 3:58 PM, starbucks4ever wrote:

    I am sure GS is a fantastic company to own a controlling packet in, but I'm afraid it will be a lousy value proposition for the minority shareholders. Whatever money GS earns will likely be spent on bonuses or channeled to its "preferred customers".

  • Report this Comment On November 02, 2009, at 5:35 PM, TMFAleph1 wrote:

    jrmart,

    That is a wonderful fairy tale indeed, but you are recounting it inaccurately. Golden Slacks never said that their automated trading software could "control the stock market" -- that would be too absurd even for a fairy tale.

    Alex Dumortier

  • Report this Comment On November 02, 2009, at 11:11 PM, TMFAleph1 wrote:

    zloj,

    Thanks for your interest.

    I certainly agree with the tenor of your remarks, but surely you meant "preferred shareholders" rather than "preferred customers"?

    Alex Dumortier

  • Report this Comment On November 02, 2009, at 11:30 PM, starbucks4ever wrote:
  • Report this Comment On December 02, 2013, at 7:16 AM, RobertBrad wrote:

    Goldman Sachs earns about 53% of its revenues from equities and FICC client executions, low trading volumes will continue to be a drag on the bank’s performance. Goldman’s revenues from FICC trading in 3QFY13 fell 47.2%, much more than it did for its main competitors.http://bit.ly/18UwiSI

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