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:

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.

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.

*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.