The Unheard Defense of Wall Street

In the midst of his 2012 presidential campaign, Mitt Romney penned an opinion piece for The Wall Street Journal about his time at Bain Capital. Mr. Romney shared his view on problem-solving:

"When you see a problem, run toward it or it will only get worse."

The recent brouhaha surrounding Goldman Sachs (NYSE: GS  ) and its involvement in the aluminum and commodities markets, as investigated by The New York Times lately and Reuters in 2011, sparked a thought similar to Mr. Romney's in my head:

"When Wall Street sees profit opportunity or market inefficiency, it runs to it."

While it's easy to rile the masses about Goldman Sachs's actions by extrapolating the costs of its operations and estimating how much consumers ultimately suffer for these practices, one of the most important quotes in The New York Times article is, "Goldman Sachs says it complies with all industry standards, which are set by the London Metal Exchange, and there is no suggestion that these activities violate any laws or regulations."

Sure, Wall Street employees can sometimes become excessively greedy and even break the law on occasion, but getting mad and cursing the names of firms that are playing within the rules of the game may be an overreaction.

Should we be happy that Goldman Sachs and its comrades exploit inefficiencies in various markets? Should we pat The New York Times and Reuters on the back for exposing one of Wall Street's latest profit engines? To both questions, I would answer yes. The combination of the profit-driven psyche of Wall Street and extensive investigative journalism ultimately lead to an improved economic environment in the future.

It's all about perspective
While negatively trumpeting Goldman Sachs's involvement in the aluminum storage business grabs attention, it's important to remember the scope of these activities and what it actually means to Goldman Sachs as a company and as a stock.

If Goldman Sachs were to fully take advantage of the regulation allowing financial companies to engage in these commodities activities, by law, the investment could not even comprise more than 5% of the firm's assets.

Goldman Sachs is a massively diversified entity with roughly 75% of its earnings coming from areas other than its "Investing and Lending" segment, which houses the firm's hoards of investments, loans, and most likely, these storage investments. Goldman's investment portfolio is filled with so many of these smaller-scale ventures that the sum of the group's parts is great enough to withstand the loss of some. Bottom line: Even if Goldman Sachs was no longer allowed to engage in this particular business, shareholders probably wouldn't even feel a pinch.

Successfully pivoting 
In the world of investment banking, the scene is constantly changing because of increased competition, better technology, decimalization, etc. -- and yet, Goldman Sachs and the likes of JPMorgan Chase (NYSE: JPM  ) have continued to thrive and win.

For example, equity trading used to be a cash cow for Wall Street firms, but the tide has shifted. JPMorgan CEO Jamie Dimon estimates that margins for the equity business have fallen 90% over the past 30 years. When opportunity diminishes, Wall Street, particularly Goldman Sachs and JPMorgan, has continually shown the ability to pivot toward the "next big thing" -- whether it was junk bonds, mortgage-backed securities, or synthetic CDOs.

Long-term greedy
From an investor's point of view (Full disclosure: I own shares of Goldman Sachs and JPMorgan), these stories about Goldman Sachs and Wall Street's involvement in the mostly unknown aluminum storage market (Full disclosure: I am not an expert in aluminum storage) has actually increased my confidence that these two companies are superior long-term investments. Warren Buffett may have said it best when questioned about his investment in Goldman Sachs, saying that he likes to "bet on brains."

Despite the presence of these brainiacs, shares of Goldman Sachs and JPMorgan are both trading at price-to-tangible book value per share multiples, a common bank valuation metric, significantly below historical norms. One driver behind these depressed valuations is the expectation that regulation will ultimately crush many of Wall Street's most profitable endeavors.

Source: S&P Capital IQ.

However, if there is one thing bank investors learned from the financial crisis, it's that banks are almost always one step of ahead of regulators.

The other half
For investors or potential investors, the trading multiples (P/TBV) are only one half of the equation. The other half lies with the firm's ability to generate sufficient returns on its equity, and thus create value for shareholders. Despite regulatory headwinds and muted merger and acquisition activity, both JPMorgan and Goldman Sachs have continued to post double-digit returns on equity -- JPMorgan still posted a return on tangible common equity of 15% in 2012 despite the London Whale trading fiasco.

Wall Street is seldom a warm and huggable entity, but casting these companies and their stocks off to an investor-deserted island without looking beyond the salacious headlines could prove costly in the long run.

LeBron James photo credit: Steve Jurvetson.

Few investment banks, business-people, or investors can do what Goldman Sachs or JPMorgan can do, but getting upset at these companies when they play by the rules and regulations largely established out of their control is a little like getting angry at LeBron James for dominating because he is just too strong and too fast to be stopped.

Since the financial crisis, many investors haven't only avoided flashy Wall Street firms, but largely the banking sector as whole. Across the banking universe, however, there is one notable stand-out. In a sea of mismanaged peers, it rises above as "The Only Big Bank Built to Last." You can uncover the top pick that Warren Buffett loves in The Motley Fool's new report. It's free, so click here to access it now.

Read/Post Comments (22) | Recommend This Article (23)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 25, 2013, at 6:26 PM, neelvk wrote:

    So I guess you think that Mark McGuire and Barry Bonds did nothing wrong by using steroids...

  • Report this Comment On July 25, 2013, at 7:07 PM, cmalek wrote:

    In other words, the ends justify the means.

  • Report this Comment On July 25, 2013, at 8:13 PM, harmonyjoe wrote:

    Actually what Mark Mcguire and Barry Bonds did regarding steroids has nothing to do with either Lebron James or JPMorgan Chase and Goldman Sachs. But since their names have been brought up I think they got raw deals because unless somebody can show me that using steroids improves your eyesight I don't see how it's use had any effect on how many homeruns they hit. You still have to see the ball to hit it!

  • Report this Comment On July 25, 2013, at 10:31 PM, dennyinusa wrote:

    When you own the people who write the rules it is not very difficult to "play by the rules", since you were in the room telling them how to write the rules with loopholes you could exploit.

  • Report this Comment On July 25, 2013, at 10:49 PM, davaidesign wrote:

    And what about those bailouts? Is that also a sign of how great they are at what they do?

  • Report this Comment On July 26, 2013, at 2:51 PM, cmalek wrote:

    Steroids may not improve your eyesight but they do enable you to hit the ball harder, turning some of the long outs into home runs. The flip side of the coin is that no matter how good an eyesight you have, if you don't have the power, you're not going to hit home runs, look at Ty Cobb and others who hit for high average.

  • Report this Comment On July 26, 2013, at 2:55 PM, TheRealRacc wrote:

    HarmonyJoe, sorry man, but when you have the body strength of Bonds/McGuire after using steroids, you don't need a better eye to hit more HRs. The bat speed and torque is enough to constitute that they flat-out cheated.

    Put another way: their hand-eye coordination was SO GOOD before they took steroids, that the steroids added hundreds of home runs on to their career totals. Please change your perspective of these cheaters.

  • Report this Comment On July 26, 2013, at 3:29 PM, hbofbyu wrote:

    "...but getting upset at these companies when they play by the rules and regulations established out of their control is a little like getting angry at LeBron James for dominating because he is just too strong and too fast to be stopped."

    "Out of their control"?? Ha!!

    They play by the regulations and rules after sending their ex-employees to Washington to lobby (buy-off) those that create the regulations and rules. Goldman Sachs overly influence our government as evidenced by the former Goldman Sachs elite who have run our economy into the ground (Clinton’s Secretary of Treasury Goldman Sachs’ Rubin, Bush’s Secretary of Treasury Goldman Sachs’ “too big to fail” Paulson, etc.). Repeal of Glass-Steagall anyone?

    Ultimately Goldman Sachs is above the rules.

  • Report this Comment On July 26, 2013, at 3:59 PM, TMFTomGardner wrote:

    I'm glad you wrote this article. I love a contrary position. I do disagree with many -- though not all -- of your conclusions. Regulation has been co-opted by the largest banks. Further more, I don't see Goldman and JP as continuing "to thrive and win." They were levered up and needed the bailout to save them from counter-party risks. This isn't true of every financial service business -- a company like Vanguard or Fidelity or Schwab saw their valuations fall but not their businesses. The use of leverage, short-term compensation systems, and co-opting regulators. . not my type of business. Too many other truly great and conscious companies to invest in. Not saying the stocks won't perform well.

    Tom Gardner

  • Report this Comment On July 26, 2013, at 4:02 PM, rudolphm wrote:

    So it seems the advice to invest in these companies still stands, if one has the moral stomach, since they are writing the rules. Imagine where Barry and Mark (and Lance Armstrong) would be if they could have done that.

  • Report this Comment On July 26, 2013, at 4:11 PM, TMFKopp wrote:

    Since this has apparently changed into a sports discussion, may I point out that steroids are a controlled substance. Not only is it against the rules in U.S. sports, but it's also illegal. So yeah, not really a good analogy here.


  • Report this Comment On July 26, 2013, at 4:30 PM, TMFHurricane wrote:

    Thanks for the comments.

    The main point I was attempting to make was not to paint Goldman Sachs as an ethical oasis, but to remind investors to look behind the salacious headlines and really ask yourself: "Is this truly material to my investment thesis?" In this case, my answer to that question is "No."

  • Report this Comment On July 26, 2013, at 4:51 PM, JaneBond wrote:

    "The main point I was attempting to make was not to paint Goldman Sachs as an ethical oasis, but to remind investors to look behind the salacious headlines and really ask yourself: "Is this truly material to my investment thesis?" In this case, my answer to that question is "No."



    Imagine a world without ethics

  • Report this Comment On July 26, 2013, at 9:06 PM, waltg19149 wrote:

    This article states that Goldman Sachs legally makes money by creating inefficiencies in the market. It's a fine defense for greed and Goldman Sachs but a terrible indictment of Capitalism, at least as presently practiced on Wall Street.

    Some may be content because 'brainiacs' are making money but they shouldn't be shocked when so many others see vampire squids.

  • Report this Comment On July 27, 2013, at 1:34 AM, C3RN wrote:

    I have to agree with all the previous commentators . Goldman Sachs and JPMorgan pretty much write the loopholes that they exploit. A good video to watch about how they're doing this

  • Report this Comment On July 27, 2013, at 2:17 AM, systemBuilder wrote:

    You are so deluded I can hardly believe I'm bothering to respond. Read "Next: The Future Just Happened" and pay close attention to the story of Jonathan Lebed, age 12, whose actions were identical to firms such as Goldman Sachs but who was almost sent to jail ... by firms like Goldman Sachs ... you see, Wall Streetsters have rigged our securities laws so all the stupid money flows into their coffers, and if anyone else tries to muscle in on Wall Street's Actions, well, those poor schmucks go to jail ...

  • Report this Comment On July 27, 2013, at 2:22 AM, TerryHogan wrote:

    I thought this was a good article, and I have to agree that GS and JPM shouldn't be faulted for profiting from so-called "loopholes", or market inefficiencies. Go ahead and be outraged when they are doing something illegal, or get angry at the politicians who give them handouts (if you think that the alternative would have been better). You can even get angry at politicians who appoint former GS employees to positions of power, although eliminating them would eliminate a lot of bright people with industry experience.

    Capitalism is about making money. If they are operating within the law and making money for their shareholders, they're doing their job.

    I also thought the article was less about ethics, and more about market inefficiencies and how they only last for so long because they are always exploited by someone to make money. Heck, that's what everyone at the Motley fool is doing, except we're looking for inefficient pricing.

  • Report this Comment On July 28, 2013, at 12:39 AM, villanue wrote:

    Fun discussion to read. Agree that JP and Goldman are not doing anything except what they are expected to do as an organization. Make money. However, it seems being able to co opt regulations leads to market inefficiencies. If Goldman didn't help write those rules I'm sure, at some point, those fork lift drivers would cease the 'merry go round of metal.' Ultimately that is inefficient to the businesses using the metal, making them less competitive, even if just a fraction of a penny so.

  • Report this Comment On July 28, 2013, at 11:23 AM, SkepikI wrote:

    ^ You are free to participate in these sorts of "unethical" or unsavory business practices. If there were no bailouts with your and my (taxpayer) money, I would say that its likely JP and Goldman will reap their bitter result eventually. But of course we (voters and taxpayers or should I say Marks) support or at least dont revolt when intervention saves these blackguards from themselves.

    Just no whining please if the unforseen happens and some smart trader gets caught with a billion or two siphoned off from some complex scheme that was "unethical" but seemed to work. I am always reminded when I see these things of one author's analysis of Bernie Madoff's hedge fund scam: his customers understood that Bernie was making money front running trades from his brokerage business. They were untroubled by this unethical, illegal activity because THEY were not doing anything unethical or illegal, Bernie was. They were ok with Bernie crooking everyone else, but when the scam broke, they were aghast that Bernie would crook them......

  • Report this Comment On July 28, 2013, at 4:28 PM, joeddins wrote:

    There is behavior that is a felony, and there is behavior that is merely crooked and deceitful and greedy that we don't talk about at church.

  • Report this Comment On July 29, 2013, at 10:10 AM, twill59 wrote:

    All I can ask, to the author, and Mr. Mittens, is: Define "Market Inefficiency".

    I'll wait...........................................................................................................................................................................................................................................................................................................................................................................etc etc

  • Report this Comment On September 23, 2013, at 4:08 PM, thidmark wrote:

    Mark McGuire, Jorge Brett, Hank Erin, Willie Maize, Derrick Jeeter, Sandi Cofacks, Tom Siever. Johnny Bentsch

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