Is Goldman's Stock a Risk Worth Taking?

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 Goldman as 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 concerns about 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 way from 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 straws down 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:

Source: Capital IQ (a Standard & Poor's company).
Results for the period 2005-2007.

At the same time, investors have seen Goldman's stock soar 71% over the past five years -- roughly 11% per year. Not bad considering the terrible returns of the overall market.

If the trading speed bumps that I outlined above never come to be, Goldman shareholders may keep right on laughing all the way to the bank. If there are any major hitches in Goldman's trading operation, though, the coming years may look a whole lot different than the recent past.

So what do you think? Are the potential returns from Goldman's stock worth the risk? Scroll down to the comments section and chime in with your thoughts.