Trading at less than one times book value, shares of Goldman Sachs (NYSE: GS), the most profitable investment bank, look like an absolute steal right now. But one U.K. equity hedge fund manager doesn't agree. At the end of July, the Financial Times reported that Lansdowne Partners had sold its entire Goldman stake. Hedge funds sell stocks every day -- that's just part of the ordinary course of business -- but Lansdowne is no ordinary hedge fund manager, and this is no ordinary sale. The truth is that Goldman is a shadow of its former self; the exceptional profitability that shareholders were used to is in the firm's past, not its future.
Old art, profitable stocks
With more than $14 billion of assets under management, Lansdowne is one of the largest hedge funds managers in Europe. Paul Ruddock co-founded the firm in 1998. An avid art collector, he recently told Bloomberg that he favors "old art." Why? His answer is highly revelatory:
"A lot of people view contemporary art as a business, so they're trying to figure out who's going to be the next star. I have no interest in that."
It should come as no surprise that Lansdowne's investment approach isn't based on trend-following or fashionable stocks or industries. Instead, the firm has a built a reputation as a smart -- and highly successful -- fundamental investor that does its homework.
Making money on the way down and the way up
Lansdowne is no stranger to the financials, either. It was one of the few funds that had the foresight to make money on the short and long side in this sector over the past several years, shorting troubled lenders at the inception of the crisis, and switching to a long position before the sector recovered. In that context, we can assume that selling down its entire $850 million Goldman position -- a non-trivial investment even for Lansdowne -- was not done on a whim.
According to a Reuters source, Lansdowne's decision does not reflect concerns specific to Goldman, but was driven instead by broader issues that affect the investment banking business, including the massive changes in the regulatory environment. Lansdowne is maintaining a significant allocation to U.S. financials with a broader set of businesses, including Citigroup (NYSE: C), in both its flagship U.K. equities fund and its Global Financials fund.
Goldman's earnings power has declined
A few numbers illustrate the change in Goldman's prospects under the new post-crisis regime. In the following table, I have broken down the bank's profitability into two components: Return on assets and leverage. In combination, those numbers determine the returns Goldman achieves on behalf of its common equity shareholders. I look at two different time periods: The 10 years up to November 2007, which represents the pre-crisis era, and the years that follow up to the present.
|
Average of 12-month periods |
THEN: 10 Years to Nov. 2007 |
NOW: Dec. 2007 through June 30 |
|---|---|---|
| Return on Assets |
0.99% |
0.81% |
| Average Quarterly Leverage Ratio (Assets/ Common Equity) |
23.9 |
17.4 |
| Return on Common Equity |
24.6% |
14.3% |
| Price/ Book Value Multiple |
2.6* |
1.4** |
Source: Author's calculations based on data from Standard & Poor's.
*8.5 years through Dec. 2007. **Jan. 2008 through June 2011.
The table shows that Goldman's profitability has dropped markedly since the onset of the financial crisis, and the largest contributing factor is the decline in leverage. The crisis demonstrated that investment banks were carrying significantly too much leverage, given the nature of their activities. Indeed, excessive debt took down two of the major investment banks, Bear Stearns and Lehman Brothers.
Goodbye, leverage
Since then, Goldman and Morgan Stanley have voluntarily reduced their leverage in order to survive the crisis, but even if they wanted to, returning to pre-crisis levels is impossible under the new, stricter capital requirements specified by the Basel III agreement. Furthermore, Goldman's recent track record provides no evidence that it can compensate for lower leverage by wringing more profits from its assets in order to maintain return on equity at historical levels.
Goodbye, premium multiples
In that context, a rerating of investment bank share valuations is entirely warranted, and that is exactly what shows up in the price-to-book multiples the market has been willing to award Goldman over the past few years (see the fourth row in the table). Potential investors should be aware that Goldman and Morgan Stanley are very different animals from their pre-crisis days; these once-proud kings of the jungle have been defanged by regulators.
Throwing the lender out with the bathwater
While Lansdowne may differentiate between investment banks and universal banks, like Citigroup, the market appears to be making no such distinction. The shares of Citi, Bank of America (NYSE: BAC), Goldman, JPMorgan Chase (NYSE: JPM), and Morgan Stanley (NYSE: MS) have all underperformed the S&P 500 this year, and by a wide margin. Even the shares of Wells Fargo (NYSE: WFC), which has essentially no exposure to the investment banking business, have lost nearly 20% of their value year to date.
Faced with the choice between Goldman at 0.93 times book value and Wells Fargo at 1.06 times, I know which I find more attractive. (Hint: It doesn't rhyme with "bold man.")
- Add Wells Fargo to My Watchlist.
- Add JPMorgan Chase to My Watchlist.
- Add Citigroup to My Watchlist.
- Add Bank of America to My Watchlist.
- Add all these companies to My Watchlist.
Goldman was one of the hottest IPOs of 1999; find out which stock is this year's hottest IPO.
