January 09, 2012 - 11:52pm EST by
2012 2013
Price: 94.80 EPS $6.00 $12.00
Shares Out. (in M): 492 P/E 16.0x 8.0x
Market Cap (in $M): 46,600 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0.0x 0.0x

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  • Discount to Tangible Book
  • Banks
  • Competitive Advantage



This is your chance to be a Goldman partner without the hours.

I hesitate to post this on VIC, as I can already feel the negative ratings coming at me but I feel it is asymmetric so I want to post it. I almost feel as though I need to expound on how worried I am about the global deleveraging, Europe’s impending nasty issues, a potential China hard landing, and potential Japanese depression, not to mention the United States’ problems in order to make this pitch more credible. The simple fact is that I am worried about most financials because loan demand will be subpar, there will be a constant deleveraging for the next decade, there are still credit problems out there, counterparty risk is a huge problem, leverage will be lower, ROEs will be lower, and when this is all done I am pretty convinced that technology will have affected a lot of the business models 5-10 years out.

I had been hesitating to post it up until this point as I am not a glutton for punishment, but if you are curious to why this investment likely will survive the impending European and global banking crisis and thrive than please keep on reading.

So, why Goldman?....

Goldman Sachs is perhaps the world’s most respected financial institution. Goldman has a best in class franchise among many business lines and their superior culture, top talent, and ability to constantly reallocate resources in an opportunistic fashion to the best risk-adjusted opportunities has allowed them to produce a 10% ROE advantage over peers over the past decade. And, as I will attempt to convince you of below, Goldman is uniquely positioned relative to most of my fears vs. large financials.


I do not want to bore the VIC audience with the math of Goldman Sachs, as everyone is already aware of how cheaply financials are trading. That said, it is trading at .78x current tangible book value of $120. It is worth noting, that in a prior life you would have been willing to slave away for twenty years working 100 hour weeks to buy into the Goldman Sachs partnership at tangible book.

Differences Between Goldman and Other Mega Banks:

1)      Goldman marks to market their assets aggressively with 50% rolling over every 45 days and 80% every six months. The GS employees are charged for capital is that charges increase over time thus incenting employees to sell stale assets. When I look at the major banks, I do not know what I am looking at generally outside of Goldman. What real estate price assumptions are being used? I heard a call with the BofA CEO saying they were using rising 2012 housing price forecasts for instance. How much is exposed to mortgage put back lawsuits? You lent how much on commercial construction deals? Goldman marks most of its assets to market so I at least feel that what I am looking at today is a good snapshot.


2)      Current and former Goldman partners own between 10 and 20% of the company. There is no way to know for sure, but I have seen various assumptions in the high teens. This is very different from most of the other banks where employee ownership is very low. The partnership culture at Goldman is not as it used to be, but the remnants are still there and the culture of ownership is still present. If you talk to people who work at Goldman or previously worked there, people are very loyal in a way they aren’t at other banks. I would argue the employee culture leads to more conservatism on the balance sheet in favor of protecting their nest eggs.


3)      Goldman is very worried about tail risk so they are holding over $150B in short-term liquidity up from $60B a few years ago and holding long term debt against this. This is taxing their earnings to a large degree, costing them over $1B a year. Although they are getting flack from investors for their lack of leverage and low ROE currently, they are purposely structuring their balance sheet to be able to survive a huge tail event.


4)      They have the most talented employee base. They have told analysts they have over a 90% yield on offers to MBAs and it is at its all time high. They have also said they get 85% acceptance against their next closest competitor. Their talent pool is very deep all around the world.


5)      As they have grown organically, their technology and systems is ahead of competitors. They have spent aggressively on technology over the years, and the value of this cannot be underestimated because it allows them to maintain a better handle on their business. This is extremely important for risk monitoring.


6)      They have a strong emerging markets franchise that will be a huge tailwind to their ROE over the next few years. They have overinvested in BRIC countries to get to scale depressing their ROE in the short term and expect their emerging markets business to be their highest ROE business over time. This could be a 150+bps tailwind to ROE as it goes from low single digits upwards over time on a double digit percentage of revenues.


7)      Goldman’s funding position is much better than it was previously. They have $60B of tangible equity, $200B of long term debt with a 7 year duration, and 100 days of average duration of secured funding. They are doing everything within their power to tax their current earnings to extend their funding. 1/3 of their balance sheet is now funded with very long term funding up from 15% a few years ago so they are in much better position today.


8)      They have higher capital ratios than their peers at the same time as their liquidity is highest. They have generally been less levered than peers so the SIFI buffer rules and Basel rules won’t hurt them as much on a relative basis. They would never use the term “fortress balance sheet” and we can debate all day how much better it is to be deposit funded, but I think the record of 2008 shows that deposit funding is not the be all end all, especially not if there is an asset problem (think WAMU). It turns out, people do not wait for FDIC insurance if they are worried about their bank going under.


9)      Although Goldman’s franchise has clearly been tarnished over the past few years, the relative gap between them and competitors has likely widened. One thing is for sure, the competitive set is lower. Lehman went bankrupt, Bear and Merrill were acquired, Morgan Stanley has lost a lot of luster, and big financial firms are exiting business lines. I think a lot of the competitive franchises are in disrepair, although JP Morgan has gotten stronger. Quite simply, Goldman has an incredible franchise as evidenced by their M&A rankings as well as the deals they have done with ICBC and Facebook for instance.


10)   There are going to be huge opportunities for well capitalized banks in the next few years as the European banks are forced to delever and are perhaps nationalized. They have been bidding up assets given their ridiculous leverage levels, so as they delever and distress erupts banks like Goldman will be poised to capitalize.


11)   Goldman’s assets and business are more fungible than competitors. They can skate where the puck is. Whereas a lot of mega banks have a huge retail bank network and fixed assets, Goldman has a large pool of capital and can reallocate to where the best opportunities are. This is very important as some of the online banks and platforms with lower cost bases than the mega banks might take significant share over the next decade. Being a retail branch focused domestic bank might not be so great in the future. Goldman is asset light and capital-heavy.


12)    Most importantly, they are keeping earnings low and holding cash to survive any potential tails and take advantage of dislocations. Although I would not bet ROEs will be over 20% over the next decade I would not take the bet that they would be under 13-15%.


Should This Just Go Into the Too Hard Pile:

It is tempting to take a pass on all financials given the fat tails in the world, but buying into Goldman Sachs at less than 80% of tangible book value is a pretty extraordinary opportunity. I would never argue that there is no risk that in an overleveraged world that has financial institutions with too much leverage that nothing bad could happen. However, I will argue that Goldman is doing everything within its power to take lumps now to limit the chance of harm and to set themselves up for the future.

If you read sellside coverage of Goldman, you will not read that Goldman has a balance sheet problem. You will read that they are doomed to have low ROEs and thus a low multiple. The problem with this static analysis is that it misses that the best thing Goldman can have happen to it is trade below liquidation value as unlike most mega banks they can shrink both sides of the balance sheet.

This is an important point that I do not think gets enough attention versus the other large banks. As Goldman does not have most of its equity tied up in loans and instead has liquid assets, if Goldman trades at depressed multiples for a long period of time, they will confront decisions like “should we give this group $5B of equity or $3B of equity and buy in another $2B of stock.” “Should we make this private equity investment or is our own stock better?” As Goldman has 3 businesses (banking, asset management, and more capital intensive trading and lending businesses), if they take capital out of the capital intensive side and buy in stock they are really shifting capital from capital intensive to capital light businesses and increasing their future valuation multiple.

Consider the following:

If banking and asset management do $1B of after tax income each in a normalized environment they might be worth $20B net of the capital they consume. Since we are paying $47B for $60B of tangible equity, we arguably are $27B for the $50Bish of tangible equity on the balance sheet (assuming the other $8Bish does a 25% ROE in the asset management and banking side). If we take capital out of the more balance sheet intensive businesses and buy in the remainder, we are accreting significant value to shareholders, increasing its prospective multiple, and derisking the balance sheet. This is somewhat theoretical in that they cannot exit major business lines and it is unclear how much stock the Fed will let them buy in but it is not theoretical in that they are buying in over $5B of stock this year alone.

This is much harder for a larger retail bank to do given their assets are not as liquid, they don’t have as much excess capital, and the top ones trade well over book. For people that are assuming Goldman will have a 10% ROE permanently, it is tough to imagine how that is possible. If just $10B of the capital can generate a 25% ROE in GS’s capital light businesses then that gives us 250bps of ROE. The remaining $50B would have to generate a 7% ROE to get to a consolidated 10% ROE. It is hard to imagine how anyone would want to run a 10+x leveraged business with that low of ROE, and if GS was earning that low of ROE what would it imply for competitors who earn less than they do. The logical response would be for everyone to shrink their capital base or increase pricing.

Regulations will for sure hamper their ability to be in certain lines and they will be forced to exit certain businesses, but given they are trading at such a low price and the businesses they will have to exit aren’t their best businesses this will be a positive for them. When you trade below liquidation value, you do not need to grow to create value. By exiting certain lines and shrinking their capital base, they will create a lot of value for shareholders.

How this plays out:

Although investors are frustrated Goldman is making no money right now, I believe they are ducking and covering and waiting to see how Europe and the macroeconomy plays out. While investors remain frustrated by their lack of risk taking, I will remain comforted. They will earn a subpar ROE in 2011 and 2012 at a minimum, but will likely buy in stock aggressively next year if the valuation stays this low thus shrinking the share base and allowing book value per share growth to be higher than their ROE. As the regulatory landscape is crystallized, European banks delever and the Eurozone situation is resolved, and the fat tails are ultimately resolved, Goldman will start deploying capital into high return areas as they did in 2009 and their ROEs will go back up. Their will be a huge tailwind to their ROE from their reduction of their excess liquidity pool, their increase of leverage, their expanding ROE in emerging markets, the decline of their competitive set, and the increase in risk taking.

There are two issues people have with financials: ROEs and balance sheets. The value of Goldman Sachs is not determined by its current ROE-it will be determined by what ROE they can achieve out a few years. Given their mix of businesses, it seems unlikely they will be willing to operate at or accept a sub 12-14% ROE and there is a shot they do better. The bull case would be that they bide their time and then put out a peakish ROE like they did in 2009 and investors revalue the stock to over 2x book at the same time as the book grows 30%. In the downside/uninteresting case for Goldman, they are forced to shrink fairly dramatically over time and return capital to shareholders. This would be the scenario where they are not able to earn their cost of capital.

The Math:

I started to put the math down here, but the reality is it is pretty silly as long as Goldman exists any potential crisis in tact. I am much less worried about their ability to generate 12+% ROEs long term than others so I have remained more focused on the balance sheet, funding, and the downside. With regard to their balance sheet, I believe they are maniacally focused right now on derisking and doing all they can do given the way they are funding. I believe it is extraordinarily unlikely they have an asset problem over the next couple of years, and I believe that given their clean assets that the liability side will not be a huge problem. There will be moments where CDS widen on all banks, but I ask myself if Goldman goes down 20% would I buy more? I come up with a different answer to this question vs. a l ot of the other big banks.

If I think about YE 2014 Book Value Per Share, I think it is unlikely they have a sub $160 book value number which would be 10% book value per share growth. This would mean they would have to earn an 8%ish ROE given how accretive buyback are. If we take a low-case of $170 of YE 2014 book, the question then becomes what does the business look like in three years prospectively. If people think they will be able to earn 15% ROEs again looking out three years from now it might trade at 2x book again. If people are assuming significantly less, it will likely trade between 1.3-1.5x.


This puts the value in the range of $220 to $350 over three years from $95 today.


Once again, I don’t think this is just theoretical. They earned a 30% ROE in 2009, and although I do not think it likely they will earn 20%+ ROEs for a long period of time, I think it is likely that they will earn over a 20% ROE in a strong year and that investors will assume it is sustainable, thus giving my asymmetry on the upside. I think the stock is trading where it is today because people are misconstruing the current ROE as lack of opportunity when it is being significantly taxed by conservatism.


Again, to not like the stock here, you have to think it will go bankrupt, will be diluted significantly in a tail event, or will earn a 7% ROE forever. Given how profitable their asset management and banking franchise in, I think the sub 10% ROE question is off the table. They will just return capital to shareholders. Trading at a fraction of liquidation value is the perfect setup if you have excess capital. On the balance sheet risk question, I think they are positioned as well as they possibly can to withstand it though nothing can be certain.


Given the tails in the world, most financials may have to go to the too hard pile but I try to think to myself of what opportunities I will regret not taking advantage of 3-5 years out. Goldman trading at a fraction of current liquidation value seems pretty extraordinary. If you are worried about Goldman going other, I think the upside is so significant that you can buy out of the money puts on GS or other financials and eat the premium along the way.


Goldman weathers the storm, shrinks their equity aggressively, and the numerous ROE tailwinds of emerging markets, increasing risk, decreased competition, lowering their liquidity pool, and increasing leverage cause their ROE to go back to much higher levels than analysts are expecting.
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