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Bull/Bear Report: Goldman Sachs -- Good As Gold or Time to Sack?
How do you solve a problem like Maria or shall I say Goldman Sachs (GS)? On one hand we are dealing with a mess in credit markets that would rival any of the worst financial crises over time and on the other hand a best in class investment bank trading at a discount.
Last year, GS was one of the few that actually made money off the mortgage crisis. This year appears to be a different story as the struggles continue.
In less than a week, Bear Stearns (BSC) managed to collapse with a rapidity that boggled the mind. From all is well to $2 per share and a Federal Reserve bailout has to put the fear of God in any trader.
What does it all mean for Goldman Sachs?
Ironically, trading desks for investment banks can be incredibly profitable during periods of high volatility. If we could just rely on those balance sheets, our analysis of GS would be fairly simple.
And that's the rub. We really can't rely on the balance sheet and therefore we must accept a certain amount of risk if we are to be long GS.
It is interesting to note that earnings estimates for behemoth banks Citi (C) and Bank of America (BAC) were reduced again this week. The Titanic continues to take on water.
Will those reductions impact GS? It is hard to say, but clearly we are not at a bottom yet when it comes to loan losses and the credit freeze.
Should you buy or sell Goldman Sachs? Get the bullish and bearish take on the stock.
Of course we now live in a United States where we can rest assured that the current interventionist Federal Reserve and our Government will do anything to prevent losses. Such actions will surely put a floor on the equities.
Personally I find these types of intervening actions to be quite offensive. I'm all for preventing a complete meltdown, but at some point we have to let the markets settle without interference.
If not we just put off the inevitable. I would much prefer digesting the excesses ridding ourselves of those that took inappropriate risk and move on. Ultimately I think the strong, like GS will survive and thrive.
With that let's get to our bloggers and their Bullish and Bearish thoughts on GS
The Bull Case - Tom Armistead
I want to talk about Black Swans first. "Black Swan" is a phrase popularized by Nassim Nicholas Tasseb in his book "The Black Swan (The Impact of the Highly Improbable)." It's a fascinating book, somewhat uneven, but worthwhile reading for investors or others concerned with potential catastrophes. His point is that life is characterized by occasional high impact events that are highly unlikely and almost impossible to predict. He notes that many of the outcomes in life just don't fit neatly into a bell shaped curve. Examples of black swan events would include the market crash of 1987 and the 9/11 terrorist attacks.
The implication for investors is that certain financial activities or transactions characterized by a very low probability of occurrence together with a very large size of loss/gain create a vulnerability to black swan events. As an example from the crash of 1987, options trader Tony Saliba had hedged himself, months in advance, with out-of-the-money-puts on the S&P index. When the totally unexpected occurred, he was protected. For those who sold him the puts, the outcome was less fortunate. In today's market, with massive amounts of derivatives outstanding, many of which are not fully understood, as well as other examples of excessive leverage, outcomes well outside the range of normal expectations are possible.
The demise of Bear Stearns is a small scale example of this type of occurrence. (For those who had their life savings in the stock, maybe it is not so small scale.) I habitually, and wrongly it would seem, regard a stock's range of potential prices as a lognormal distribution. The options market implicitly relies on this assumption. But the sudden plunge of Bear Stearns from 30 per share to 2 is simply outside the realm of this type of probability thinking. Those who bought and sold puts in the days and hours before the plunge were enriched or impoverished accordingly and disproportionately.
With that for a preface, on to a discussion of Goldman Sachs.
This large investment bank has done well during the sub-prime meltdown, having sold mortgage backed securities to their customers while at the same time betting against them by means of credit default swaps. Not beautiful ethically but it is effective economically. Their reputation as I perceive it is that they are very, very clever.
In any event, I prepared my workbooks on GS and find that it is trading very low in its normal range when compared to either 5 year average earnings or book value. GS has traded in a range of 1.3 to 3.1 x tangible book over the past seven years, and currently trades at a multiple of 1.5. You could have made money any year during the past 7 by buying the stock at less than 2 x book and selling it for more. So, in my happy world of normal distributions, this qualifies as a buy. Of course the question comes up, what if GS suffered a fate similar to Bear Stearns?
I went over the financial statements and in particular the balance sheets, looking at liquidity and so on and so forth. Liquidity should be less of a worry now that the Fed is standing by to lend money on less than first class collateral. What I did see was that their balance sheets carry a large amount of more or less offsetting derivative liabilities and assets or short and long positions. Presumably there is a lot of hedging going on. If some of the hedges are not fully thought out, problems could ensue. The whole thing is kind of a black box, earnings come out, but it's not fully transparent. I experienced the same reaction when I tried to analyze Citigroup (C). Buying any of these type shares is something of an act of faith.
On balance, I would tend to bet in favor of these clever people, but I would keep position size modest in case they outsmart themselves. Because most market participants have been thoroughly scared by recent events, it is likely that a lot of the excessive leverage and derivatives will be unwound over time, and that risk management will be tightened up. That plus an economic recovery would make GS very attractive over the long term.
The Bear Case - John Freeman
John says that while Goldman looks better than most of the financial sector, he's not ready to buy...yet.
In response to the question of the week about Goldman Sachs:
I will agree (GS) looks to be the best of breed in the financial sector, certainly at least in the investment banking side. It was genius to short the sub-prime mess while selling the same product to others or is that called sleazy? Either way though, it didn't seem to be illegal. Their numbers were better than expected but hardly good. The bar had been lowered so much by reducing expectations, that it would really have been a disaster to have missed earnings. So far, their name has been untarnished, their trading desk seems to be doing well in this market and they have held their price better than most of their competitors. These all seem like good signs to me. But I don't think it is that simple.
Usually when one or more companies get dragged down, their entire sector goes down and trying to fight that trend is futile. This has been the case for GS to date. There are other good names here too like JPMorgan that just got a steal that could pay off in spades for year to come with the purchase of Bear Stearns (assuming there are no more legal complications from Bear Stearns shareholders that seemed determined not to take the offer.) GS should also pick up some business with the imminent closing of (BSC).
In a time when a rumor can cause a run on a bank or take them out, anyone invested in these companies are playing with fire. But, risk is where the profits are and if you can stomach it, these financials have been beaten down so badly that when the worm turns, they are due for a big run. To me, the questions are who and when? Who do we pick to invest in and when do we choose to do so?
There is an interesting fact to mention here. The investment banks and the commercial banks use two different accounting methods. The investment banks use a "market to market" approach that means they have to markdown (or up) their assets when similar assets are traded. This means the investment banks have to take the big write-downs faster than the commercial banks which use an accrual accounting method. The hidden writing on the wall here is that the commercial banks may not have shown the public how bad it is yet as their losses may still be hidden in accruals. The flip side of this argument is that the markdowns are too extreme and when the liquidity comes back and these assets can be priced better, there should be significant write ups. This would also mean the commercial banks accruals get reversed and the paper losses that he investment banks suffered may never happen to the same degree at all for them.
We are dancing on the edge of a knife here. If the commercial banks take a big hit as the accruals pile up, the investment banks like GS can still take a big hit as the entire sector goes down. It also seems that no bank is truly safe at this point in time. As Bugs Bunny used to say "Hare today, goon tomorrow." The Fed has proven it's willingness to preserve the banking system at virtually all costs (as I believe it is mandated to do) but that does not mean it will take pity on any bank that stands in the way of stability. Witness Bear Stearns and the Fed's participation to virtually take the bank down to prop up the system as a whole. Was BSC really only worth $2? I think most people know the answer is no. They were obviously worth more than that. (A moment of silence please to morn the non-executive employees of BSC and their retirement portfolios and careers.) But that was the number that was needed to make things happen so it became the target number. Technically, its not a $2 per share offer, it is a stock swap for JPMorgan shares and as JPMorgan goes up in value so does the offer but not by much considering it's low starting point. I also have to love the observation that Dylan Rattigan made that JPMorgan paid less for Bear Stearns then the Yankees paid for A-Rod! /grin
To wait until this clears up may mean missing a huge part of the recovery and run up. To jump in now may mean taking a big bundle of risk with a possible hefty return or loss. The general consensus on the street seems to be that it will take the financials to lead the way to a market recovery. Without them, the market will clearly either stagnate or continue it downward trends.
My personal risk tolerance does not lean me towards buying GS as these prices or at this point in time. Once the commercial banks report in the next few weeks and the rate cuts and Fed actions have been digested by the market, we could very well see a quick leg down for the financials again, especially if someone else gets into trouble. (Lehman Brothers?) Both Lehman and GS got a negative outlook and possible downgrade from S&P today. GS has also jumped almost 40 points in the last week and that probably was an over shoot.
If I were to buy into GS, it would be at a lower price point as it could very easily retest its 52 week low of $140. A price point of closer to $150-$155 and a few weeks of more earnings, especially the commercial banks with no more bad news (failures, runs, huge unexpected write downs etc...) would make it interesting but still, very risky with only the possibility of a high reward. My prediction is we will see Goldman Sachs back at the $150 range and some point next month and only then, based on the news could it be worth dipping a small toe into the water with maybe a quarter position and look for opportunities to buy dips over the next 3-6 months. Until then, the knife is way to sharp for me.
OK, time to get back to basketball and a weekend of beer, pizza and poker. (Hmmm, maybe I should by BUD instead.)
So what should an investor do about Goldman?
The whole point of the Bull/Bear report is to present both sides of the story on a particular stock, pulling from the best of the InvestorPlaceBlogs community. My Rational take: At the end of the day, I would view GS as an opportunity, but not one I want to rush into. This is another dollar cost averaging special. If you want to establish a position in GS, do so over time.
There is too much that can go wrong and in my opinion the upside does not yet properly compensate you for taking that risk.
Jamie Dlugosch
Executive Editor, InvestorPlaceBlogs
Additional posts and InvestorPlaceBlogs resources on Goldman Sachs (GS):
the Stock Surfer - Goldman Yes, Gold No
Family Man -- Goldman Sachs vs. Gold
Ahknaten - Luster Lost and Dull Gold (Gold I Have None)
Vad -- Why Investment Banks are not Cheap
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