Tom A's Stock Picks

Goldman Sachs, Bear Stearns and Black Swans

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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.