Goldman Sachs: in the right direction

By | June 17, 2015

Warning: this is going to be a long–but an interesting–post.

In this post I summarize a call that we had with Goldman’s VP of investor relations, who knows the business very well and helped me to better understand the risks and opportunities that lie ahead. Let’s get started!

Warming up and risking down

We started with a few highlights from Goldman’s presentation to its creditors. Something that many people are not aware of is that about 40% of Goldman’s business is fee-based:

Screen Shot 2015-06-17 at 8.05.10 AM

 

As we know, fee-based businesses usually deserve higher-than-average multiples, which is not yet the case with Goldman. Moving on, there was another nice slide that many of you probably seen before. This slide shows the magnitude of de-risking that Goldman has been through in the past eight years:

Screen Shot 2015-06-17 at 8.06.56 AM

My immediate response to this was “so I guess we are never going to see ROE of about 30% as was the case in 2007.” It might fly in the face of what many people think, but Goldman is aiming high, even under the current constraints. In this first quarter Goldman produced an ROE of 14.7% and this is with the global economy being in shambles, interest rates are at all time low and financial regulations not finalized yet (which makes Goldman be very conservative in the amount of capital it holds, lowering the ROE). Should things get better on the macro front Goldman believes that it can deliver an ROE figure well north of that 14.7%. Amen to that.

Are margin loans a risk to be concerned about?

The main reason I initiated this call with Goldman was to ask about the risks that are embedded in the margin loans that Goldman extends to its clients. A few weeks ago, I had lunch with a friend who spent many years doing investment banking and he highlighted that this might be a risk because banks hold a lot less inventory than they used to and should a shock occur in fixed income markets and liquidity dry up, many clients might be in a “negative-equity” situation and Goldman’s (and other brokers’) capital will take a hit. Here is a part of the email I sent to Goldman:

The part we want to learn more about is the exposure to margin loans that are extended to clients, the risk it posses and risk mitigation actions that the firm takes. The reason that we want to look into this is that in recent years, due to the new regulations, issuance of bonds of various grades have been sky rocketing but banks’ inventory has gone down wherein in the past, before the new regulations, the two used to go in tandem. This, in turn, may lead to large bid/ask gaps when liquidity dries and banks won’t have the “ammunition” to step in and act as a buffer to absorb inventory. Should such adverse scenario take place, many customers that borrowed on margin may get margin call and have negative equity that will have to be absorbed by Goldman.

Craig has obviously done his homework and came prepared. Page 69 of Goldman’s latest 10-k (annual report) contains an alternative balance sheet that is very useful in understanding the various exposures the firm has:. Here is the assets side of the alternative balance sheet:

Screen Shot 2015-06-17 at 8.15.51 AM

Margin loans are presented in the line called “Receivables from customers and counterparties,” $36.9bn. Most clients are long-short equity hedge funds. The first bit of good news is that there are not too many fixed income loans in that amount. Goldman protects itself from “negative equity” risk in the following ways:

  • It takes a serious “haircut” on the value of the collateral that the client has to post. This “haircut” is in the area of 35% and is calculated conservatively, that is to say that the lower the collateral quality is, the higher the haircut that Goldman takes when calculating how much collateral it should require the client to post. So, in order for Goldman’s capital to suffer, that collateral has to take, on average, a 35% hit after the client gets a margin call.
  • All that must occur within one day because Goldman marks-to-market on a daily basis! So in order for Goldman to suffer here the market has to plunge, the clients, which are mostly long-short, have to lose a lot of money on their leveraged positions, the collateral (which, again, is mostly long-short) has to take a 35% hit and it all has to occur in one single day.

No wonder, then, that in the 15 years since Goldman became a public company they had no losses on this margin book and this period includes the financial crisis–a time in which there were many hedge fund blow ups, some of these funds were Goldman’s clients.

Another two lines that are important to look at are “Securities purchased under agreements to resell and federal funds sold” and “Securities borrowed.” There are two components here:

1. Short covering to hedge funds: this is a fully collateralized, low risk securities-lending business. Mostly borrowing pension funds and other asset-management companies assets to hedge fund and earn a spread. Similar to what I described above, this is calculated daily and done very conservatively. This activity didn’t lose money for Goldman even in tough times.

2. Match book: taking money market funds that have cash and want yield and lends it to hedge funds that need financing, while GS stands in the middle. Same risk management techniques apply here.

Another thing to note is that Goldman doesn’t hold what is called “directional inventory.” That is, the inventory that Goldman holds is usually market neutral so that in theory, Goldman takes not market risk. The following chart shows the VaR that is associated with these activities:

Screen Shot 2015-06-17 at 8.29.24 AM

This VaR is calculated based on a 99% confidence-interval. Being the “math-savvy” engineer that I am, I had to ask how do the numbers change should we calculate it based on a 99.8% confidence interval I didn’t get an answer except for that it will go up. Some risks we just have to live with I guess. This is how it worked in practice:

Screen Shot 2015-06-17 at 8.31.22 AM

Not too bad.

Revenue opportunities

In terms of FICC, Goldman’s main earnings engine things just start to look good. In Q1 they started to see divergence, in terms of macro, between the US/UK and rest of the world. This, in turn, drove higher client activities in Q1 and this trend remains in place today.

As for investment banking and M&A, we just returned to a normal level recently. These cycles are long multi-year cycles and Goldman is optimistic about that going forward.

For asset management, AUS (assets under supervision) has been growing and they see this trend continuous. The flow of earnings from this business is highly valued by the market because it is less prone to cyclical changes like the investment banking and the FICC segments. Just look at the multiples that companies like Blackrock get.

Investing and Lending: some people think it will dry up when GS sells the PE investments. Volker impacts the form of the investment but not the ability to invest and the investment portfolio will be opportunity dependent. They (Goldman) think the market is short-sighted in thinking that earnings from this segment will dry up. Even if it will, they can reinvest or return to shareholders over time.

Another interesting thing that won’t move the needle much but testifies at Goldman’s ability to adjust and exploit opportunities is their move into what is called “digital lending.” Since Goldman doesn’t have the high legacy costs that are related to retail banking branches etc. it can offer consumer credit online by using big data and analytics. Goldman has already hired a big shot in this field and is moving forward with this plan, you can read more about it in this DealB%k article. It is nice to see that the company does not rest on its laurels.

Final thought

I really like Goldman Sachs. I spent a lot of time studying this company and I have been continuously studying it since 2011 when I first became interested after reading “The Partnership.” How I got to read this book is an interesting story in itself: before the Jewish holiday of Yom Kippur I was walking around the Jewish center in Shanghai to look at nearby hotels to book for the holiday. While I was walking around, I saw this Chinese guy with a pushcart selling second-hand books. A few books caught my attention and being the frugal person that I am I started to bargain with the guy and I almost ended up not buying anything. Fortunately, I managed to get myself to pay extra RMB5 (less than $1) to get this book. Needless to say, this book was one of the best investments ever made in human history 🙂

I was lucky enough that by the time I finished the book about Goldman’s history, the stock traded at an extremely cheap valuation and one didn’t have to be a genius to buy it in bundles and double the money from that point on. Goldman has fantastic management team that is both a savvy operator and an intelligent capital allocator and that is one of the reasons that it has performed so well through the years and the many changes that it experienced. Look at the figures below that include one of the worst financial crisis in history:

Screen Shot 2015-06-17 at 8.41.51 AM

However, while I’m a big fan of the company, there is one thing that bothers me about this investment: Goldman’s performance depend too much on global macro trends being favorable. I usually like investments that will perform well in almost any weather and this is not the case here so that’s minus one for Goldman. But given it’s qualities, I can “suffer” a few names like that in the portfolio.

Cheers

Yaniv

 

5 thoughts on “Goldman Sachs: in the right direction

  1. John

    “While I was walking around, I saw this Chinese guy with a pushcart selling second-hand books.”

    ahah, no they were not second hand 🙂 Nice try.

    Thanks for the article.

    Reply
    1. Yaniv Uliel Post author

      Thanks for your comment John. You never know who is reading this blog so I had to be politically correct 🙂

      Reply
  2. Shlomi Ardan

    On its surface it looks like the stock is trading at a P/E of about 9, is that representative of its earning power right now? If so, this is indeed very cheap

    Reply
    1. Yaniv Uliel Post author

      Shlomi, I think that each investor should estimate GS’ earning power based on the assumptions (conservative, preferably) that he believes will hold. The most useful exercise I can think about is to think what would the equity be 2-3 years down the road and where would the ROE stand. Then put on that your favorite multiple for a business with such qualities and see what it may worth 2-3 years down the road.

      Reply
  3. Barak

    What are your thoughts about the downtrend in FICC income?
    This activity is around 30% of revenue, and went down 28% in q2 and 33% in q3 2015.
    Management claimed that this is due to increased volatility that caused institutional investors to hold back.
    I would like to offer an alternative explanation, focusing on Fixed Income:
    Bond trading is leaving Investment Banks trading desks and going electronic. This is a secular trend and not based on market “mood” as GS management trying to explain.
    The claims about lower volumes are not supported by facts. Trading volume in bonds during q3 and YTD is about the same as 2014.
    https://www.sifma.org/uploadedfiles/research/statistics/statisticsfiles/cm-us-bond-market-trading-volume-sifma.xls
    On the other hand, trading volumes at Electronic Bond Trading venues are rising steadily:
    http://investor.marketaxess.com/volume.cfm

    Many thanks for the efforts you put into this blog!
    Barak

    Reply

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