Monday, April 10, 2006

Barron's Cover Story on Goldman Sachs

  
Barron's, Michael Santoli, 10 April 2006

THE REMARKABLE THING ABOUT GOLDMAN SACHS Chief Executive Henry Paulson is not that he made $38 million last year, the most of any Wall Street chief. It's that he might have been underpaid.

Churlish as that sounds, consider Goldman's achievements on his watch, which began in mid-1998, a year before the storied investment firm came public. Through a bubble, bust and brutal bear market, revenues have soared 190%, to last year's $24.8 billion. Earnings have risen more than fourfold, to $5.6 billion, or $11.21 a share. And the stock, which started trading in May 1999, has rallied 203%, compared with a gain of 156% for the broader brokerage sector.

In the past 10 months alone, Goldman Sachs shares have tacked on 69%, endowing the firm, which was founded in 1869, with a stock-market capitalization of more than $70 billion.

Fueling much of Goldman's recent growth has been its prowess in trading fixed-income securities, commodities and currencies. Though it is often referred to as an investment bank, and has one of the largest and most successful advisory businesses in the securities industry, Goldman more than anything these days is an allocator of capital for the benefit of clients and its own account.

Indeed, trading activities accounted for two-thirds of revenue and three-fourths of profits in 2005, and contributed mightily to this year's stupendous fiscal first-quarter results. In the three months ended Feb. 28, the firm produced net income of a $2.4 billion, or $5.08 a share, a 62% increase over year-ago results and an embarrassing 50% improvement over analysts' expectations. Annualized return on equity for the quarter, the key measurement of a securities firm's profitability, was 39%, nearly double what is considered a strong performance industrywide.

CFO David Viniar, 50, takes pains to note that such results are not "sustainable" quarter to quarter. Yet, full-year earnings estimates have risen to just over $15 a share for the fiscal year ending in November.

Goldman's increasing dependence on trading has led to charges that the firm must be shouldering enormous risks to collect such winnings. Some skeptics glibly describe it as a house of cowboys, slinging shareholders' money around for their own benefit. Needless to say, the naysayers eagerly await its comeuppance.

It could be a long wait, however. While a summer slowdown in the stock and bond markets could rough up Goldman's shares, which Friday hit an all-time high, the odds are strongly against a calamity or implosion in the company's business.

SURE, GOLDMAN'S TRADING RISKS HAVE RISEN -- and management has promised they will continue to rise. But that's only because Goldman has figured out where the world of high finance is going, and is heading there faster than the competition.

As markets become more global, demanding greater expertise in complex instruments and requiring middlemen to put more of their own capital to work in the service of clients (and shareholders), Goldman "gets it," arguably better than anyone else on the Street. And its long lead promises to make it a long-term winner.

The new world of trading is not about flipping stocks for nickels and dimes ahead of client orders, or holding corporate bonds in inventory and selling them at a markup. It is about credit-default swaps and total-return swaps and volatility arbitrage, and all sorts of other investment exotica designed to give huge players even the slightest edge. Yet, only a sliver of this activity involves Goldman traders wielding the firm's capital to initiate bets across markets. Most involves client-initiated transactions that the firm facilitates and, increasingly, accomplishes by taking the other side with its own money.

Here is what Goldman is not, despite what alarmists say: It is not a huge hedge fund, or an impenetrable "black box," though the firm offers fewer details about its trading operations than some shareholders would like. Nor is it a leveraged proxy for stock prices, or a surfer of the yield curve, or a mere play on oil prices through its commodities business. Goldman is not a place where folks with MBAs and nice golf strokes simply roll the dice hoping for a seven. No gambler, it is much more like "the house."

Though the firm might bristle at the suggestion its clients are gamblers, the reality is that those clients, including many hedge funds, lay the bets, on which Goldman helps set the odds. And, like the casino credit window, Goldman can elect to lend them money on its own terms, or not.

Goldman's unabashed willingness to use its own capital to facilitate client trading also gives it an edge. There are attendant risks in this, and losses happen every day. But, on average, the firm's vast knowledge of the market has helped it price risk fairly, or at least better than the competition.

Merrill Lynch, in contrast, curtailed its risk-taking in debt markets several years ago, as did Morgan Stanley under former CEO Philip Purcell. New CEO John Mack, is working to enhance the firm's trading-risk profile.

Viniar countered attacks on Goldman in a recent interview with Barron's. "In the past five years we've had periods of falling interest rates and rising rates, a widening and tightening of the yield spreads, falling energy prices and rising energy prices, and a rising dollar and a falling dollar," he says. "And, we've had five consecutive record years in FICC."

FICC? That's Goldman-speak for the trading of fixed-income, commodities and currencies, and derivatives of same. Viniar notes that each business is larger today than the whole of FICC 10 years ago.

It is not the mere luck of Goldman to be in the right places at the right time. Its FICC business grew out of the firm's knack for discovering new opportunities ahead of the pack, and its discipline in sticking with them through tough times.

Says Glenn Schorr, who follows the brokerage industry for UBS: "Goldman is always early. Before anyone had heard of hedge funds [in the mid-1980s], they were inventing prime brokerage. Then there's energy trading, foreign exchange, commodities, electronic stock trading -- always early."

For example, Goldman acquired the J. Aron commodities business in 1981, not a great moment to dive into commodities trading. But the firm never wavered in its commitment to the business, from which it has reaped huge rewards in recent years. Merrill Lynch exited commodities near the bottom of the cycle, in 2001, and now is trying to rebuild its presence in the market.

Goldman made the sometimes ho-hum currency-trading business a priority, as well, even as others walked. Now it is the only non-bank among the top five foreign-exchange traders.

In fiscal 2005, trading and principal investments produced $16.3 billion of net revenue and $6.2 billion of the firm's $8.3 billion in pretax income. Asset-management and securities services, which includes prime brokerage for hedge-fund clients, kicked in $4.7 billion of revenue and $1.7 billion of operating profit, while investment banking contributed $3.7 billion of revenue and $413 million of profit.

Remarkably, where Goldman was not early, in the asset-management business, it methodically built Goldman Sachs Asset Management from scratch, beginning a decade ago. It now manages more than $500 billion across many asset classes, including private-equity and real-estate funds. GSAM produced an unexpectedly large $739 million in performance fees in the latest quarter.

GOLDMAN'S BANKING BUSINESS SEEMS SMALL by comparison with the rest of its operations, and has lower margins. But it is integral to the rest of the firm, Viniar insists. Advising on deals produces all sorts of related financing, hedging and co-investing opportunities.

Goldman's long-term perspective, perhaps rooted in its partnership heritage, also allows it to step aggressively into troubled markets and bid at advantageous prices. The firm took a preferred equity position in Sumitomo Matsui in 2003; it acquired power-generating assets in the aftermath of the Enron scandal and it became a large owner of golf courses in Japan -- all at times when those assets were in varying degrees of distress. (No risk taker gets them all right, of course. Goldman's $6 billion purchase of Spear Leeds & Kellogg, a stock and options market maker, occurred right at the top of the bubble, and the goodwill related to the hefty price still sits on the balance sheet.)

This steel-gut boldness has allowed Goldman to be the buyer of last resort at advantageous prices, leaving it to harvest gains at its discretion. The firm has taken some profits on the Sumitomo investment and has sold three of its 28 power-generating plants in recent months, including one this month to General Electric, at big prices.

"We have a culture of doing this for a long time," Viniar says, invoking legendary Goldman risk-takers such as the late Gus Levy, and his protege Robert Rubin.

"Culture" seems a squishy -- and self-serving -- explanation for an organization's strength. Yet, at Goldman, it's hard to escape. A securities firm is nothing more than a pile of money and a group of people, and by extension the reputation those people have built. Capital is neutral, every dollar or yen the same. But attracting, cultivating and retaining people is something all companies do differently.

Even seven years after it shed its status as a private partnership, Goldman seems to have an effective process for hiring and developing talent, and instilling the right combination of risk-taking discipline and bold opportunism.

The firm begins with a head start in recruiting, as a preferred employer of the brightest business-school, law-school and even engineering and mathematics graduates. Its evaluation and compensation systems are built to reward people for teamwork and effort, not the luck of having been in a particular division in a good year.

Goldman uses "360-degree" performance reviews, in which everyone, including Chairman and CEO Henry M. Paulson, is evaluated by peers, superiors and junior employees. The process can be entirely anonymous, if the evaluator chooses. There is an explicit social component in the reviews, meant to engender collegiality and weed out those who fail the teamwork test. Viniar personally reviews annual compensation for 10,000 employees.

EVERY SECURITIES FIRM TALKS ABOUT AVOIDING the star system and getting lots of ambitious, competitive achievers to work for the greater good. By most accounts and the preponderance of evidence, Goldman has succeeded better than most.

The firm boasts an unusual number of career employees, each with more than 20 years at Goldman, especially in senior management. This includes Paulson (32 years), President Lloyd Blankfein (23), who is likely to be the next CEO, and Viniar (25). Among the 24 members of the management committee, there is some 500 years of collective Goldman experience.

The focus on talent management and reputation is evident in the little things, as well as the big ones. Goldman barely was scathed, relative to competitors such as Merrill and Citigroup, by the post-bubble wave of Wall Street scandals, even though it caught flak more recently for operating on both sides of the New York Stock Exchange-Archipelago merger. The firm was an investor in and adviser to Arca and advised the stock exchange, which is headed by former Goldman President John Thain.

Yet Goldman's management pays more than lip service to ethical matters. When new managing directors gather for orientation-style meetings, they are told, among other things, that as Goldman MDs, they are not to pay their nannies off the books.

There is an alumni section on the firm's Website, further evidence of the pervasive nature of the Goldman culture. Sure, this is a networking measure, and many former employees do business with the firm. But in an industry in which departing workers often are escorted to the lobby by security guards, without so much as a detour to grab their coats, Goldman's familial ties stand out. There was some alarm last year when several highly regarded traders -- Eric Mindich, Dinakar Singh and William von Mueffling -- left to start multibillion-dollar hedge funds. But their funds became important new Goldman clients, and the firm's results suggest their labors as insiders weren't missed.

Goldman has tried to maintain something akin to the old partnership ranks, with about 300 of the firm's 1,300 managing directors sitting on a "partnership committee." In one key regard they're like the partners of old: They reportedly are compensated exceedingly well, even by Wall Street standards. Most managing directors receive a sizable portion of their annual compensation in stock, which helps bind their interests to those of the firm, and fosters more productive planning.

Nonexecutive employees, too, have shared in Goldman's good fortune. In the first quarter, the firm's compensation expense amounted to more than $800,000 for each of its 23,000 employees, every man and woman, banker and receptionist. Perhaps it is no surprise, then, that in a survey of financial employees in London by the industry trade publication www.hereisthecity.com, 89% of Goldman respondents said they were pleased with their 2005 bonus, the highest percentage of any firm.

Still, some former Goldman hands sense that parts of the old culture have eroded with the firm's huge increase in scale and its continued shift toward trading relative to banking. If Blankfein, 51, succeeds Paulson, 60, a former trader again will be at the helm. Paulson, a long-time banker, is rumored to be under consideration by the White House to replace Treasury Secretary John Snow.

WHILE GOLDMAN'S INTERNAL WORKINGS ARE a source of fascination -- and envy -- the length and breadth of the Street, what do things like culture and compensation mean for the shares at current levels?

There are several ways to view the stock. The view from 10,000 feet is that Goldman is a direct and leveraged play on increasingly global capital flows, rising asset values, the urgent search for returns and the markets' inexorable tendency toward greater complexity. The total value of global bond markets was $22.8 trillion at the end of 2005, up from $14.3 trillion four years earlier. Global equity markets were worth $24.2 trillion, up from $16.6 trillion. Then there's the notional value underlying all over-the-counter derivatives, which has more than tripled in the past four years, to a staggering $230 trillion.

There is more than $1 trillion of purchasing power each in hedge funds and private-equity funds -- active, highly motivated investors who need debt and trading counterparties, and advice. Mergers and acquisitions are in an uptrend, and commodities are regaining status as an institutional asset class. Goldman, along with a small handful of other institutions such as Citigroup and UBS, is at the center of it all.

To the extent that Goldman continues to skate to where the puck is going to be, as hockey great Wayne Gretzky once advised, the firm has a shot to outperform its peers. It did so in China last year; after decades of wooing the country's authorities, it became the first Western institution to gain a broker-dealer license to operate in China, via partly owned Gao Hua Securities.

For some investors, this is enough to know. Barring a major rupture in financial markets, Goldman over the long run will be able to capitalize on macro trends to boost its book value and share price. After all, the company has had only three annual earnings declines in the past 20 years (in '94, '01 and '02), notwithstanding a spike in interest rates, the Asian crisis and the stock market's meltdown after the dot-com bubble.

ON A NEAR-TERM BASIS, HOWEVER, GOLDMAN shares have come awfully far in a hurry. Although they sell for only 11 times this year's forecast earnings, a reflection of the relative opacity of the firm's trading business, they're richly priced at around 2.5 times book value, near the top of their historic range. A lot of hot money has climbed aboard the stock, which trades far more actively than its size would suggest.

Goldman's earnings momentum has continued into the current quarter, abetted by rising asset markets and a heavy merger backlog. In addition, the company should book a gain of 45-to-55 cents on the power-plant sale, and should have additional gains from its Archipelago investment.

The special items point up a crucial issue, however. How much should investors pay for an earnings stream that includes various gains from principal investments? "These are not one-off gains," UBS' Glenn Schorr says. "It happens all the time. These stocks trade off book value, and this builds book value."

TO BE SURE, THE BIGGEST RISK TO OWNING Goldman stock at current prices is an unforeseen financial calamity -- the "exogenous shock" that so many fear. Smaller disturbances -- from rising interest rates to the stock market's seasonal slow-down -- also could do damage, albeit to a lesser degree. Rare is the year, in fact, in which a fast-moving stock such as Goldman's fails to decline at least 10% from its high to its low, however. It has happened in five of the past six years.

If the shares hit a similar speed bump in coming months, and pull back to the 140s, investors will have an opportunity to own a world-class money mill at a considerably lower price. As any Goldman trader might tell you, that's a sweet deal.
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