Michael Santoli

As Profit Snapshot Nears, Goldman’s Edge Is Clear

Michael Santoli

When Goldman Sachs Group Inc. (GS) reports its fourth-quarter results early Wednesday, the press coverage and analyst reaction will focus on a handful of predictable elements.

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Goldman Sachs sign
Whether the quarterly profit exceeds the consensus forecast of $3.70 a share will be treated as an important sign of Goldman’s momentum and Wall Street’s strength -- even though Goldman typically exceeds estimates, and quarterly predictions are inherently imprecise for trading-and-brokerage firms.

Note will be taken, as it is every quarter, of how much Goldman pays its employees on an average, per-head basis, even though its compensation levels have settled into a steady range substantially below pre-crisis levels.

Commentators will muse whether Goldman’s muted return on equity -- the key measure of profitability, which has been running in the high-single-digit percentage range -- represents the “new normal” for Wall Street powers. Longtime CFO David Viniar will be bid a happy retirement and his successor Harvey Schwartz will (presumably) be welcomed onto the conference-call hot seat. Chatter will arise about the eventual successor to CEO Lloyd Blankfein.

Yet all this represents fleeting screen shots in a long-evolving story about how Goldman has widened its advantage over most of its banking peers, through both its own constructive actions over the past few years and its competitors’ fitful retreat. Here are a few bigger-picture factors that distinguish Goldman, and help explain why its shares have outpaced those of J.P. Morgan Chase & Co. (JPM) and Morgan Stanley Inc. (MS) with a 40% gain the past 12 months.

--Goldman has been hunkering down, husbanding capital and biding its time as it waits for the industry landscape to become clearer and for client investing and deal-making activity to pick up. The company is sitting on $170 billion in liquid funds in its “global core” reserve, up from less than $100 billion a few years ago, which along with $74 billion in shareholders’ equity support its vast client-trading activities and $950 billion balance sheet. With substantially lower leverage (borrowed funds versus equity capital), Goldman is intentionally “under-earning” today as capital rebuilds and opportunities in the markets re-emerge, while sharing cash in a measured way through buybacks and increased dividends.

One would not hope to see a global investment bank earn excellent returns -- closer to the 15% to 20% returns on equity they used to routinely produce -- in an environment such as the past quarter, with still-soft stock and bond trading volumes and macroeconomic concerns keeping corporate acquisition levels weak. It would mean that the company had cut costs too deeply or took too many one-off risks in search of short-term profit.

Perhaps trading volumes and corporate risk appetites will remain muted for some time to come, but there’s a better shot that, as the global economy revives and high-risk fiscal and monetary policy debates get settled, pent-up demand for financing and M&A will follow. Global M&A activity averaged 6.8% of total stock-market value over the past decade. The first 10 months of last year it was 28% below that trend, and should recover, to the benefit of top-ranked deal adviser Goldman.

--Goldman has pruned its cost base without hollowing out its leading franchise catering to institutional investors and big companies, and without compromising its status as first-choice employer of financial talent. Its headcount was down 8% as of October from five quarters earlier, and compensation expense was 39% below inflated 2007 levels. Yet most of the trimming is done, and much of it took the form of moving support employees to lower-cost locations such as Salt Lake City and Florida.

Most competitors have been shrinking in a more aggressive, more urgent manner. UBS AG (UBS), of course, late last year announced it was exiting fixed-income trading and sales. Credit Suisse Group (CS) last week was reported to have slashed its bonus pool by 20%. Citigroup Inc. (C) is shedding 11,000 employees, many in capital markets. And Morgan Stanley, which has elected to emphasize wealth management, is cutting 6% of its institutional-securities headcount, including a 15% reduction in Asian investment-banking staff. Goldman is getting ahead by retreating less.

--No doubt Goldman and all other banks will be more constrained under the Dodd-Frank rules still being formulated, as well as so-called Basel III capital regulations due to be enforced on large institutions in coming years. Lower leverage levels mean lower return potential, of course, which is largely already reflected in Goldman shares’ valuation near its tangible-book value.

Yet the ban on proprietary trading has mostly worked its way through, and was never destined to be a major hindrance on profits anyway. The key for Goldman is that it is on an even regulatory playing field in each of its businesses with every relevant competitor. The heftier capital requirements levied on huge banks don’t hinder Goldman in head-to-head competition where it plays (derivatives, bond trading, etc.) in the way that, say, J.P. Morgan or Citigroup might be disadvantaged in the credit-card or mortgage-banking game against less-constrained players.

--Finally, Goldman’s ethic of institutionalized paranoia, high insider ownership and residual partnership culture suggest it can navigate tricky markets better than most. Good risk managers rise faster at the firm, which managed to grow book value all through the crisis. Goldman traders are charged stringently for the firm’s capital they use and have incentives to off-load “stale” positions.

Most top managers date from before the firm’s 1999 IPO, a time when partner-owners were on the hook for trading losses and bad business decisions. More than 10% of the stock is owned by current and former Goldman insiders, a hefty stake that implies its “long-term greedy” mindset and prudent risk-taking will remain management priorities. Buying the stock near the current price means getting in at tangible book value, which is where Goldman partners used to have their ownership interests priced.

Goldman’s results certainly might not dazzle the way they used to in the heady credit-bubble days, given the tough environment and regulatory squeeze. But the outlook for Goldman is like the old joke about the bear chasing a group of campers: Goldman doesn’t need to run faster than the bear, it merely has to outrun the others. So far, that’s the way this race is shaping up.

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