Is the Goldman Sachs Pedestal Real?

One thing I've noticed among college students, academics and business professionals alike is that the name Goldman Sachs (GS) turns heads. People react with a sense of awe toward Goldman and most of these people probably could not even explain the first thing about Goldman outside of the fact that they are an investment bank. (Score one for Goldman's marketing and branding efforts) It had me thinking that if everyone reacted this way to Goldman, are there perhaps boatloads of people that put money into Goldman's stock not based upon a fundamental understanding of Goldman's business but based upon their name.

If you need proof of the blind investments that people often make then look no further than to any episode of Jim Cramer's Mad Money. All you need to do is watch one segment of Cramer's show and watch the live ticker at the bottom of the screen immediately run rampant with trades of whatever stock Cramer has just recommended. If this blind rationale occurs in the after-hours market based upon Cramer's name isn't it just as possible that this type of blind rationale occurs at an even greater pace based upon Goldman Sachs's name?

I don't want to doubt Goldman's ability to make money nor do I want to refute the claim that they are probably the strongest of the investment banks. What I do see though is that investors place Goldman on a pedestal and this pedestal perhaps doesn't allow Goldman's stock to trade at the level that it would be valued at without the pedestal in place.

Let's take a quick look at the numbers. Goldman Sachs has shown phenomenal earnings in some of the toughest market conditions. Their recent second quarter numbers were still down 11% despite their proven risk management abilities which have been heralded as some of the best in the business. The drop in their numbers still shows that they are susceptible to unseen market swings and that it is virtually impossible for them to make every single correct decision. That being said, their numbers are still far superior to anything that their peers are posting. The only number that Goldman posts which may be a turn-off for the more finicky investor is a negative enterprise value 463 billion.

If the Goldman Sachs pedestal is real then how could it come crumbling down and bring Goldman's share price with it? Well, the first thing that would bring them down would be weaker earnings and though it's certainly possible that the market could turn unfavorably, I don't think that would effect Goldman's earnings more than by 10% or so because they operate such a diversified business. Below is a graph provided by Goldman Sachs of their revenue sources by percentage.

Source: Goldman Sachs

The one issue that could hurt Goldman and its pedestal the most would be if somehow the high public opinion of Goldman which props up the pedestal were changed into public disfavor. If this were to happen then it would most likely arise out of the business model which has been Goldman's key to success. By this I mean that this business model, which may be perfect for Goldman to maximize earnings and decrease losses, can lead to a multitude of conflicts of interest many of which Goldman simply brushes aside.

Look to last May for an example of this when Goldman gave a "sell short" recommendation on Washington Mutual's stock (WM). Though a "sell short" recommendation is a fairly rare occurrence on Wall Street, what made this particular one even more rare is that Washington Mutual is a client of Goldman Sachs. It was not long after Goldman had underwritten Washington Mutual's 7 billion dollar recapitalization and earned millions in fees from WaMu on this deal that Goldman was now telling their clients to sell WaMu's stock short.

Goldman Sachs also was dismissed from contention by the government of the city of Chicago for an advisory role on the possible sale of Midway Airport after Chicago's government had learned that Goldman was actively pursuing ownership into UK based airport operating group BAA, which was viewed as one of the potential bidders for Midway. Many might argue Goldman had an ethical responsibility to inform the city of Chicago of this potential conflict rather then letting them find out about if for themselves. Instead Goldman of doing so, Goldman pursued the advising deal without informing the city of this possible conflict of interest.

Goldman's conflicts of interest with their attempted BAA deal goes deeper than their Midway advisory bid. Just after the Spanish group Ferrovial launched a hostile bid for BAA, management at BAA invited Goldman Sachs to do a pitch for an advising role that would advise them about how to fend of Ferrovial's bid. Instead of doing a pitch for the advising role, though, Goldman banker Bill Young recommended to BAA's management that they sell themselves to a special investment vehicle spearheaded by Goldman Sachs. Needless to say, Goldman did not get the advising job and launched their own bid for BAA.

In all of the above cases Goldman Sach's will defend itself by claiming that they are protected by the firm's "Chinese Wall". For those of you not familiar with the Street lingo of the "Chinese Wall", it is the ethical responsibility of members within the various divisions of financial institutions to remain separate from the other divisions of the institution to prevent leaks of information that may lead to conflicts of interest. In the case of Goldman Sachs, a Chinese Wall is said to exist between the corporate advisory business and the mergers & acquisitions business.

The problem with the Chinese Wall in firms as large as Goldman Sachs is that they are never really airtight. The conflicts of interest problem is not solved by the Chinese Wall which leads to the greater question "can a financial institution combine M&A activities and advising/underwriting businesses and truly avoid conflict of interest?"

With the government beginning to play a greater role in oversight of the investment banks, it seems as though it is only a matter of time until the multitude of the conflicts of interest at the investment banks is brought to light and brought under public scrutiny. If this happens then I see the Goldman pedestal crumbling and their share price crumbling with it.

As mentioned earlier in this article part of the reason that Goldman has been so effective at risk management is that they are extremely diversified in their various businesses. The problem with this is that many of the various businesses fall on opposite sides of the Chinese wall. If government oversight increases drastically (and it is already beginning to) it is not outside the realm of possibility that new, radical laws could be enacted along the lines of Glass-Steagall, which in this case would separate M&A from advising. If this were to happen then the diversified business model which has led to superior risk management for Goldman would be in serious jeopardy.

Government scrutiny over the manipulation of short sellers could also be a thorn in the side for Goldman and a potential threat to their pedestal. Though it was Goldman complaining recently that their own shares were being manipulated by short-sellers, they have found themselves on the other side of this table as well. Goldman's executives were confronted by executives from Lehman Brothers (LEH) and Bear Stearns, which is now part of JP Morgan Chase, regarding Goldman's manipulation of their respective stocks. Bear Stearns CEO Alan Schwartz confronted Goldman CEO Lloyd Blankfein to ask if Blankfein had any knowledge as to the rumors that Goldman's London office engaged in manipulation (false rumor spreading) of Bear Stearns's stock just prior to its collapse. Lehman's Richard Fuld contacted Blankfein just recently and told him he was "hearing a lot of noise" that false rumors about Lehman, which was experiencing all time lows in its share price, were coming from the Goldman traders. If these issues are made even more public and the government launches a full scale investigation into them then I would certainly look for investor confidence to put downward pressure on Goldman's share price and deteriorate their pedestal.

A quick look at the price to book value of the company based upon the book value for the most
recent quarter and the price as of July 18, 2008 shows a value of 1.71. If that is compared to the industry peers of Citigroup (C), Lehman Brothers (LEH), Merrill Lynch (MER), Morgan Stanley (MS) and JP Morgan Chase (JPM) the Goldman Sachs value is much higher than any with the above companies reporting .87, .54, 1.18, 1.27 and 1.10 respectively.
With a price to book value that much higher than that of its peers, I am left to wonder just how much of that, if any can be attributed to the Goldman Sachs pedestal. Perhaps part of it is attributable to the Goldman Sachs pedestal, but it is also very possible that part of it is due to investors pulling money out of the stock of Goldman's competitors and putting their money into Goldman, which is viewed as far more stable.

If anything were to happen to the Goldman pedestal I think they would still trade at a price to book value of at least 1.4, which would still be better than all of their peers. At a price to book of 1.4, the stock price would be at $150. This price certainly wouldn't signal an end of the world to Goldman or to Wall Street and would still reflect Goldman's superior capabilities it just wouldn't reflect the pedestal any longer.

When all is said and done I cannot deny that Goldman Sachs is indeed a profitable and well managed company. I do believe that they trade on a pedestal in the minds of investors and that pedestal is working to inflate the stock price somewhat. If it this pedestal were to crumble either from government action or negative public opinion then the stock probably would fall and be a good opportunity for a put option investor to pick up a quick chunk of cash. That trade would certainly carry some risk, but if you're not willing to take any risk then the options market certainly is not where you belong anyway.

Happy Trading

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