Why is silver now a value magnet
Adecade ago, the Wall Street grapevine contended that Goldman Sachs is “the world’s largest hedge fund that just happens to be listed on the New York Stock Exchange”. This cliché was not without merit; Goldman had created the biggest, most profitable trading franchise in the history of world finance, whose revenues dwarfed its corporate finance/mergers advisory business and enabled Wall Street’s preeminent investment bank to post stellar 25 per cent returns on equity. Then came the Sophoclean tragedy for Wall Street’s quintessential Masters of Universe: the 2007 subprime crisis, the global capital markets meltdown, the squalid Abacus trading scandal, draconian regulations like the Volcker Rule and Dodd Frank, the Greek sovereign debt crisis, Brexit and the oil price crash. The scale and profitability of Goldman Sachs’ trading franchise plummeted. The bank only managed a quarterly return on equity above 10 per cent last week.
The first half of 2017 generated a dismal performance from the once fabled trading franchise — the de facto listed hedge fund that was once Goldman’s profit and growth engine. Fixed income, currencies and commodity (FICC) revenues fell by 26 per cent from a year earlier. True, this was not a Goldman problem but an industry problem as all its global money center bank rivals also delivered dismal fixed-income trading revenues. Yet Goldman’s trading book exposure was far higher than its archrival Morgan Stanley, whose CEO Jamie Gorman made a strategic decision to slash risk limits and market making in global debt and derivatives markets. Moreover, while Goldman’s trading revenues fell, its corporate finance dealmakers and mergers/acquisition bankers increased revenues by 38 per cent despite a shrinkage in the global investment banking fee pool.
Goldman Sachs delivered respectable, if not fabulous, thirdquarter results last week — $2 billion in earnings and an annualised return on equity of 10.9 per cent. Unfortunately, trading was not Goldman’s profit engine in the third quarter of 2017, but a $1.4 billion windfall in its private equity investing book. Without this non-recurrent windfall, Goldman’s return on equity would be a mediocre 8.6 per cent. Lloyd Blankfein made a strategic mistake not scaling up revenues in wealth and asset management. This business, targeted by Morgan Stanley with its seminal joint venture with Citigroup’s Smith Barney as far back as 2009, now contributes 50 per cent of its earnings while using only 25 per cent of its capital and generating a 26 per cent pretax profit margin. Morgan Stanley’s recurrent fee business is both highly profitable and “capital light”, making its parent far more resilient than Goldman. It is no coincidence that Goldman Sachs shares lost 10 points after its thirdquarter earnings to 235 as I write.
I will only buy Goldman Sachs in the 210-215 range, which is possible if the US stock market declines three to five per cent before Christmas. Goldman has identified $5 billion in revenue opportunities, expects to reduce its share count by six per cent via buybacks and increase its tangible book value by five per cent in 2018. Goldman Sachs trading revenues are correlated to a rise in volatility, which is inevitable once the Federal Reserve balance sheet unwinding accelerates. Goldman Sachs also benefits from the rise in crude oil and industrial metal, given its venerable J. Aron commodities division. Commodities is a potential $1.2$1.5 billion business for Goldman Sachs in 2018. Goldman is also restructuring its cost base and ruthlessly culling even managing directors who fail to meet profit targets. These are all bullish catalysts for Goldman Sachs shares in 2018.
The valuation metrics on Goldman Sachs are modest. The bank trades at 11.5 times earnings and 1.2 times tangible book value. If Goldman Sachs maintains its global preeminence in equities underwriting/mergers advisory and moves up the league table in its FICC trading franchise (now a mere sixth), while cutting compensation, Goldman can well achieve the operating leverage and increase tangible book value by seven per cent in 2018. This will mean Goldman shares can trade upto $280.
Morgan Stanley has earned $5.5 billion in net income in the first three quarters of 2017, its most profitable year since the credit bubble peak of 2006. This milestone was achieved despite dramatically reducing the bank’s dependence on leveraged high risk debt and derivatives trading. The institutional asset management division has achieved scale at $1 trillion in AUM. The retail banking balance sheet benefits from steeper yield curve and accelerating loan growth. Morgan Stanley now trades at 12 times forward earnings, a justified valuation premium to Goldman Sachs.