The summer passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act will result in the rewriting of many rules governing Wall Street and the financial services industry, among other areas. Although many of the specifics remain to be worked out, the outlines of several key changes seem clear by now. Perhaps most importantly, the act includes a version of the so-called “Volcker Rule,” which bans banks (or corporate owners of banks) from proprietary trading (trading for its own account and not to facilitate its clients’ trades) and ownership of, or investment in, hedge funds and private equity funds.
There can be little doubt that the ban on proprietary trading will hurt the profits of large, diversified financial services companies, such as Goldman Sachs (GS), JPMorgan Chase (JPM - Free Analyst Report), Bank of America (BAC - Free Analyst Report), and Citigroup (C). These four banks made news in connection with their trading operations in the first quarter of 2010, when all four turned a trading profit every day of the period, an achievement dubbed a “perfect quarter.” Although it is unclear the extent to which proprietary trading fueled their spectacular performance, the companies came under some uncomfortable scrutiny as a result of the coincidence of all four recording perfect trading quarters.
Perhaps no company has come under closer scrutiny in the last few years, however, than Goldman Sachs. The company, a stock market darling through the middle years of the last decade and often regarded as the most innovative and daring Wall Street investment bank, was charged by the SEC in April with fraud (since settled) and has been the subject of unflattering reports from former customers, who claim that the company routinely trades against the interests of its clients. Goldman’s management, while fighting the SEC charges and denying any wrongdoing vis-à-vis its clients, seems to have acknowledged that the company has a P.R. problem. It created a Business Standards Committee in May, which was given the task of “reinforce[ing] the firm’s client focus and improve upon the transparency of [its] activities.”
The problem for investors in Goldman Sachs stock is that, due to Dodd-Frank’s ban on proprietary trading, the company may have to rely on its client-service-oriented businesses at just the moment that its client brand has taken its most serious hit. What’s more, Goldman’s commitment to restructure its business away from proprietary trading is uncertain. The current CEO, Lloyd Blankfein, was originally a commodities trader at the company and has almost certainly promoted the trading operation since taking over the captain’s chair. Also, there have been reports that Goldman has sought to circumvent the “Volcker Rule” by moving proprietary traders into the Asset Management division and labeling the trades they make “customer related.” This is in marked contrast to Goldman’s competitor Morgan Stanley (MS), which abandoned the proprietary trading business in the wake of the financial crisis in 2008.
Indeed, Goldman Sachs’ history has been marked by a long standing tension between its investment banking division and its trading unit. When the company went public in 1999, management predicted that the trading unit would account for a decreasing share of Goldman’s revenues going forward. This prediction turned out to be wrong. Principal Transactions grew from an average of 21.3% of revenues in 1999-2000 to an average of 35.8% in 2008-2009 (15.1% in 2008 and 55.8% in 2009; the 2008-2009 average is more consistent with the average of 36% from 2003-2007).
A closer look at Goldman’s balance sheet confirms the suspicion that the company came to rely on trading to generate its outsized profit growth in the 2000s. Goldman’s financial assets (government and corporate debt, mortgage-backed loans, derivative contracts etc.) as a percentage of total assets grew from a low of 31.9% in the second quarter of 2001 to 42% in the first quarter of 2008; the ratio of financial assets to shareholder’s equity grew from 5.26 in June of 2001 to 11.7 in March of 2008, a 122% increase that far outstripped the 69% increase in the ratio of total assets to shareholders’ equity in the same period. The overall impression is of a company where trading leverage was growing even faster than its overall leverage was growing.
This growth in trading leverage was not a problem for Goldman in the 2000s, not even during the financial crisis, as the company did far better than its peers in its trades. Rather, the growth in trading leverage and the reliance on trading that it implies should matter to investors because it raises the following questions for investors trying to predict GS’ future performance: has Goldman become so reliant on its rightly vaunted proprietary trading operation that it needs to circumvent the Volcker Rule in order for profits to grow? Has the company really become, as the New York Times (NYT) reported, “more like a hedge fund than an investment bank”? Have Goldman’s client-facing businesses been damaged enough to impair earnings going forward? Discovering the answer to these questions will likely take a few quarters at least.
In the meantime, should investors stick with Goldman stock? Perhaps not. There is a group of middle market financial firms that may be more attractive due to their having some or all of the following characteristics: they do not have proprietary trading desks, are moving aggressively into international growth markets, and are not freighted with the baggage that is attached to Goldman and its peers. Take Stifel Financial (SF) as an example. The company dealt with some difficulties in the mid-2000s and as a result passed through the financial crisis and recession with growing profits and a comparatively stable share price. What’s more, it is expanding rapidly, buying branches from UBS AG (UBS), and acquiring Thomas Weisel Partners (TWPG) to bolster its investment banking operations.
Another example is Jefferies Group (JEF). Jefferies suffered far more than Stifel did during the financial crisis and recession, but it has bounced back strongly, earning an overall record $280 million in 2009. Share net was $1.38, only three cents short of its previous record of $1.41 in 2006. Jefferies has made an aggressive move to capture investment banking market share from bigger competitors, by hiring through the downturn. The company’s strategy seemed to pay off in late 2009, when it landed its largest mergers and acquisition transaction in company history, Exxon Mobil’s (XOM - Free Analyst Report) $41 billion takeover of XTO Energy.
All told, investors in Goldman Sachs may want to consider moving some funds into competitors as a hedge against the possibility that the former Wall Street darling will struggle to adapt in a post Dodd-Frank Act industry environment. Goldman remains a very financially strong company and management there has a long track record of beating expectations and profiting in even very turbulent markets. But investors worried about a few quarters or years of stagnation in GS’ share price may want to consider Stifel’s or Jefferies’ stock as an alternative.
At the time of this article’s writing, the author had a position in Citigroup.