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Goldman’s blues (and portfolio theory)

People think Goldman Sachs is down and out, mostly because of this chart:

Over the past decade, Goldman’s shares have returned less than half of what its rival Morgan Stanley’s have, and have underperformed the market in general. Goldman is supposed to be where all the smart money people are, so this is awkward. Here is the diagnosis from the Economist, a couple of weeks ago:

After the financial crisis of 2007-09 . . . Morgan Stanley built a thriving arm managing the assets of the wealthy, which mints reliable profits. Goldman, however, stuck to its game of trading, advising on deals and bespoke investing. Penal new capital rules made this less lucrative, but the firm staked a Darwinian bet that the resulting shakeout would kill off many competitors.

Goldman bet wrong. Post-crisis capital rules meant returns from capital markets activity declined. It tried, over the past few years, to get into retail banking, with a digital lending operation and a credit card business. This has not gone well, and now the company is pulling back. Efforts to expand the transaction banking and wealth management operations have met with only modest success. The result is that Goldman is still overwhelmingly dependent on trading and investment banking — capitally intensive, volatile businesses where most of the returns go to the employees. The bank’s reward is a low valuation. A chart of the price/tangible book value ratio shows that much of the divergence in stock performance with Morgan Stanley is down to a rapidly widening valuation gap:

It is interesting that the Morgan Stanley’s valuation edge blew open not when it diversified and Goldman didn’t — a process that started a decade ago — but in the throes of the pandemic. But timing aside, what is Goldman to do about it?

Here’s the Economist’s suggestion:

Mr Solomon is wisely laying off staff and shrinking the bank’s proprietary investments. Over time he may be vindicated by prosaic changes — running its asset-management arm better, say, or pioneering new tech to cut exorbitant labour costs — or even by orchestrating a merger.

Yet there is something uniquely hard about reforming elite firms whose unwritten code is that they are smarter than everyone else . . . [Goldman] now needs to be self-critical.

This weekend in the FT, William Cohan takes that bit about a merger and runs with it:

Goldman needs access to the cheap capital that banking deposits provide to keep its lending machine humming. In short, it needs to buy a big commercial bank . . . The perfect merger candidate for Goldman has long been Bank of New York Mellon, which operates in 35 countries around the world and has $1.8tn of assets under management and another whopping $44.3tn of assets under custody or administration.

It also owns Pershing, one of the leading clearing houses on Wall Street, and — perhaps best of all — the company is a complementary fit with Goldman. There is no overlap with Goldman’s world-class investment banking and principal investment businesses.

Cohan’s view acknowledges the simple problem. Goldman has a low valuation because its core franchises, trading and investment banking, are simply not very good businesses from the point of view of investors (they are great businesses from the point of view of traders and investment bankers; that’s part of the problem). Self-criticism isn’t going to help Goldman, but a merger might.

Cohan is right that a deal — if executed without too much bungling, a point never to be taken for granted — would likely boost Goldman’s valuation, just as it has boosted Morgan Stanley’s. Goldman probably knows this, given that it employs a lot of smart people who think about this sort of thing for a living. Why hasn’t it happened, then? Perhaps Goldman has concluded that regulators wouldn’t let such a deal happen; indeed, regulators might not. Alternatively, Goldman may have approached BNY or another bank with a large wealth management operation (like, say, First Republic) and been told to either pay way above the odds or buzz off. I prefer the second theory, but who knows.

One point that gets lost in this discussion, however, is that the diversification strategy does not make loads of sense. As an investor, if I want a diversified financial institution with cash flows that are sensitive to varying economic factors, I can build a synthetic one, at no cost, from the safety of my portfolio. I can own, for example, shares of Goldman (capital markets) US Bancorp (retail) and Charles Schwab (wealth management/retail brokerage) and get a diversified cash flow profile. Why would I prefer a real-world Goldman-BNY hybrid, with the attendant risk of a failed real-world integration?

One objection to this view is that it ignores synergies between the different parts of a “financial supermarket” (to use a term associated with Sandy Weill). It is often argued, for example, that retail deposits can be a cheap source of funding for investment banking activities. But this is true only in a limited sense. Under post-crisis banking rules, currency and rates trading can be done at the bank holding company level, and therefore take advantage of deposits. But most capital markets activities have to take place within a broker-dealer subsidiary, and rely on the broker-dealer’s repo, wholesale or equity capital.

Furthermore, the history of financial supermarkets includes plenty of failed ones, most prominently Weill’s own Frankenstein monster, Citigroup. Yes, both JPMorgan Chase and Bank of America are very well run and successful banks that incorporate both retail and capital markets operations. But that is not proof that deep synergies exist; just that both of those banks own various great assets under one roof (It has also helped those two banks, and Morgan Stanley, that they were able to buy up diversifying assets for cheap in the financial crisis fire sale. Goldman won’t be so lucky).

Can you cross-sell customers products from the different divisions of a diversified bank — convert retail customers to wealth management customers, for example? The problem with that approach is that in the digital world, it’s not clear what if anything customers get out of having their deposit and retirement accounts at the same institution. And you can ask Wells Fargo about how tricky cross-selling can be in practice.

Despite all this, investors are prepared to pay premiums for diversified financial institutions. For example, Morgan Stanley has not traded like a cross between Goldman Sachs and Charles Schwab in the past few years, which is what you might expect (Schwab is not a perfect compare for MS’s wealth management business, but it’s close enough for our purposes). Instead, it just trades more or less like Schwab, as if it was not dragging a volatile, capital-intensive capital markets operation behind it. Investors really like diversified banks!

Why, though? Morgan Stanley’s capital markets business is worth what it’s worth, whether it is bundled with a wealth manager or not. Similarly, Goldman’s core business will not magically become investor friendly after it buys a retail bank. It will just have a separate, more investor-friendly business in the same corporate roof.

One bank expert I spoke to argued it largely comes down to optics: diversification “provides the perception of a big stable funding base. After all a lot of this is a confidence game, and if debt holders don’t feel like they’re the only ones holding the bag then that provides a layer of stability.”

Certainly this is the general perception now. Whether it will always be is another question; sometimes rationality does break out in the stock market. But given the questionable real (as opposed to perceived) benefits of diversification, and the execution risk involved in a big deal, Goldman might want to stop trying to be something it is not.

Goldman’s competitive strengths are on Wall Street, and it should extend and deepen them. Will this earn them a premium multiple? No. Is it a strategy for increasing profits that is more likely to succeed than entering new areas of finance? Yes. As Ebrahim Poonawala of Bank of America put it to me, “they are as good as it gets in terms of the capital markets, and they need to remind investors of that”.

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