Lloyd Blankfein is careful about mentioning the word “cyclical” these days.
“Some people think it makes me sound daft,” the chief executive of Goldman Sachs Group (ticker: GS) told Barron’s in his Manhattan office, which offers a sweeping view of New York Harbor and the Statue of Liberty.
Interest rates and volatility have been so low for so long that what was once abnormal is starting to look normal. How much of this is a cycle and how much is a lasting change?
This is no mere academic matter to Goldman. Its overall financial results have been strong, and three out of four of its main business units are thriving. But the fourth, trading—which lives or dies on volatility and which sealed Goldman’s reputation as the elite firm on Wall Street—has been reduced to crumbs.
The most important part of trading for Goldman is fixed income, currency, and commodities, known as FICC, a unit that Blankfein once ran. Last quarter, it produced just $1 billion in revenue, down 50% from a year ago. During past peaks, it sometimes made four to five times as much.
“I hear, ‘Don’t you know the world is different?’ ” Blankfein, 63, says. “It is, but it’s not as different as they say.”
For now, the trade is not going Goldman’s way. Although its stock price hit a new high this past week, other banks have shot ahead during a recent reflation rally. Morgan Stanley recently eclipsed Goldman’s market value for the first time in more than a decade.
Yet that actually makes today an opportune time to buy Goldman shares. With trading humbled, the firm is more diversified than it was before the financial crisis. And it is becoming more prosperous, as it expands in mergers, lending, and money management; buys back stock; and invests in technology. Return on equity climbed to 10.8% last year from 9.4% in 2016.
“If they can do almost an 11% return on equity in a bad year, I’ll take that,” says Michael Mattioli, who helps manage the John Hancock Fundamental Large Cap Core fund (TAGRX), which counts Goldman as a top 10 holding.
Shifting Goldman’s performance up a gear would enhance Blankfein’s legacy as CEO. After 12 years at the top, speculation about succession persists, with one or both of the firm’s two chief operating officers, Harvey Schwartz and David Solomon, seen as likely candidates.
As with other big corporations, Goldman could benefit from the Trump administration’s lighter regulatory touch. It will definitely gain from a deep cut to corporate taxes and full access to overseas cash, even if the firm must mark down some tax assets and pay a one-time repatriation tax. More significantly, when trading conditions improve, FICC could bounce back quickly. No one else is as poised as Goldman to profit.
“Goldman’s greatest asset isn’t on its balance sheet,” says Michael Mayo, an analyst with Wells Fargo. “It’s intellectual capital, and it will become more valuable as markets return.” Mayo predicts a return on equity of 12% by 2019.
There are early signs that trading is picking up. “It is most definitely very early,” said Goldman’s chief financial officer, R. Martin Chavez, on the Jan. 17 earnings call. “But I would say market conditions can change and turn rapidly, and they have.”
Oil has recently spiked. The dollar has tumbled. Rising interest rates appear more likely. All of which amounts to volatility, which gets investors thinking about risks—taking them, or protecting against them. And it gets them trading with Goldman.
The firm could also gain without a change in conditions. In September, Goldman outlined a plan to go after $5 billion in fresh revenue, including $1 billion in FICC, from filling in gaps in its mix of services and customers. For example, Goldman excels at trading derivatives with hedge funds, but it could stand to do more workaday hedging for corporations, even if that business had been less alluring in the past.
Barron’s recommended Goldman shares the summer before Donald Trump’s surprise move to Washington (“Battered Goldman Sachs Poised for Rebound,” June 25, 2016). They have performed well enough, returning 91%, or twice as much as the Standard & Poor’s 500 index.
Goldman stock could rise another 20% over the next year if the bank continues with improvements it’s making and gets only a modest lift from trading conditions, as the stock’s discount to peers narrows.
“In the old days, investors said we were too reliant on FICC,” Blankfein says, “Now, all investors focus on is the decline.”
To Blankfein’s point, Goldman’s overall revenues rose 5% last year, the fastest in five years, to $32.1 billion. Excluding a large, one-time charge related to the corporate tax overhaul, earnings rose 14%, to $8.1 billion, and earnings per share climbed 21%, to $19.76.
THE FIRM’S GLASS-AND-STEEL headquarters in lower Manhattan, finished in 2009, has no name on the outside, so it attracts little attention despite taking up two city blocks. But Goldman wouldn’t mind getting more recognition now for its success outside of trading.
Goldman breaks results down into four operating divisions that, despite how their names sound, are different things: investment banking, investing and lending, investment management, and institutional client services.
Investment banking refers to advising companies on deals, and assisting them with raising money through stock and bond offerings. Revenue in investment banking grew 18%, to $7.4 billion, as debt underwriting, a growth focus for Goldman in recent years, brought in more than twice as much as stock underwriting.
Investing and lending is where Goldman books proceeds from its equity stakes, both private and public, and its loans. Revenue jumped 61% last year, to $6.6 billion, mostly on equity winnings. There was also an excellent ramp-up for a distinctly non-Goldman-like business called Marcus.
To average savers, Goldman’s offerings, which are largely aimed at wealthy individuals and professionals, can seem about as relevant as Gulfstream jet pricing.
Marcus, on the other hand, is an online platform where any Tom, Dick, or Sally with, say, a 700-plus credit rating and a nagging credit-card balance can borrow up to $40,000 at rates that are lucrative for Goldman, but safely below what card issuers charge, or deposit their savings at a recent rate of 1.5%. Why the down-market move? Competitive advantage.
“Some of the card companies offer personal loans, but they can’t push them too hard or they’ll cannibalize their card balances,” Blankfein says. “The fintech companies don’t have balance sheets, so they’re limited to a narrow set of loans they can package and resell. We can use our data expertise to grow this business profitably, with little incremental cost.”
Launched in 2016, Marcus—named for Marcus Goldman, who founded the firm 149 years ago—has so far made $2.3 billion in loans and last year brought in over $5 billion in deposits. It accounts for $1 billion of the $5 billion in new revenue Goldman seeks.
The investment management division is where Goldman takes a cut for putting other people’s money to work, including in its family of mutual funds. Revenue rose 7% last year, to $6.2 billion. Assets under supervision reached $1.5 trillion, up $115 billion from a year earlier, including a net $42 billion from clients adding new funds—not bad when the industry’s index funds have been outshining its stockpickers.
THAT LEAVES INSTITUTIONAL CLIENT SERVICES, a catchall trading business that includes Goldman’s problem child, FICC. The entire division reported $11.9 billion in revenue last year, down 18%. FICC led the wrong-way parade, falling 30%, to $5.3 billion. Equities trading slipped 7%, to $2 billion. Add commissions and securities services, and the stock side declined 4%, to $6.6 billion.
The best year for Goldman overall was 2007, when stocks peaked ahead of the housing bust and earnings per share reached $24.73. But the best year for FICC was 2009, the bottom for stocks, because trading was chaotic, and major Goldman competitors had been run out of the business. Revenue for the unit that year topped $23 billion. That figure has given rise to dire comparisons; technically, Goldman’s FICC revenue is down 76% from the top. But no act of God, Trump, or even Oprah will bring the business back anywhere near its 2009 peak in the years ahead.
Peer comparisons are further complicated by two things. In 2011, Goldman changed the list of items it includes in FICC. And some of its peers include services in FICC that Goldman counts as lending. In September, Goldman offered its own comparison using 2005 as a benchmark. That year, it reckons, it had a 7% share of industry FICC activity of $77 billion. In the 12 months through June, it had a 10% share of $66 billion.
Last year’s FICC results were also depressed by poorly placed bets. Banks are not supposed to bet with their own capital anymore, thanks to the Volcker rule that came with the Dodd-Frank overhaul, but practically, any business with inventory does bet. Walmart speculates on $5 gym shorts, and McDonald’s, sometimes, on Shamrock Shakes.
“We expected reflation and a pickup in rates, and we were poorly inventoried for what we got instead,” Blankfein says. Details are few, but what is clear is that Goldman did particularly poorly in commodities last year, which it says accounted for a third of its decline in FICC. In November, the firm named new co-managers to run FICC: Jim Esposito and Justin Gmelich.
Mayo of Wells Fargo, who could be described as bullish but antsy on Goldman, wishes the firm had adjusted its mix of trading customers sooner. “It’s Goldman’s job to be in the right place at the right time by being in a lot of places a lot of the time,” he says.
Mayo says he prefers Goldman to peers because it has preserved more infrastructure while reducing expenses, in compensation and beyond. He predicts that next year the firm’s pretax profit margin will reach its highest level this decade, and earnings per share will rise to $25.70, a new record.
JPMorgan analyst Kian Abouhossein estimates that Goldman’s FICC revenue will reach $6.9 billion by next year. That compares favorably with last year’s $5.6 billion, but is still low by historical standards, and less than half of the improvement is tied to better conditions. Abouhossein calls Goldman his top pick among global investment banks for 2018.
When yields are low, trading spreads get squashed. Worse for traders, low volatility in a rising market can lull investors into a false sense that money spent on hedges is wasted, much the way property owners can get lax about flood insurance until a hurricane hits.
THIS TOPIC—HOW TO TELL when the world is making mistakes on measuring and pricing risk—is a favorite of Blankfein’s. He drew praise for navigating Goldman safely through a financial crisis that sank others. His experience in FICC would seem valuable now. And he is no mere figurehead: Boys who grow up in Brooklyn housing projects do not rise to the top of American finance by accident.
But Goldman is not a place that tolerates underperformance for long, even at the top and even among its stars. It has plenty of talented leaders in reserve. That may help explain why Blankfein took the step, unusual for Goldman, of making public the details of its growth plan and goals.
“We’re not sitting here singing ‘Kumbaya’ waiting for FICC to turn around,” Blankfein says. “We can grow other things so fast that we make the whole company grow.”
That is clear, but after last quarter’s results, Blankfein will face intense pressure to show that his bet on the future of trading, too, can pay off. We like his chances.