Turkey of the week: take profits on this banking giant
By
Paul Hill Jul 24, 2009
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Although the bulge bracket banks are making big money again, my advice is to steer clear of these 'black box' stocks. The likes of JP Morgan, Bank of America and Citigroup all posted impressive numbers last week, yet I suspect this uptick is only temporary. Just look at Goldman Sachs, which has seen its stock leap by 200% since November.
It's one of the world's top investment banks, providing a wide range of advisory, underwriting and asset management services to corporations, governments and wealthy individuals. Like its peers, it also released blockbuster figures.
But what is less well known is that more than half of its revenues come from volatile market-making and proprietary trading activities – for instance in credit default swaps (CDS), commodities and currencies. And because of the demise of Lehman Brothers, and the troubles that engulfed its rivals last year, competition has significantly reduced, allowing Goldman almost free rein to widen spreads and make easy money, particularly in pricing illiquid over-the-counter (OTC) securities.
Goldman Sachs (NYSE: GS), upgraded to OUTPERFORM by Keefe Bruyette
But this is a classic 'feast or famine' sector. My guess is that these 'super profits' will be eroded as rivals creep back into the market and Libor interest rates fall to more normal levels. And there is a much darker cloud on the horizon too.
One consequence of the credit crisis has been that law-makers around the world are planning to regulate many OTC operations to improve transparency. One recent temporary measure was to ban speculators from short-selling, for example. But it could mean driving some or all of the Goldman's bread-and-butter activities on to regulated exchanges, wiping out a big chunk of its profits. And if approved by the Senate, President Barack Obama's proposals could also impose much stricter capital, liquidity, leverage and risk-management standards.
So what about the rest of the group? Well, irrespective of the welcome boost from a recent wave of rights issues, Goldman's core merger and acquisitions division will stay soft for the time being, while its asset management services are suffering as clients withdraw funds.
Don't get me wrong. The company deserves credit for avoiding the worst of the sub-prime fiasco, and has achieved an average 12% a year increase in net tangible assets over the past decade to $97 a share at the end of June.
No, the main issue I have with Goldman is not its ability to generate returns, but its lofty valuation. At over $150, the stock is rated at over 1.5 times book, which looks vulnerable. I would place the stock on a 1.2 multiple, equating to a fair value of around $116 a share, or 25% lower than today.
And as an example of the substantial risks still at hand, let's not forget that if AIG hadn't been bailed out by the US government, then Goldman would have lost over $13bn – in one fell swoop destroying a quarter of its capital base. Even its chief financial officer David Viniar says "the world is still not a great place", indicating there are a few more skeletons in the cupboard, perhaps hidden in its own $54bn chest of illiquid assets.
Recommendation: TAKE PROFITS at $156
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments
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