Gold Versus Goldman

From the depths of the credit crisis last November, the price of Goldman Sachs’ stock (NYSE: GS) has soared 178%. The price of gold, meanwhile, has advanced a mere 25%. Is Goldman, therefore, the new gold? An investment acolyte could easily draw that conclusion.

In fact, most experienced investors have reached a similar conclusion. These sophisticated investors know that Goldman is a far better investment than gold, not merely because CNBC worships the former and despises the latter, but also because Warren Buffett took a $5 billion position in Goldman Sachs, not in gold.

That said, a few of us experienced investors are slow learners. We do not comprehend as rapidly and facilely as most folks do that Goldman is better than gold. We are slow to understand that a highly leveraged trading operation – subsisting on short-term financing, friendly accounting conventions and intermittent governmental coddling – is a better vehicle for preserving wealth than a bar of gold.

Sure, we understand that speculations sometimes succeed, and that leveraged speculations sometimes succeed in spectacular fashion. But we have a hard time making the leap from “leveraged speculation” to “prudent long-term investment.” And, therefore, we have a hard time making the leap from “pinstriped crap shoot” to “better than gold.”

Admittedly, over the last eight months, Goldman has performed seven times better than the gold. But if we extend the time frame of our analysis, back to May 1999, when Goldman Sachs first became a public company, we discover that gold has produced twice the return of Goldman Sachs’ stock. Which prompts the question: Which of these pasts will be prologue? The last eight months? Or the last 10 years?

To answer this question, we must examine the relative virtues of each investment, as well as their relative deficiencies.

First, let’s consider a few of gold’s deficiencies:

Gold never installs an ally in the office of Treasury Secretary. Gold does not receive multi-billion-dollar bailouts from the US treasury. Gold has no CEO to dispatch to Washington D.C. to attend closed-door meetings with the Treasury Secretary. Gold has no “prop trading” desk that can sell short the very same toxic mortgage- backed securities that it just sold to its own clients. Gold has no access to credit, and therefore, has no mechanism for leveraging its balance sheet 40-to-1 in the pursuit of outsized investment returns.

Come to think of it, gold doesn’t have much going for it at all. Of course, that’s also gold’s principal virtue. It is what it is – simply a rare, naturally occurring element without a CEO or a standing army or even an official fan club. Instead, gold’s short list of virtues would include only its alluring gleam in the sunlight and its multi-millennial history of preserving wealth.

Goldman Sachs, for its part, has also withstood the test of time…sort of. Goldman has been an operating enterprise since 1869, when a German Jewish immigrant by the name of Marcus Goldman first hung out a shingle. Thirteen years later, his son-in-law, Samuel Sachs joined the firm. From this humble beginning a modern-day financial marvel has emerged.

But a closer look into the annals of Goldman Sachs’ history would reveal that this illustrious investment firm has flirted with corporate death on more than one occasion.

“I just recently finished perusing Charles Ellis’ new history The Partnership: The Making of Goldman Sachs,” Chris Mayer, editor of Capital & Crisis, observed a while back. “I was particularly interested in the early history of Goldman Sachs. I thought I would come away thinking how Goldman Sachs used to be a simpler business. I thought Goldman’s history would show how it took prudent risks with adequate equity backing those risks. My conclusion would then be that the current crop of leaders at Goldman were just reckless and had imperiled a franchise that had been around since the 1880s.

“In fact, that’s not what I learned at all,” Mayer continued. “From Goldman’s earliest days as a commercial paper specialist it operated with minimal capital. All through its history, it has been an enterprise that took big risks and often took huge losses. That Goldman even exists at all today is something of a financial miracle.

“In reading this history,” said Mayer, “I was struck by how the company found itself in the soup again and again and again. In the 1920s, one of the biggest speculative busts was in investment trusts in which a small amount of capital supported a spider’s web of investments in other companies. Guess who had the biggest blow-up of them all?

“Goldman was big in this through a subsidiary called Goldman Sachs Trading Corporation, which basically lost everything for its investors. Ellis writes: ‘While all the investment trusts suffered, Goldman Sachs Trading Corporation – because it was so large and so highly leveraged…became one of the largest, swiftest, and most complete investment disasters of the twentieth century.’

“The loss to Goldman Sachs itself was enormous,” Mayer explained. “It basically wiped out thirty years of profits and eliminated the ‘fruits of all the labors of a generation.’ Fast forward to 1970 and the biggest bankruptcy in the country at that time. You find Goldman was waist-deep in it. Penn Central at the time of its bankruptcy in 1970 was the eighth largest corporation in the country. Again, Ellis writes: ‘The loss it [Penn Central] threatened to impose on Goldman Sachs was not only larger than any prior loss, it was larger than Goldman Sachs.’

“And so it is again today that the company finds itself in the middle of another big crisis,” Mayer concluded. “All of these anecdotes scream at me to avoid complex and leveraged companies, where the potential for large, potentially catastrophic, losses is never far away.

But who says history has to repeat itself? According to Goldman’s top brass, the successful investment firm has emerged from the credit crisis (it’s over, isn’t it?) in tip-top shape, and certainly does not need any of that nasty, compensation-crimping TARP money.

Hopefully, things are just as good as Goldman proclaims. But that doesn’t mean its stock is anything more than a call option on leveraged speculation. In other words, the worst might be over…or it might not be. Not even Warren Buffett knows for sure.

The nearby chart suggests that the worst is NOT over.

The estimates of total losses in the banking industry continue to climb. One year ago, $1 trillion of total losses seemed like an outlandish number. Today, most estimates range from $2 trillion to $4 trillion (of which only $1 trillion has been recognized to date). In other words, the banking industry is still in deep doo-doo. The industry’s ENTIRE tangible common equity is only $1 trillion, which means the banking industry does not have the balance sheet to absorb losses of this magnitude.

Presumably, finance companies like Citigroup, Bank of America and Wells Fargo are holding most of the industry’s toxic assets, but Goldman Sachs certainly owns SOME of them. Goldmans’ “Level 3” assets, for example, total nearly $100 billion (“Level 3” is an accounting term for the kind of assets that are hard to value. In the real world, Level 3 assets are the kind of assets that hardly ever hold their value. This is the toxic stuff.)

$100 billion is a dangerously large quantity of illiquid, partially impaired, assets – equal to 150% of the company’s total shareholder equity. And remember, Level 3 assets are only one part of Goldman’s toxic-asset pie. The investment firm also holds billions of dollars of other toxic assets that are EASY to value. So it’s not hard to imagine that one little, unanticipated wiggle here, or one unexpected wiggle there could cause a big part of the Goldman balance sheet to go “Poof!”

Goldman’s situation is not unique. In fact, Goldman probably remains one of the best investment banks still standing. But that’s exactly the reason for raising a few questions about the company’s bullet- proof public image. The company’s share price seems to assume business-as-normal.

But forward-looking investors would probably do well to assume that business-as-abnormal will resume sometime soon.

Gold or Goldman? Your call.