Goldman Sachs is a "Sell"

For once, we agree with the insiders at Goldman Sachs. The company’s stock is a “Sell.”

Okay, so the insiders didn’t exactly say their stock is a “sell,” but they didn’t need to. Their feet did all the talking. Last week, nine Goldman insiders scurried away from their stock as fast as the law would let them.

They cashed out $20 million worth of stock at an average price of $107.44. This is the very same stock (NYSE:GS) that Goldman — on behalf of its shareholders — spent $21 billion buying over the last five years. The average price of those purchases was about $171 per share.

Here’s our question: Why is Goldman’s stock a “Buy” for shareholders at $171 a share, but a “Sell” for insiders at $107 per share?

Something’s wrong with this picture. Or, to change metaphors, something’s rotten with this onion. Let’s peel it back until we find the source of the stench.

First data point: Goldman’s revenues and earnings are falling even faster than its reputation. Two weeks ago, the company reported a whopping 58% drop in fourth quarter earnings, compared to 2010.

Change in Goldman Sachs' 4th Quarter Earnings by Division

This latest quarterly report punctuates a troubling three-year trend. Goldman’s full-year net income hit a record $13.4 billion in 2009, then slipped to $8.4 billion in 2010 before tumbling to $4.4 billion last year.

Reflecting this downward earnings trend, Goldman’s share price has plummeted from its 2009 high of $192 to the current quote of $111. Perhaps the stock has now reached “deep value” territory. Then again, cheap stocks have a way of becoming even cheaper when a company’s core operations are in “deep trouble” territory. Goldman’s core operations may not yet be in deep trouble, but they seem to be wading into shallow trouble, at least.

Strangely, the worse Goldman’s operations perform, the more aggressively the company repurchases its own shares. During 2009 and 2010, Goldman spent 71% of its net income buying back its stock. But last year, the company spent a whopping 264% of net income buying its stock. Even after excluding the repurchase of preferred stock from Warren Buffet, Goldman still spent a hefty 140% of its net income buying its own shares last year — double the rate of 2009-10.

Goldman Sachs Spends 100% of Net Income Buying Back Own Stock Over Last 3 Years

Furthermore, Goldman did not buy back its stock very opportunistically. In other words, Goldman did not “buy low.” The company paid an average of $128.33 for the shares it acquired in 2011, compared to a low tick for the year of $84.27 and a current quote of $111. Is it not a little strange that the same Wall Street firm that is supposed to be packed to the ceiling with genius traitors couldn’t trade its own stock any better than a raw amateur?

When stewards of the company are trying to build shareholder value through a share-repurchase strategy, they usually try to buy their stock on weakness…and only on weakness. By contrast, when the stewards are trying to build personal checking account value, they buy their stock aggressively, no matter the price.

Just maybe, Goldman’s “investment” in its own stock was executed so carelessly and unprofitably (so far) because it had nothing to do with investing, but everything to do with lifting the stock to levels that would reward Goldman’s stock-laden partners.

Last week, the top brass at Goldman cashed in $20 million worth of stock that had been “locked up” for the last three years. (The nine privileged recipients also received another $27 million in stock that they did not sell immediately). “Starting in 2009,” Reuters explains, “Wall Street banks began shifting more of their bonus awards into stock that executives are required to hold for multi-year periods in an effort to align incentives with long-term performance.”

But as it turns out, “aligning incentives” is trickier than it sounds, especially if management is repulsed by the idea of aligning its incentives with the common shareholder. Under the new and improved “aligned incentives” era at Goldman, for example, the top insiders still found a way to enrich themselves at the shareholders’ expense. The only shareholders to enjoy an alignment of incentives were the ones in the mirror.

As noted above, Goldman’s management spent $21 billion of the shareholders’ capital buying GS stock in the open market at an average price of $171 a share. Today, the stock sells for $111. On a mark-to-market basis, therefore, Goldman’s stock buy-back “investment” has produced a loss of about $7.3 billion for shareholders — or more than the company’s total net income during the last five quarters! That’s the bad news. The good news is that these share purchases helped support the share price so that the top nine guys at Goldman could sell their stock for $20 million.

I think we just found the source of that stench.

Just maybe, the company could have identified a better investment opportunity during the last three years than its own stock…like a Treasury bond or an S&P 500 Index fund — both of which have been rising while Goldman’s stock has been sinking.

Goldman’s CFO, David Viniar begs to differ. Two weeks ago, when discussing Goldman’s share re-purchases in 2011, he said he felt “relatively certain that at some point we’re going to wish we bought back more.”

No doubt! Viniar still holds more than one million shares of GS! CEO Blankfein holds more than two million shares. “Aha!” the Goldman apologists might say, “You see, their incentives are aligned with shareholders.”

“Think again,” we would reply, “If this particular crew of insiders did not hold so much Goldman stock, they probably would not be blowing so much of their shareholders’ capital buying it. But these particular insiders have demonstrated repeatedly that they will squander shareholder capital to pay almost any price for GS, while they, for their own accounts, will unload GS at almost any price.”

If incentives were truly aligned, you would never observe a gaping spread between what the shareholder pays for his stock and what the insider is willing to receive for his stock. If the stock is a “Buy” for shareholders at $171 a share, then it is also a “Buy” for Lloyd Blankfein and David Viniar at the same price, or any price below that level. But the last three times these guys unloaded large chunks of stock — August 11, 2010, January 25, 2011 and last week — they realized average prices per share of $150, $162 and $107.

On the other hand, if the stock is a “Sell” at $107 for insiders, why did the company spend $6 billion in 2011 to pay $128 per share for the stock?

One final curiosity about Goldman’s hefty share repurchases in 2012: They took place in the midst of a period of high market volatility and uncertainty — a period during which the Federal Reserve was mandating all banks to bolster their balance sheets.

“Under the Fed’s Comprehensive Capital Analysis and Review, or CCAR,” Bloomberg News explains, “US lenders must prove they have enough capital to withstand a ‘severe’ US recession before they can increase dividends or repurchase shares.”

Despite this mandate, however, Goldman continued churning through its precious capital to re-purchase its own shares. This process has contributed to a steady erosion of its Tier 1 Capital ratios since early 2010.

Although Goldman’s Tier 1 capital still remains relatively healthy, it is moving in the wrong direction. During the last two years, most major financial institutions have been ramping up their Tier 1 capital — i.e. strengthening their balance sheets. But not Goldman. In fact, as of year-end 2011, Goldman’s Tier 1 capital — at 13.8% — had dropped to within a whisker of Citigroup’s — at 13.6%.

The 2-Year Change in Tier 1 Capital at Various Financial Institutions

A 13.8% capital ratio may be just fine in most market environments, but it is hardly disaster-proof. For perspective, Goldman’s Tier 1 ratio was 11.6% on the eve of the 2008 credit crisis. That “conservative” capital buffer would have sent Goldman into bankruptcy during the crisis, were it not for the infinite Tier 1 capital of the US Treasury.

“We put in what we want to do and the Fed tells us yes or no,” David Viniar, Goldman’s Chief Financial Officer, told analysts when asked how the bank was able to spend so much more on buybacks than it earned.

From all outward appearances, this process has always operated in reverse: The Fed tells Goldman what it wants to do and then Goldman says “yes” or “no”… but usually “yes”… as long as Goldman’s trading desk is properly positioned.

The US stock market may be a “Buy,” just as O’Neill predicts. But Goldman is a “Sell”…until the day it disappears completely.


Eric J. Fry,
for The Daily Reckoning

The Daily Reckoning