A Bet On Goldman's Future

By Dr. Duru written for One-Twenty

November 19, 2008

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After the Federal Reserve Board paved the way to transform Goldman Sachs (GS) into a bank on Sept 21, 2008, I expressed doubt that GS was worth its $130 share price at that time. For the next two weeks, GS gyrated wildly around (mostly below) $130 and has not been that high since. Warren Buffet's sweetheart deal for a piece of Goldman brought a temporary reprieve to the selling. But since mid-October, GS has been on a steady and sure decline to $62 - a near all-time low, and less than half its value just two months ago. GS has been beaten up by persistent analyst downgrades and a growing sense that this decline in the shares means that "something is seriously wrong" with GS. It is a wonder that the on-going liquidation and exit from GS positions has proceeded in such an orderly fashion these past several weeks.

Given the growing negativity surrounding Goldman, I was a bit surprised to read a piece in today's Wall Street Journal by James Stewart titled "How Investors Can Get In On Buffett's Goldman Play." My first reaction was to say "why bother" betting on Goldman's future when even Buffett is now so deep underwater on his GS investment? Why bother when it seems that Buffett has slipped in the footsteps of so many other big money men who have been scalded the last 12 months trying to play value investor in financials? It turns out that Mr. Stewart is a long-time investor in GS, so he can be excused for wanting to come up with some positive rationale for clinging to those holdings. Stewart's Buffett play is to buy Jan 2010 calls to achieve the $115 strike price on the warrants. For some downside protection, Stewart recommends nabbing Goldman bonds which are now trading for 80 cents on the dollar. He purchased some bonds yielding 10%. Although such a high yield effectively puts Goldman in junk bond status, Stewart finds comfort in the seniority of these bonds and the government's incentive to do what it takes to keep Goldman alive: "Note that these Goldman bonds are senior to both Mr. Buffett's preferred stock and the government's, which means bond interest and principal gets paid before either Mr. Buffett or the Treasury. Even in the unlikely circumstance that Goldman would be facing default, the U.S. would have a strong incentive to inject more capital into Goldman."

OK. Good point perhaps. Goldman probably has a much better chance of surviving than the other investment bank disasters of 2008 given its direct and active partnership with the Treasury and the Feds. We taxpayers are being generous with corporate welfare, so maybe there is some residual I as a taxpayer can gain from this situation (besides the social good of financial stabilization). This prospect is enough get me to look one level deeper. I am not interested in purchasing Goldman bonds since I am not convinced such a pruchase is a good way for a retail investor to get some downside protection. So I focus on the options and finding downside protection with them. Whenever Stewart wrote his article, the Jan 2010 $105 calls were selling for $10. Buying at that time would achieve Buffett's $115 strike. The Jan 2010 $105 calls are now trading at $8.05/$8.55 (bid/ask). That is already at least a 15% loss in just a few days. Given the very real downside risk (and extremely high implied volatility in the options), I think a call spread would be much more prudent. For example, the Jan 2010 $105/$100 call spread costs at most $1.65 (depending on how you resolve the large bid/ask spreads). So, if GS reaches at least $105 by January, 2010, we get $3.35 upside. That is still $10 below Buffett's strike, and you get a 200% return on the spread while the stock gains 70%. Not bad for a low-risk 14-month investment. There are other spread options with similar cost profiles.

Of course, if you insist that Buffett nailed this one, if you insist that the 50% loss in just 2 months is only a temporary set-back, capping your potential gains at 200% on the calls will not look attractive...even if you need Buffett's warrants to go 14% in the money to achieve the 200% return. If the downside risks mean nothing to you, then by all means, buy the (expensive) calls outright. But I am arguing for caution by proposing the call spread as a substitute. Even Treasury Secretary Henry Paulson admitted in his recent New York Times Op-Ed that "we are going through a financial crisis more severe and unpredictable than any in our lifetimes." He reiterated this warning in recent testimony before the House Committee on Financial Services: "we have not in our lifetime dealt with a financial crisis of this severity and unpredictability." So on what basis can you really count on any specific outcome in the stock market just 14 months from now? If you want to pump up the absolute returns on this play, trade in the $8.55 for 5 call spreads. (Note that I am not considering buying puts for long-term protection given their extremely high cost. I am also assuming that someone who wants to consider this play must expect GS to survive the next 14 months and to have a higher stock price by then.)

So what is GS worth? I have no idea, and I am skeptical anyone else can assign a reliable number. GS is trading at almost half its book value, but if we have learned nothing else from this latest financial crisis, we should understand that book value means almost nothing for financial stocks, especially in a crisis economy. What is not created out of thin air can disappear into thin air just as easily. Now that the Treasury will not use its $700B authorization to purchase toxic mortgage-related assets, we will have to wait even longer for price discovery to work its way into the dark matter of the financial system. In the meantime, Goldman's steady downtrend suggests more downside to come. I will remain on the sidelines: guilty until proven innocent. The next trial (earnings) are another month away on December 18.

Be careful out there!

Full disclosure: No related positions. For other disclaimers click here.

DR. DURU®, 2008