BARRON'S COVER
Diet Time!
By ANDREW BARY
Wall Street pay is, indeed, too high. But management and corporate boards should do the trimming, not Uncle Sam. Why Goldman's selloff last week could be a buying opportunity.
Gary Hoveland for Barron's
WHETHER OR NOT YOU AGREE WITH President Obama's new proposals to restrict the size and activities of America's big banks, it's hard to argue that he shouldn't have a role in the policymaking process. But when it comes to cutting Wall Street pay, he's barking up the wrong tree.
It's up to management and corporate boards to rein in compensation because it's in shareholders' interests to do so. Shareholders own these companies, not employees, although the firms have long operated as if employees' interests were paramount. Lower pay probably will mean higher profits and bigger capital cushions against potential losses. It's time for an end to the notion that Wall Street employees are entitled to half the firm's profits.
Goldman Sachs and JPMorgan Chase are starting to get it and that's good news for investors. Goldman (ticker: GS) surprised Wall Street last week when it reported that its ratio of compensation to revenue was 36% last year, the lowest figure since it went public in 1999 and below the annual average of 47% over that span. JPMorgan (JPM) set aside 33% of net revenues as compensation in its large investment bank during 2009, down from 62% in 2008. Morgan Stanley's (MS) ratio of compensation to revenue at its institutional securities division stood at 40% in 2009, adjusted for the big impact of movements in its debt spreads on its financial results. That was down from an outsized 110% in 2008.
The political backdrop obviously helped drive the new pay restraint, but the trend ought to continue, with a 35% compensation ratio becoming the new norm. Lower compensation is good politics and good business. It's notable that another people-intensive business, asset management, has a compensation-to-revenue ratio of around 35%, including industry leader BlackRock.
There is enormous franchise value at companies like Goldman Sachs, JPMorgan and Morgan Stanley owned by shareholders and built up over a generation that allows current traders and investment bankers to earn some of the best pay in America. Having a Goldman Sachs business card is a big help to the firm's investment bankers and Goldman bond, equity, currency and commodity traders benefit from knowing what big institutional investors are doing. Bernstein analyst Brad Hintz wrote that he's regularly asked how bond trading desks can make money without taking a lot of proprietary trading risk. "It's like being an 8-year-old child standing over an ant hill. The child sees patterns in all the ants' movements" while the individual ants only "see the tail of the ant ahead of them."
Part of the 2009 compensation decline is cosmetic because firms are paying a greater proportion of employee bonuses in stock rather than cash. Stock awards are expensed over the life of the vesting period, which typically runs three to five years, while cash is expensed immediately.
The game, meanwhile, is getting tougher on Wall Street because of higher capital requirements, tighter regulation and potential new taxes. In an environment of lower returns and potential curbs on trading, major firms need to retain more of their profits for shareholders to maintain profit levels and returns.
Shares of Goldman, Morgan Stanley, JPMorgan and Citigroup (C) fell sharply Thursday and Friday after the Obama administration proposed new rules to curb proprietary trading. Obama isn't popular on Wall Street but he has a point here. All the major firms benefit from a federal financial safety net. Why should they take advantage of that backstop to gamble with firm capital? If they win, they reap the benefits. If they lose badly, taxpayers may have to foot the bill, as they did for AIG and Bear Stearns.
A separate, proposed new tax on non-deposit liabilities would sting trading operations and potentially cost JPMorgan and Citigroup $2 billion annually and Goldman and Morgan Stanley, $1 billion each, KBW analysts have estimated. "The political pressure probably will be around for a while," says Keith Davis, an analyst with Farr, Miller & Washington, a Washington, D.C., investment firm that holds Goldman and JPMorgan shares. "I think the compensation-to revenue ratio is going to be something south of historical levels for a while, whether its 34% or the high 30s. The actions by Goldman and JPMorgan incrementally take some political heat off them, but the absolute pay numbers are still huge. They're still paying a ton of money to their traders."
Wall Street employees may represent the most highly paid large group in the country, with a more restrained Goldman still rewarding its 32,500 employees an average of $500,000 in pay and benefits last year and JPMorgan doling out an average of almost $400,000 in 2009 to the workers at its investment bank.
The selloff in shares of Goldman and its peers last week could represent a buying opportunity. The major firms remain highly profitable and they've already curbed their proprietary trading. Morgan Stanley and JPMorgan are largely out of proprietary trading, while Goldman is believed to have scaled back its Special Situations Group, which invests firm capital around the globe.
JPMorgan, at 39, trades at its book value and for 1.4 times tangible book, a conservative figure that excludes goodwill from acquisitions and other intangible assets. Morgan Stanley, at 28, trades around book value and 1.3 times tangible book. Goldman, which historically has earned some of the best returns in the group, trades for 154, 1.3 times book value of $117 a share and 1.5 times tangible book.
The stocks also look reasonable based on projected 2010 profits, although Goldman's heavy reliance on trading operations makes earnings harder to predict.
JPMorgan trades for 13 times estimated 2010 profits of $3 a share and eight times projected 2011 earnings. Morgan Stanley trades for nine times estimated 2010 profits of $3 a share and Goldman fetches eight times projected 2010 profits of $18.60 a share. If Goldman can earn $18 a share in 2010, its year-end 2010 book value could hit $135 a share, meaning the stock trades for a reasonable 1.1 times forward book.
Goldman, Morgan Stanley and JPMorgan aren't likely to return much cash to investors in 2010. The three have dividend yields of less than 1% and only JPMorgan is seen making a major boost in its payout. Stock buybacks are on hold for now because regulators probably want to see capital build, not get reduced. Goldman was noncommittal on its conference call about buybacks, citing regulatory uncertainty.
On a sum-of-the-parts basis, Goldman looks intriguing because of the value of its nontrading operations, including Goldman Sachs Asset Management, which runs $871 billion and could be worth $15 billion. If Goldman's investment-banking advisory were spun off and got the high valuation of banking boutique Greenhill (GHL), it could be worth $15 billion, too. That suggests investors are paying about book value for the rest of the firm, whose market value is $90 billion.
"We don't believe there is significant downside potential" in Goldman shares, Barclays Capital analyst Roger Freeman wrote Friday. One positive for Goldman, he noted, was that rising book value should underpin the stock given the high level of profit retention expected in 2010. "The good news for investors is that reduced compensation flows directly to higher earnings, ROE (return on equity) and book value growth." If Goldman shares rise in line with book growth in 2010, the stock could hit $190. Freeman has a neutral rating on the stock and a price target of $195.
Goldman earned $22.13 a share in 2009, up from $4.47 in 2008, helped by its surprise fourth-quarter move to remove more than $500 million from the $16.7 billion pool already set aside in the first three quarters of 2009 for compensation and benefits. This was a shrewd move to help defuse the bonus outcry. The reduction in compensation more than offset a decline in trading profits. Analysts expect trading conditions to be even tougher in 2010.
For Goldman in particular, employee compensation is crucial to earnings because it gets nearly all its profits from trading and investment banking, two bonus heavy businesses. Goldman's decision to set its compensation-to-revenue ratio at 36% rather than 45% boosted profits by around $4.50 a share in 2009. Each percentage point of compensation expense is worth about 50 cents a share to its earnings.
A big issue for Goldman is whether it maintains the 2009 compensation-to-revenue ratio into 2010. That was the first question posed to Goldman Chief Financial Officer David Viniar on the firm's conference call on Thursday. Viniar dodged it, saying, "I don't have an answer for you."
Wall Street firms have long defended outsized compensation as a necessary evil needed to attract and retain top moneymaking talent. It's the free market in people, our most valuable resource, the firms said. That always seemed a stretch.
The reduced pay levels of 2009 will be a test to see whether key employees bolt or stay put. Our bet is that the vast majority of the people who matter don't go anywhere. Compensation levels are being reduced Streetwide, which means that there probably aren't many other greener pastures. Additionally, more compensation is in the form of stock that vests over several years, tying employees to their firms.
There aren't many investment bankers who can be absorbed by boutiques like Greenhill and Lazard, and departing Goldman bankers may find that they don't have the same clout with clients without the vaunted Goldman underwriting and trading franchise behind them. There also are only so many hedge funds to lure top traders. Goldman talks endlessly about its prized culture. But if the culture is so attractive, why do employees need to be paid so much to stay? Maybe they're being paid too much.
Moreover, the trend away from proprietary trading and an emphasis on customer oriented transactions reduces the need for expensive star traders who successfully take big risks with firm capital. And what else are Street employees going to do that will pay them remotely like what they earn now? What special skills does the average investment banker or trader possess?
Let's face it. Wall Street has been a great place to work, but a lousy place to invest in the past decade. There were eight major securities firms and banks with big investment-banking operations around a decade ago. Three of those companies, Lehman Brothers, Merrill Lynch and Bear Stearns no longer trade, and the average performance of the eight stocks has been negative 47%. Only Goldman Sachs is above where it stood at the end of 1999. During this period, employees reaped hundreds of billions of dollars in compensation.
It's time for management to put shareholders' interests first. The Street is creative at finding new ways to make money, and Goldman and its rivals likely will continue to do so. Let the Street pay people well. Just don't give away the store to them.
Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved
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