Wither Goldman Sachs?

In this recent post, I noted that Goldman Sachs is currently the 'class of the class' among US publicly-held large financial service firms.

Nearby is one of the charts I used in that post. If you were to strip away the other banks, Goldman's consistently superior performance would be more obvious.

From my records, it appears that Goldman first entered our equity portfolios a year ago, in January of 2006. Generally speaking, companies don't appear in our portfolios for more than a few years.

From a Schumpeterian perspective, firms typically fall from consistently superior performance after a rather definable time period.

That said, I don't believe Goldman will continue its enviable streak of consistently superior total return performance for too much longer. Perhaps another 18 months.

What will eventually bring GS back to earth?

Looking back to other great firms which eventually became simply average, such as Microsoft, Home Depot, Kohls, Compaq, Dell and Pulte Homes, one or more of four forces usually do the job.

First, natural market saturation can simply bring a firm's business model to a halt. To some extent, that became true of Home Depot, Pulte and Microsoft.

Closely related to this is competitive action. When a firm is consistently superior for too long, it becomes an easy target for one or more competitors to take advantage of the former's business model and exploit weaknesses, or evolving consumer preferences. Again, Microsoft partially fell victim to this force, as did Dell.

Third, regulatory attention can end a consistently superior streak, too. Wal-Mart has encountered some of this, as well as the other two forces. So has Microsoft.

And, fourth, the market simply accepts the firm's stellar performance, and expects it. This effectively destroys consistently superior performance, by pricing it into the stock, and depressing gains back to the index, or lower. Even sell-side analysts eventually wake up to a firm's consistently superior performance after about a decade.

My guess is that Goldman will face a sort of market saturation/push-back, coupled with some nuanced competitive reactions. And, then, the rising expectations among sell-side analysts that the firm will power through various problems, and maintain its performance. Once this happens, the stock's price will reflect expected continued good performance, and end the run of outperformance.

As I described Goldman's diverse business activities to a friend the other day, she quickly observed how many conflicts the firm has created with its proprietary trading operations and various underwriting and advisory businesses.

Already, it has drawn fire publicly from economist/actor Ben Stein. He wrote a New York Times editorial excoriating the firm's chief economist for having allowed the firm to underwrite so much mortgage securitization earlier this year, while privately forecasting a bear market for the instruments.

But, really, everyone knows this is Goldman's game. Stein, while perhaps technically correct, appeared naive by writing that piece.

It's no accident that Goldman publishes its equity recommendations. How better to make sure the rest of the market piles in and drives up the prices of its holdings?

I think eventually various customers/counterparties of Goldman Sachs will begin to back away from the firm, sensing they are being used and abused. Calling into question Goldman's commitment to doing the best for the customer will, I think, eventually curb its growth.

They seem pretty well-managed with respect to risk. But growth may be a different story, as the firm's profile continues to remain so high. With their CEO, Blankfein, earning north of $50MM two years running, and the firm's relatively unblemished performance, counterparties realize they are paying for these phenomena.

Perhaps one other investment banking firm will eschew so much proprietary trading, in order to earn more market share in underwriting.

Or, given that underwriting is really a commodity business, perhaps enough competitors will attract Goldman alumni that its trading approaches will be cloned, depressing the margins earned by proprietary trading among all competitors.

With John Thain running Merrill now, it could easily become a viable competitor to Goldman in a few years. I had a spirited debate last night with an ex-Merrill friend. I contend that Thain will get rid of the retail brokerage business, while my friend heatedly disagreed. But in Merrill, Thain has the perfect vehicle on which to build a newer version of Goldman, keeping what he liked about his alma mater, and changing what he thinks could be improved.

Between Blackstone, a new Merrill, and customer caution regarding Goldman's self-interested conflicts with so many of its customers, I think the next two years will see Goldman's business growth attenuate.

Add to that analysts' expectations, and Goldman's run as the single consistently superior total return performer among US large financial entities is likely to end within the next two years.