THE "GOLDMAN" SAGA

"If there must be madness, something may be said for having it on a heroic scale."
-- John Kenneth Galbraith, "The Great Crash of 1929"

"Corporations don't tell lies; someone within the corporation lies."
-- John Coffee, Columbia Law School Professor

On Monday, the Securities and Exchange Commission (SEC) hit Bank of America with a (measly) $33 million penalty for paying nigh unto $6 billion of bonuses to Merrill Lynch execs in 2008.

The bailout of American banks was supposed to provide money for loans. But -- according to a report released last week by a watchdog agency overseeing the financial rescue program -- instead of boosting lending, banks have used the funds provided by the government (read: "you and me") to pay down debt or, believe it or not, buy other banks.

So today, I won't be asking you to look at the market or at a sector or a stock. Instead, I'm going to tell you a story. It's a fairly involved story, with lots of intrigue; as such I'll tell it in two parts.

It's a story with many lessons. And it's a story that is not, unfortunately, unique, in that there are others who could also be placed under a similar revealing lens (see B-of-A mention above).

Today we're going to turn our attention to Part 1 of "A Wall Street Saga." Today's installment is "A 'Goldman' Opportunity."

Let's Start at the Very Beginning ...

In 1869, a German immigrant named Marcus Goldman, along with his son-in-law Samuel Sachs, founded a company that led the way in propagating the use of commercial paper.

In other words, they loaned short-term IOUs to small businesses (vendors, really) in New York City. The company’s name, as you’ve probably guessed, is Goldman Sachs.

There are many interesting things about the history of Goldman Sachs that are worth knowing about:

• The investment trust game it played during the Great Depression.
  
• Its pioneering role in the introduction of IPOs, the firm’s adoption of the ethical mantra “long-term greedy” in the '70s and '80s.
  
• Robert Rubin’s relaxing of financial-market regulations that led to the complete disregard for underwriting standards (established in the '30s) and the subsequent dot-com bust (because only "insiders" knew about the changing of the rules, investors were left out in the cold).
  
  
• Its practice of laddering while introducing Internet IPOs, for which it paid a paltry settlement of $40 million in 2005 (Google “Nicholas Maier” and “Jim Cramer” -- yes, that Jim Cramer, a former GS employee) and its practice of spinning, which earned it another meager settlement of $110 million, prompted by a 2002 House Financial Services Committee report. (Google GS and “special stock offerings,” along with eBay and Enron).

Between 1999 and 2002, GS paid an average of $7 billion a year in comps and "bennies," about $350,000 a year per employee.

Now last year, during the financial crisis with which we all have become intimately acquainted (through no desire of our own), Goldman Sachs Group Inc. became a bank holding company (BHC).

The trouble is, after more than half a year as a BHC, several analysts at CreditSights (an independent fixed-income research firm) have noted that Goldman is still "not reporting like a bank and not acting like one, either."

In a note to investors after the latest earnings report, they wrote, “The company has basically been given a green light to continue operating in a 'business as usual' fashion.” In fact, at the end of 2008, CEO Lloyd Blankfein reiterated that the firm would continue "to be an adviser, financier, co-investor and asset manager." No talk of ATMs there, is there?

With more banks continuing to fail, regulators have their hands full and are apparently ignoring Goldman’s unchanging behavior. For instance, say the analysts, the firm doesn't disclose a full balance sheet in its earnings release.

Hmm.

The 'Thought Plickens'

Goldman was a big player in the bundling of mortgages into Collateralized Debt Obligations (CDO), which mixed the good with the bad (and garnered its AAA rating). Companies like AIG provided the insurance on the CDOs in an instrument known as credit-default swaps.

Old news, I know.

Now, I'm not a conspiracy-theorist sort. I am a rationalist, and most conspiracy theories seem to me to be a linking of disparate facts by coincidence in the fashion of "The Da Vinci Code." But I started to wonder just how far Goldman Sachs' influence spread, and by what means.

I first found out that back in 2000, AIG asked the New York State Insurance Department (NYSID) whether default swaps would be regulated as insurance. The head of the NYSID ruled that swaps were not to be regulated. This was Neil Levin, a former Goldman Sachs V.P.

Now, we all know that Henry Paulson was a former GS CEO, and that former Clinton administration Treasury Secretary Robert Rubin was a 26-year veteran of the company. But the list goes on:

• John Thain of Merrill Lynch ("who bought an $87,000 area rug for his office as his company was imploding")
  
• Robert Steel of Wachovia (received $225 million as Wachovia disintegrated, only to rise from the ashes as a Wells Fargo subsidiary)
  
• Joshua Bolten, GW's chief of staff, and Mark Patterson, Obama's Treasury chief of staff (former GS lobbyists)
  
• Ed Liddy, former GS director placed in charge of AIG by Paulson

There, of course, are more. But you get the picture.

Something you may not have known, however, is that -- in addition to the $10 billion in TARP funds that GS recently paid back to the government -- it received $13 billion from AIG when Liddy was put in charge.

"By the peak of the housing boom in 2006, Goldman was underwriting $76.5 billion worth of mortgage-backed securities -- a third of which were subprime. ... But even as it was doing so, it was taking short positions in the same market ... and that net short position was profitable."

So Goldman was hedging its bets, and making more money doing so than from the mortgage CDOs themselves.

Is there no justice?

Well, of course there is. Sort of.

Lawsuits came. Some are still there. Massachusetts won a humungous settlement from GS of $60 million.

Black Gold, Texas Tea

Where to go?

Well, as Barbara Cohen has so poignantly pointed out in her Monday columns in The Tycoon Report, futures can make a world of difference in the market.

We saw what happened to the price of oil in the last year, even though production was increasing while demand was decreasing. (A classic scenario for a reduction in the price of a commodity. Even now, we're at a 20-year high in supply and a 10-year low in demand.)

How did we get here? Guess who had a dipstick in the oil tank. ...

Goldman Sachs got big, big investors to start buying oil futures, transforming the commodity into a gambler's dream. No longer dependent upon supply and demand, by 2008, "a barrel of oil was traded 27 times, on average, before it was actually delivered and consumed. ...

"(I)n fact, commodities speculators had bought and stockpiled enough oil futures to fill 1.1 billion barrels of crude, which meant that (they) owned more future oil on paper than there was real, physical oil stored in all of the country's commercial storage tanks and the Strategic Petroleum Reserve combined."

(Google "Bona Fide Hedging exemption" for more insight into GS' dealings with the Commodity Futures Trading Commission, the body that tried and failed to regulate credit-default swaps.)

That's enough to chew on for this week, but the best on this topic is yet to come. Next week, we'll talk about how Goldman Sachs gets its grubby little fingers into taxpayer money, global warming, and programmed trading.

The Only Things Certain are Death and ... WHAT?!!?

If you said "taxes," you must not be at Goldman Sachs! Check out this timeline of events:

September 2008: Treasury Secretary Hank Paulson chooses to let Lehman Brothers fail. By doing so, he eliminates Goldman Sachs' last real competitor.

The Next Day: Treasury Secretary Hank Paulson bails out AIG. AIG hands over $13 billion of the received funds to Goldman in repayment of debt owed.

Shortly Thereafter: Treasury Secretary Hank Paulson implements the Troubled Asset Relief Program, a $700 billion federal bailout for the financial industry, placing Neel Kashkari, a 35-year-old Goldman banker, in charge of administering the funds.

In the Wink of an Eye: POOF! Goldman transforms from an investment bank into a bank-holding company and gets $10 billion in TARP monies.

Same Day: Since the transformation, Goldman is now supervised by the New York Federal Reserve, headed by Stephen Friedman, former co-chair of GS. (He got a conflict-of-interest waiver, which made him big bucks because he not only didn't have to divest himself of GS stock, but he also bought 52,000 more shares.) He leaves the Fed in May 2009.

Current Day: William Dudley is now the N.Y. Fed president, a former -- surprise! -- Goldman Sachs fellow. And GS is back to its old tricks, moving up its earnings report calendar to effectively wipe out December of last year ($1.3 billion loss) and reporting a $1.8 billion Q1 profit, partly due to the AIG bailout money. That, remember, is money that you and I paid.

Goldman Sachs paid out $10 billion in comps and "bennies" in 2008 and made over $2 billion in profit.

It paid 1% in taxes in 2008. An incomprehensibly insignificant $14 million.

According to Matt Taibbi, "The low taxes are due in large part to changes in the bank's 'geographic earnings mix.' In other words, the bank moved its money around so that most of its earnings took place in foreign countries with low tax rates. ... A GAO report, in fact, found that between 1998 and 2005, roughly two-thirds of all corporations in the U.S. paid no taxes at all."

Cap'n (Trade) Crunch

There's a Democrat in the White House. Regardless of your political leanings, it's hard to escape the fact that around $981,000 was given to Barack Obama's campaign by Goldman Sachs employees. Or the fact that many GS alumni are still in high places in government posts.

In case you missed last week's section on commodities, you can read it here. But all you really need to know is that it's déjà vu all over again.

This time it's carbon credits.

The current cap-and-trade bill in Congress is designed to allow those companies who produce greenhouse gases over a given limit for their industry to buy “credits” from those companies who were able to come in under the limits in their carbon emissions. The estimates for these auctions over the course of the first seven years ranges from $650 billion to $2 trillion.

During the past few years, Goldman Sachs has sent its lobbyists to Capitol Hill to full-court press Congress for cap-and-trade. One of these lobbyists was Mark Patterson, current Treasury chief of staff.

Why Would GS be so Environmentally Concerned?

Tabbi reports that GS “owns a 10% stake in the Chicago Climate Exchange, where the carbon credits will be traded,” as well as a portion of carbon-credit reseller Blue Source LLC. (Read about the “strategic alliance” at Ghgworks.com/2b-alliances.html.)

I consider myself an environmentalist but I, for one, am against the cap-and-trade legislation making its way through the congressional halls of D.C. I believe that the fairest and most-effective way to give companies the incentive to reduce emissions is by taxing them directly.

I’m not alone in this thought. Hedge-fund director Michael Masters said:

"If it's going to be a tax, I would prefer that Washington set the tax and collect it. But we're saying that
Wall Street can set the tax, and Wall Street can collect the tax. That's the last thing in the world I want.
It's just asinine.”

A Man's Reach Should Exceed His Grasp, or What's a Market For?

The market is designed for good, worthwhile and well-managed companies to rise to the top and for companies with bad ideas, insufficient capital or poor execution to sink to the bottom. Money goes to the productive and shies away from the ineffective.

Conventional wisdom says that the market is just too big to be manipulated. I’m beginning to question the conventional wisdom.

Super-fast computers make trades in milliseconds. They can buy and sell hundreds of securities while you’re still reaching for the “Enter” key.

Honestly, I’m not sure what value they add to the market, other than the efficiencies and excessive profits they grant their owners.

Goldman Sachs admits that it profits from HFT, High-Frequency Trading, but it refuses to admit the possibility that this might give them an unfair advantage over those without such advanced computers, including you and me.

Here’s one example of how it could.

I know that, to ensure transparency, orders issued by an exchange are supposed to arrive simultaneously, so that everyone sees them at the same time. Enter the loophole: Some marketplaces (e.g., the Nasdaq) that pay a fee can receive the orders ahead of everybody else.

To put it simply, investment banks like Goldman Sachs are able, with these super-fast computers, “to front-run the rest of the market by determining investors’ sentiments by virtue of being able to examine incoming orders and estimate the upper limit of how much the market traders (a)re willing to pay for shares”.

Can anyone tell me what this ability to quickly make has to do with developing a analytical investment strategy or with improving liquidity in the market?

The Final Straw

On July 3, Sergey Alynikov, who used to program these supercomputers for Goldman Sachs, was arrested in Newark, New Jersey. He was charged with allegedly stealing the software code for GS’ proprietary trading program.

According to an article by David Glovin published on Bloomberg.com, “The prosecutor, Assistant U.S. Attorney Joseph Facciponti, was quoted as telling the court: ‘The bank has raised the possibility that there is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways.’ “

If someone else could use the program to manipulate the markets in unfair ways, why is it assumed that Goldman Sachs would do no such thing?

I think you already know what I think.

A mistake that could wipe out your returns

Quite a few experts have taken the July payrolls report in the US as an indication that the worst is behind. And now, there has been another landmark event that has had its genesis in the same report. As readers would have noted, ever since the onset of the global financial crisis, every sign of US economic recovery has been greeted with a fall in the dollar and vice versa. However, this trend, which lasted for about 18 months, was broken recently when the employment report came in better than expected, leading to a rally in the dollar. This has led many to believe that the US dollar has now embarked on a new journey, which will see it surge even more in the coming months. And if the upcoming Fed meeting has some bullish undertones on the US economy, it will give the dollar's rise even more wings.

However, not all are convinced. Some believe that the dollar's rise just as in the month of May is a temporary phenomenon and the dollar is likely to remain under pressure till Fed raises interest rates, something that is not going to happen at least until 2011. Clearly, with the US not likely to turn into trade surplus anytime soon and with its assets not expected to generate substantial returns, interest in the US dollar is likely to be speculative at best.

Indeed, if the US dollar is likely to remain weak and hence, erode its value in real terms, gold is likely to reinforce its case of being the most suitable countervailing asset class. Infact, as per a leading daily, in almost all but a global soft landing scenario, gold is likely to rally and with a global recovery unlikely to be smooth, the two main threats, viz. inflation and US dollar are both a big positive for gold. Little wonder, gold prices are expected to continue with its good performance in 2009 and also likely to breach the 2008 highs of US$ 1,030 per ounce as per the same daily. What's more, even after the rally of the past eight years, the yellow metal is still just half of its inflation adjusted previous peak, leading many experts to believe that its price may touch US$ 3,000 per ounce in due course of time.

Monsoon, Agriculture & Government

Source: CMIE

The India Meteorological Department (IMD) has indicated that the monsoon rains this year is likely to be 87% of the long-period average. That's the weakest in seven years. The last time the rains were this bad was in FY03. Given the very strong linkages between rainfall and the entire Indian economy, we decided to revisit FY03 to gauge the impact of poor monsoon rains. The two crops that are likely to suffer the most due to poor rains this year are Rice and Sugar. Let us see how they fared in FY03. As per RBI data, Rice production fell by 23%, from 93 m tonnes (MT) in FY02 to 72 MT in FY03. Sugarcane production fell by 3%, from 297 MT in FY02 to 287 MT in FY03. Overall, the impact on agriculture was severe as food grain production fell by 18%, from 213 MT in FY02 to 175 MT in FY03.

Industries which depend on agriculture directly suffered. Production of tractors fell by 15%, from 226,000 units in FY02 to 192,000 units in FY03. In fact, the effect lasted for another year as production of tractors fell by another 7% in FY04 to 179,000. However, commercial vehicles (CVs) production did not suffer at all. Production of CVs grew by 36%, from 146,000 in FY02 to 199,000 in FY03.

The last time monsoons were this bad, it did leave a big impact on the overall economy. In FY03, GDP growth rate declined to 3.8% from 5.2% in the previous year. The question is will India suffer as much this year as it did the last time the monsoon was this bad? We will discuss this topic further in the forthcoming issues.

Speaking of agriculture, the sugar prices in the international markets have skyrocketed, rising 60% since December 2008. The situation is aggravated by fears of shortfall in supply due to adverse weather in producing nations such as India. The global shortfall is projected to be 8 m tonnes (MT).

The chart captures the trend in sugar prices and production in India. India, the second-largest producer, is likely produce around 18 MT of sugar and is expected to import a total of 5 MTs in FY10. The feast- to- famine swings in sugar cycle is aggravated by the government's policy of regulating the sugar prices. For example, in 2006 the government banned exports in order to bring down the prices, resulting in a glut and a steep fall in price in the subsequent months. As a result, many farmers switched to different crops. In contrast to India, Brazil, the world's largest sugar producer has steadily increased production and exports, and is now benefiting from India's shortage.

Today's investing mantra

The really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions. - Warren Buffett

Reality Check for China's Growth

Source: IMF World Economic Outlook 2009

This can really be the revelation of this decade. Marc Faber, a leading economist and publisher of the Gloom, Boom and Doom report has said that China's economy is growing at 2% and not 7.8% as its government claims. If this is true, then the Indian economy, expected to grow by 6% in the current fiscal, will be outperforming China by 3 to 1 (now this is assuming that the Indian statisticians are not lying as well!).

Interestingly, Faber has also told a leading business channel, "The Chinese government is one of the few governments in the world that knows its GDP numbers three years in advance. I'd be a bit careful about China."

Faber adds, "If you throw money at the system, lots of things go up in value - but maybe they go up for the wrong reasons. What disturbs me today is that the lows in March and late last year, sentiment was incredibly bearish about everything. Now there's this incredibly bullish sentiment when insiders are actually selling and the technical picture of the market doesn't look that great."

Faber believes that the Chinese markets face headwinds because there's a huge supply of available shares and a record number of new issues, which dampens share-price increases. (China State Construction Engineering Company just launched a US$ 7.3 bn IPO, and the shares listed 56% higher than the offer price at 40 times 2009 forecasted earnings!)

Faber warns, "My sense is that, near term, we could still have disappointments because now the mood is very optimistic. I don't think we'll make new market lows in Asia, but I do think we'll have a meaningful correction."

ARE YOU AN INTELLIGENT INVESTOR?

Now let’s answer a vitally important question. What exactly does it mean by an “intelligent” investor? it is clear that this kind of intelligence has nothing to do with IQ or SAT scores. It simply means being patient, disciplined, and eager to learn; you must also be able to harness your emotions and think for yourself. This kind of intelligence, “is a trait more of the character than of the brain.”

There’s proof that high IQ and higher education are not enough to make an investor intelligent. In 1998, Long-Term Capital Management L.P., a hedge fund run by a battalion of mathematicians, computer scientists, and two Nobel Prize–winning economists, lost more than
$2 billion in a matter of weeks on a huge bet that the bond market would return to “normal.” But the bond market kept right on becoming more and more abnormal—and LTCM had borrowed so much money that its collapse nearly capsized the global financial system. And back in the spring of 1720, Sir Isaac Newton owned shares in the South Sea Company, the hottest stock in England. Sensing that the market was getting out of hand, the great physicist muttered that he “could calculate the motions of the heavenly bodies, but not the madness of the people.” Newton dumped his South Sea shares, pocketing a 100% profit totaling £7,000. But just months later, swept up in the wild enthusiasm of the market, Newton jumped back in at a much higher price—and lost £20,000 (or more than $3 million in today’s money). For the rest of his life, he forbade anyone to speak the words “South Sea” in his presence.
Sir Isaac Newton was one of the most intelligent people who ever lived, as most of us would define intelligence. But, in my terms, Newton was far from an intelligent investor. By letting the roar of the crowd override his own judgment, the world’s greatest scientist acted like a fool.
In short, if you’ve failed at investing so far, it’s not because you’re stupid. It’s because, like Sir Isaac Newton, you haven’t developed the emotional discipline that successful investing requires.
I will later describe how to enhance your intelligence by harnessing your emotions and refusing to stoop to the market’s level of irrationality. There you can master his lesson that being an intelligent investor is more a matter of “character” than “brain.”.

Stock picking is more of a art than science

I do not believe the times are uncertain. Only the era of easy money making is behind us. Current market conditions call for more skills and the stock selectivity would play a key role now onwards.

1. My message would be firstly that equities are the riskier class of assets. That does not mean one should avoid it. It only means that one should allocate only that portion of one's savings with which he can afford to take such risks.

2. Secondly, one cannot expect superlative returns of the recent past from equities. But equities will deliver superior returns over a longer period. Hence, one should always keep the long term perspective in mind while investing in the capital market and should not invest money for short-term requirements in the capital market (stock market).

3. Instead of trying to time the market for entry, one can invest in equities through the Systematic Investment Plan. I am not too sure investors would be able to track the many variables influencing the market. Hence, I believe investing through mutual funds could be a safer option to the investors as they get diversification and quality fund management backed by research.

The Indian market has been in a bull trend since the march of 2009 and I don't believe that this trend will continue for a longer period. Of course, the market will have sharp volatilities as it scales newer peaks. The valuation concerns would keep coming every now and then.

I believe the players would be surprised by the companies performance. One needs to take a call on the future growth potential of the companies as stock prices build in the future expectations.

While we could see plenty of opportunities and no-brainer stocks two years back, market at current levels is a real challenge.

Nevertheless, opportunities exist in this market for a patient and discerning investor.

One cannot expect superlative returns of the recent past but can reasonably expect returns, which are superior to any other alternative form of investment available to the investors. The market would remain volatile though.

Where to invest for a regular income

Stock picking is both an art and a science and in my opinion, more of the former.

As basically the stock prices reflect the future expectations, one tends to differ with another in the perceived or intrinsic value of a stock.

Stock picking is the core of fund management.

We take full advantage of the bottom-up and the top-down approaches. And also consider both value picks and growth picks.

Essentially, we focus more on the future growth prospects of the company along with the valuation.

We believe in combination of different approaches like what Charlie Munger calls 'Latticework of Mental Models' involving application of various sciences to the art of investing.

If there are huge growth opportunities for a company and they have the managerial abilities to tap those opportunities, then they merit a closer look.

Continuous data analysis is carried out by our research department to select the companies in terms of attractiveness of valuation and the growth potential. This is followed by due diligence by meeting the management and undertaking the plant visits.

We look at variables like quality of management, the size of the market, ability of the company to scale up operations, the competition and a host of other factors.

when to sell the stocks

Decision to sell is one of the critical decisions for any fund manager.

Normally I exit a stock when I find a better opportunity. When I believe the stock price is running ahead of fundamentals.

We have a system of review of our holdings when the price moves up by 20% from our cost price or the last review price to decide on booking the profits.

We exit partly if we decide to increase the cash position as a defensive strategy to reduce the market risk.