Is the decision by Goldman Sachs to increase compensation this year a) stupid b) stubbornly short-sighted or c) eminently sensible?
Welcome back, Goldman Sachs. It may be too early to call a recovery just yet, but Goldman Sachs had plenty to smile about in its third quarter results (for a full summary of its performance see the table at the bottom of this article).
But perhaps the best indication that Goldman Sachs thinks it is on the road to recovery is that it chose to increase the amount its set aside to pay its staff in the first nine months of the year: compensation increased by $1bn (or 10%), even though the average number of staff at the firm fell by around 7% over the same period.
Averages are fairly useless when it comes to pay, but this means that the annualised average compensation cost per employee at Goldman Sachs has increased this year by some 18% to around $451,000.
While its headline compensation ratio (compensation as a proportion of net revenues) stayed the same, Goldman Sachs passed on the opportunity to reduce pay in absolute terms. In other words, Goldman Sachs stuck two fingers up at critics who argue that it should pay its staff less and give a higher proportion of the rewards to its shareholders.
Dividing the spoils?
It’s very easy to get worked up about this. On paper, you can make a strong case that Goldman Sachs should have paid its staff less. Let’s assume that over the first nine months of the year Goldman Sachs showed more restraint and set aside the same as it did last year to pay its staff. This would have saved $1bn, and the bank’s comp ratio would have fallen from 44% to 39% (compared to 34% at JP Morgan this year).
In theory, pretax profits would have increased by 13%, and the bank’s pretax margin would have jumped to just over 33%. Pretax ROE would have been a couple of percentage points higher than the reported 14.7%, taking the bank dangerously close to generating a return above its cost of capital.
In terms of valuation, this shift in reward from staff to shareholders may even have pushed the bank to trade above book value for the first time in years (it currently trades at 0.9 times book value on a multiple of just over 10 times its annualised net profits). Run a billion dollars less cost through the business over the first nine months of the year and you might just end up with a market cap north of the bank’s book value.
But then again, you might not. While all of this makes a lot of sense on paper, in the real world shareholders should perhaps be even more concerned if Goldman Sachs suddenly decided to slash a billion dollars from its wage bill just to keep them happy.
Goldman Sachs would argue that in order to be successful over the long term, any company needs to stick to its strategy. And an essential part of strategy is ‘fit’ – that slightly indefinable notion that everything a company does should ‘fit’ with everything else that it does. Once you start tinkering at the edges, and doing things on an ad hoc basis for short-term gain that don’t ‘fit’ with the rest of your strategy, then things start to unravel.
An excellent article on Harvard Business Review this week argued that one reason Goldman Sachs survived the financial crisis was by not putting the short-term interests of its shareholders first.
Over the past few years, even as its returns to shareholders have collapsed and its business model has looked increasingly broken, Goldman Sachs has resolutely stuck to its strategy. Part of this is trying to hire and retain the best people in the industry and pay them very large amounts of money in exchange for working unfeasibly hard.
If it suddenly starts paying less, then it suddenly stops being Goldman Sachs, and becomes something closer to JP Morgan or UBS or Morgan Stanley. In the short-term, this approach may be hitting profits and dragging on the share price, but the bank would argue that this course is in shareholders’ longer terms interests.
This is a polite way of saying that if shareholders want to own shares in a bank that pays its staff less, they have a wide selection of banks from which to choose. Nobody is forcing them to own shares in Goldman Sachs, but if they want to do so (and its shares are up more than 30% this year), they should accept that high pay is part of the deal.
This line of argument may seem counter-intuitive (and even offensive). But at a time when the entire industry is reinventing itself, it makes sense. The issue for Goldman Sachs is that this line of argument has a short half-life: if the bank is not making proper money for its shareholders within the next few quarters, then it will merely look like its staff were being short-sighted and greedy, and it may well have to think again.
This chart summarises how Goldman Sachs’ performance in the third quarter and over the first nine months of this year, and looks ahead to its full year results. At this rate, pretax profits at the firm will be nearly 90% higher than last year: